JOHANNESBURG — Chartered Accountant Glynnis Carthy is going to set out a series of stories about what questions audit committee members should be asking. These should be interesting articles for many in the industry who want to seek to avoid another Steinhoff-styled debacle. – Gareth van Zyl
By Glynnis Carthy*
The debacle at Steinhoff is but one example that illustrates the risk that non-executive directors face. It is unlikely to be sufficient to say, “I did not know” as this may give rise to the immediate question “are you competent?”.
According to reports, Benguela Global Fund Managers made the following comment to its clients regarding the Steinhoff board of directors:
“While Markus Jooste has resigned and made to look like the only person involved in the so called ‘mistakes’, we find it to be unbelievable that the board and particularly the chairman didn’t know a thing about them either,” Benguela noted. “Our position is that the whole board is tainted either for complicity or incompetence and should accordingly be forced to resign.”
An audit committee member is not an executive director and does not have all the facts. Asking the right questions can go a long way to making sure you understand what is happening in the business. Having said that, how can you know which questions to ask if the topic is unfamiliar?
The Audit Committee Snippets is a series of articles that aim to simplify accounting issues and highlight some of the questions that you, as an audit committee member, could ask. The first few of these will deal with the accounting issues that arise when a company buys another business because the accounting can be extremely complex.
Buying a business – part 1
The accounting standard that generally applies when a company buys a business is IFRS 3 – Business Combinations. It is important to consider whether a business is being acquired or whether an asset is being acquired. This can be a significant judgement that management makes because the accounting will often be significantly different depending on the judgement made.
From here on, when I refer to “business” and “business combination”, I mean as defined in IFRS 3 as follows:
An integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs or other economic benefits directly to investors or other owners, members or participants.
A transaction or other event in which an acquirer obtains control of one or more businesses. Transactions sometimes referred to as ‘true mergers’ or ‘mergers of equals’ are also business combinations as that term is used in this IFRS.”
If the definitions above are not met, then a company will not be buying a business and will account for the acquisition as the purchase of an asset.
For example, assume a company is buying an office block with many existing tenants and pays legal and transfer costs in cash. The table below illustrates the accounting implications of the legal and transfer costs paid – it considers the difference if a business is acquired versus if it is not a business that is acquired.
|Business||Not a business|
|Legal and transfer costs paid||Expense in profit or loss||Add to the cost of the asset|
|Impact on the cash flow statement||The cash flow is already recognised in profit or loss, therefore no adjustment to the cash flow statement||The cash flow is not recognised in profit or loss but forms part of the “additions to assets” which is included in investing activities|
|Deferred tax||No impact on deferred tax (assuming the tax deduction is permitted immediately)||Usually deferred tax would arise if the tax deduction would be allowed immediately whereas the legal and transfer costs are only recognised within profit or loss (for accounting purposes) over time.|
|Complexity||Less complex accounting||More complex accounting|
When you consider the extent of costs incurred when a company makes an acquisition, you can see that there is an incentive for management to avoid accounting for an acquisition as a business combination if it prefers to increase profit or loss. Conversely, if it has been a good year, or if there is a new CEO who wants clean up everything, there is an incentive to account for the acquisition as a business combination and decrease profit or loss.
As a start, you need to understand whether the company is buying shares in another entity, an asset from another entity or the net assets from another entity.
There is also likely to be more focus on the total costs of the acquisition when these are recognised in profit or loss, rather than being added to the cost of the asset. Irrespective of the accounting, ask management for an analysis of each cost as it will help you to assess whether the costs are reasonable and in line with what was budgeted.
- Glynnis Carthy is a chartered accountant who is based in England. She is an independent financial reporting advisor and is employed by BhalaGood Limited.