The misconceptions around purchasing a business versus its assets

There seems to be a significant misconception as it relates to the purchase of an asset versus that of a business. However, it is highly imperative that one appreciates the difference whenever executing transactions.

The IFRS, or International Financial Reporting Standards, defines a business as an integrated set of activities and assets that are capable of being conducted and managed for the purposes of providing goods or services to customers, generating investment income, such as dividends or interests, or generating income from ordinary activities.

The IFRS conceptual framework defines an asset as a present economic resource controlled by an entity as a result of past events. An economic resource is a right that has potential to produce economic benefits. Rights are generally established by contract, legislation or in other instances, past practices or policies of one party.

Not all rights are assets of an entity. When rights become an asset of one party, the rights must produce potential future economic benefits beyond the economic benefits available to all other parties; plus, the rights must be controlled by the entity.

Control of economic resources normally emanates from the entity’s ability to enforce a legal or constructive rights. An entity controls an economic resource if it has the present ability to direct the use of the economic resource and obtain the economic benefits which might flow from it.

An entity controls an economic resource whenever future economic benefits from that resources flow to the entity either directly or indirectly rather than to another party.

The IFRS definition of an asset appears to be a single ingredient or a resource involved in the creation of an entire business.

Because of misconceived notions, buyers of either businesses or assets are confronted with numerous implications, which are not limited to increased taxation risk, incorrect financial reporting recognitions, risk of assuming additional liabilities and lack of synergies which potentially inhibit growth and the value of their entities.

Occasionally, entities purchase businesses rather than assets without understanding and appreciating the differences, as well as their implications. A common rule of thumb is where entities are not acquired as a going concern then it is likely that the transaction does not involve purchase of a business, but merely the purchase of a set of assets.

The purchase of a business generally requires the recognition of goodwill in the event that the purchase consideration for a business exceeds the net identifiable assets of the entity that is acquired. Where the net identifiable assets exceed the purchase consideration, then the excess results in the recognition of a bargain purchase in accordance with the IFRS.

Generally, the recognition of goodwill depicts signs of potential synergies and success of the business being acquired, which makes not only the entity purchased, but also the group of entities more appealling to potential acquirers in the future.

Goodwill and bargain purchase gains represent additional value to the sellers and buyers of a business, respectively, which will require recognition for financial reporting purposes.

Neither goodwill nor bargain purchase gain requires recognition where the purchase involves an asset.

On the purchase of a business, the Employment (Termination and Redundancy) Payments Act, does not require the change of ownership to result in redundancies under circumstances where the employees are renewed or re-engaged on the same terms, conditions and scope by the new owner, or where the terms of the purchase of a business entails the new owner being substituted for the original owner – unless the parties to the transaction agreed otherwise by way of a contract of sale for the seller to effect a redundancy exercise of all the employees affected.

Redundancy payments might be required especially where the employees affected have met the conditions in accordance with the Employment (Termination and Redundancy) Payments Act.

Entities acquiring a business should be cognisant that the purchase will include the employees’ right to vacation, sick leave and other emoluments that are vested by way of past agreement with the prior owner of the business, and which the new owner will become obligated to satisfy.

Where an entity’s assets or a significant portion of the assets of a business is acquired, it is generally the intention of the purchaser to utilise these assets to form another business, which normally requires a redundancy exercise by the seller. These redundancy exercises generally entail very complex calculations of the employees’ emoluments, plus significant income tax risk.

It might be incomprehensible, but many people are unaware that both the purchase of business and the purchase of assets generally involve the taxable supply of assets – save and except for real properties – on the part of the seller involved in these sales, and that the relevant rate of GCT should be applied.

Moreover, the assets transferred as part of the sale will have income tax implications and the properties involved, in most instances, attract transfer taxes at a rate of two per cent, which can be exorbitant and a significant upfront cost for the sellers involved; not to mention legal fees, registration fees and stamp duty.

The obligations involved are sometimes a definitive factor in the choice of whether to purchase a business or the assets of the business. In short, unless mitigated by contractual agreement between the parties involved, the purchaser of a business assumes the risk, obligations and all liabilities associated with the business, which can be significant and unknown at the time of acquisition, especially where proper due diligence was not done by the party buying the business.

Where adequate due diligence is not executed by the purchaser, the downside exposure to risk could become overwhelming.

One should perform adequate cost benefit analysis to ascertain not only what method of purchase is deemed more suitable, while taking into consideration that acquiring a business as a going concern has numerous other benefits such as goodwill, synergies, as well as ongoing agreements that might be incalculable, but outweigh the costs and risks involved.

No single method might be a panacea; one should always conduct adequate due diligence so as to ascertain what works best for the parties involved.

However, provided that adequate due diligence is performed and the risks involved are adequately priced, the purchase of a business could be more feasible, especially where the seller is fully tax compliant and there are no actual or potential legal claims against the proposed acquiree.

Kerwin D. Hamil is Chief Financial Officer of The Cliff Hotel & Spa Limited and & Managing Partner of Kerwin D. Hamil (KDH) Chartered Accountants.kerwin_hamil@hotmail.com