In the world of business combinations, step acquisitions—where a company gradually increases its stake in another business, ultimately achieving control—pose unique challenges in accounting. IFRS 3, “Business Combinations,” offers guidance on how to account for these types of acquisitions, including the effects on net income. When a step acquisition occurs, a gain on revaluation may be recognized, impacting the company’s net income. This article explores how a gain on step acquisition is treated under IFRS and its implications on net income.
Understanding Step Acquisition
A step acquisition, also known as a phased acquisition, occurs when an investor gradually acquires shares of an investee, eventually achieving control. Typically, these acquisitions begin with a non-controlling interest, followed by a series of purchases over time, culminating in the acquirer obtaining control of the investee. Under IFRS, the acquisition is evaluated at each step, and when control is finally achieved, the prior equity interests are remeasured at fair value.
Accounting for Step Acquisition: Key Steps Under IFRS
When an investor gains control in a step acquisition, IFRS 3 requires the acquirer to:
- Reassess Previous Equity Interest: The acquirer must revalue its existing equity interest in the acquiree at its fair value on the date control is obtained.
- Recognize a Gain or Loss: Any difference between the fair value of the existing equity interest and its carrying amount on the acquirer’s books is recognized as a gain or loss in the income statement.
- Consolidate Financial Statements: After obtaining control, the acquirer consolidates the financial statements of the acquiree, which includes incorporating the acquiree’s assets, liabilities, revenues, and expenses into its financial statements.
Impact of Step Acquisition Gain on Net Income
The gain or loss recognized from revaluing the previous equity interest can have a significant impact on the acquirer’s net income. Here’s how this impact plays out:
- Recognition in Profit or Loss: Under IFRS 3, any gain or loss arising from the remeasurement of the previously held equity interest is recognized in profit or loss. This means that if the fair value of the previous holding has appreciated since its acquisition, this revaluation gain increases the acquirer’s net income in the period when control is achieved. Conversely, if there’s a loss due to a decrease in the fair value, it will reduce the net income.
- Non-Recurring Nature of Gain: The gain on step acquisition is typically classified as a non-recurring item, given its one-time nature associated with obtaining control. Consequently, it may be reported separately from operating profits in financial statements to distinguish it from regular, operational earnings. This distinction is essential for stakeholders who analyze a company’s ongoing profitability versus one-off gains.
- Fair Value Considerations: Determining the fair value of the previously held equity interest can be complex and subject to market conditions, making the gain or loss on step acquisition volatile and potentially large. This revaluation can create a significant, albeit temporary, fluctuation in the acquirer’s net income.
Example of Gain on Step Acquisition
Suppose Company A initially held a 30% interest in Company B, accounted for as an investment in associate (using the equity method). When Company A acquires an additional 40% of Company B, it gains control, owning a total of 70%. At this stage:
- Company A must revalue its previous 30% interest to fair value.
- If the fair value of the 30% interest has increased from its carrying value, the difference is recognized as a gain in the income statement.
- The gain, reflected in net income, is included in that year’s financials but does not recur in subsequent periods.
Implications for Financial Analysis
The gain on step acquisition, being part of net income, can temporarily inflate profitability ratios, such as return on assets (ROA) and return on equity (ROE), potentially giving a skewed view of the company’s operational performance. Analysts and investors often adjust earnings to exclude these non-recurring items when evaluating a company’s core operating performance.
Conclusion
Under IFRS, a gain on step acquisition can have a considerable effect on net income, reflecting the increase in the value of previously held interests. While this boost to net income is favorable in the short term, it is a one-time gain, not reflective of operational performance. Therefore, it’s essential for stakeholders to distinguish this gain from recurring income to assess the company’s true profitability accurately.
