Initial and post-acquisition recognition of joint ventures in the con-text of M&A transactions

published on 17 May 2023 | reading time approx. 4 minutes

In the context of a business combination, it is necessary to perform a purchase price allocation of the investment regarding the consolidated financial statements prepared in accordance with IFRS. Apart from the initial recognition, especially post-acquisition recognition can cause difficulties if interests in a joint venture are also acquired as part of the deal. In this case, it is necessary that, for the purpose of post-acquisition recognition, an allocation of the purchase price is performed regarding the assets of the joint venture. In order to navigate pitfalls and manage the level of details, this necessity should be recognised early on.

The necessity and the objective of purchase price allocation

After the successful closing of an M&A transaction, a so-called Purchase Price Allocation (also known as “PPA”) in accordance with IFRS 3 is required for business combinations in order to prepare the consolidated financial statements in accordance with International Financial Reporting Standards (IFRS)*.

The objective of a PPA is to allocate any differences between the carrying amount of the assets acquired and the purchase price paid. Thus, the identifiable assets acquired and the liabilities assumed are measured at their acquisition-date fair values [IFRS 3.18]. This in-cludes both assets already recognised and assets not yet recognised.

In addition to the revaluation of land and buildings or machinery and office equipment as part of property, plant and equipment, the most common intangible assets valued in the context of PPAs are trademarks, customer relationships and technologies. Often and in line with reporting standards, this marks the initial balance sheet recognition of these items.

However, a PPA also directly influences the future earnings position of the acquirer. This is because the disclosure of hidden reserves in the case of acquired tangible and intangible assets appropriately increases the depreciation basis, which results in lower earnings before interest and taxes (EBIT) in subsequent periods.

Joint arrangements: a joint venture or a joint operation?

If the activity of the target company is carried out jointly with a partner, it is imperative to conduct thorough analysis on the according IFRS treatment. A distinction should be made as to whether the jointly carried out business is a joint venture or a joint operation. According to IFRS 11.16, a joint venture is a joint arrangement whereby the parties that have joint control of the arrangement have rights to the net assets of the arrangement. The classification of a joint arrangement as a joint operation or a joint venture depends upon the rights and obligations of the parties to the arrangement [IFRS 11.14]. To simplify, what distinguishes a joint venture from a subsidiary is joint control.

If the activity is a joint operation, it is accounted for in the balance sheet in a similar way as a proportional consolidation. However, if it is a joint venture, the parties ought to recognise their interests in the joint venture as an investment in a separate line item as part of financial assets and account for those interests compulsorily using the equity method in accordance with IAS 28.

Initial recognition of a joint venture

If a company that has interests in a joint venture is acquired in the context of a business combination under IFRS 3, the fair value of the joint venture is determined according to the discounted cash flow method. The fair value is then recognised as part of the PPA proportionately to the level of shareholding, and any hidden reserves or liabilities are disclosed.

This already concludes the necessary steps for the initial recognition. The difficulty, however, lies in the post-acquisition recognition of the recognised joint venture.

Post-acquisition recognition of a joint venture and the resulting necessity to perform a shadow purchase price allocation

For post-acquisition recognition of interests in a joint venture using the equity method, the at equity value is adjusted in every subsequent period for the changes in the investor’s share of the investee’s net assets. The particular feature here is that all underlying transactions cannot be explicitly discerned from the acquirer's consolidated financial statements, which is why items accounted for using the equity method in accordance with IAS 28 are also called “one-line consolidation items”.

According to IAS 28.10, net asset changes may include the following factors:

Increase/decrease by the proportionate profit or loss
Reduction by distributions received from the joint venture
Changes in equity that were recognised at the joint venture level with no effect on the income statement (e.g. formation/reversal of deferred taxes).
Amortisation of the recognised hidden reserves and liabilities of the joint venture

The difficulty in post-acquisition recognition arises from the last point above – amortisation of the recognised hidden reserves and liabilities of the joint venture. This is because of the necessity to not only carry out the actual PPA to enable the initial recognition but also to perform a so-called “shadow PPA” for the proportionately acquired identifiable assets and assumed liabilities of the joint venture.

The name “shadow PPA” stems from the fact that revalued assets and liabilities as well as any hidden reserves and liabilities are not directly capitalised either in the consolidated financial statements of the acquirer, the joint venture partner, or at the level of the joint venture itself in the balance sheet but are only calculated off balance sheet. Hence, the sole purpose is to derive the effects of depreciation of the proportionately acquired assets and liabilities for the purpose of recognising the joint venture using the equity method in accordance with IAS 28 in the acquirer's consolidated financial statements.

According to IAS 28.32(a), any goodwill arising from off-balance calculations may not be amortised or tested for impairment separately as per IAS 36. This is because goodwill, while not being reported separately when accounting is carried out according to the equity method, remains an integral part of the carrying amount of the investment. Therefore, if there is any objective evidence, goodwill is only implicitly tested for impairment in that the at equity value of the investment is tested for impairment [IAS 28.42]. After application of the equity method, it should be determined whether there is any objective evidence that the net investment in the joint venture is impaired [IAS 28.40].

Conclusion

The treatment of joint ventures in the context of business combinations and the necessity to perform so called shadow PPAs are an accounting peculiarity and require attention to much detail, as the determined fair values do not factually appear in any financial statements, but indirectly carry accounting effects. If the necessity to perform a shadow PPA is not identified from the outset as part of the transaction or by the preparer of the PPA for the purpose of initial recognition, this can become a significant stumbling block when preparing the consolidated financial statements at year-end.

* This also applies to US GAAP and HGB. This article exclusively focuses on the IFRS approach.

The following example for illustration purposes: