Fair value hierarchy. The Board discussed the fair value hierarchy. The FASB intends to issue an exposure draft soon outlining their fair value hierarchy, and the Board considered what its approach to this should be, given that a comprehensive and consistent fair value hierarchy is critical to the success of the Business Combinations Phase II project. The Board agreed that it should publish a proposed fair value hierarchy for public comment separately from the business combinations project. That is more likely to catch the attention of constituents that may have a limited interest in the Business Combinations project, for example investment banks, as the outcomes of the hierarchy debate will have wide ranging implications across all IFRS that require the use of fair value, including the requirements relating to financial instruments. The Board agreed that the proposed fair value hierarchy should highlight any differences with the hierarchy proposed by the FASB. The initial view of some Board members was that there did not appear to be any substantive differences, and the staff indicated their intention to work with the FASB staff to determine whether mutually acceptable drafting could be agreed upon.

Replacement grants of stock options. The Board considered the replacement of acquiree share-based payment awards by acquirers, and whether some or all of such replacements should be treated as part of the cost of the business combination. The Board agreed that where the acquirer has an obligation (legal or constructive) to replace the share-based payments at the date of acquisition the replacement must be considered as part of the cost of the business combination. The Board agreed that the requirements of IFRS 2 must be applied in determining the fair value of the replacement award. Where a replacement grant partly relates to future employee service it should be allocated between purchase price and post-combination expenses. Where this occurs future 'truing-up' of the expense should be relate only to the period between the date of the acquisition and the date of truing-up.

Where the fair value of the replacement grant exceeds the fair value of the original grant, the incremental fair value is to be treated a post-combination expense. The Board agreed that the measurement of post-combination expenses should be based on the acquisition date fair value of the instrument.

The Board agreed the following principles with respect to replacement of employee benefit awards:

• Where vested awards are replaced with vested awards, the full acquisition date fair value should be included in the cost of the business combination.
• Where a vested award is replaced with a non-vested award the fraction of the acquisition date fair value relating to prior requisite service must be included in the cost of the business combination, and the remainder is treated as a post combination expense. The staff noted that this represents non-convergence with FASB, as the FASB have agreed to allocated based on the total period outstanding (for example, ten years between grant date and new vesting date) while the IASB have agreed to allocate based only on the requisite service periods (for example, an employee may have needed to do four years service for it to vest initially, and another three under the new conditions - IASB would allocate the amount between seven years, while the FASB would allocated between the total number of years elapsing between grant date and final vesting which may be significantly greater than seven years).
• Where a non-vested award is replaced with a non-vested award the entity must recognise the effect of any acceleration of the vesting conditions as a post-combination expense immediately. Where no acceleration occurs the acquisition date fair value of the replacement award is allocated between cost of acquisition and post combination expense based on the fraction of the requisite service period still outstanding.
• Where a non-vested award is replaced with a vested award the acquisition date fair value is allocated between cost of acquisition and post-combination compensation expense based on the fraction of the requisite service period of the original award still outstanding. The effect of the immediate vesting is then recognised immediately as a post combination expense.

Post-acquisition date events. The Board agreed that where post-acquisition-date events alter the measurement of share-based payment awards the purchase price of the acquisition should not be amended for the effect of those events.

Mutual entities. The Board considered the inclusion of business combinations between one or more mutual entities within the scope of the FASB's Phase II project on Business Combinations. The Board agreed that they should discuss at the September meeting the issues the FASB considered in reaching this conclusion and determine whether or not those issues have been adequately addressed by the Phase II project. If the Board believe the issues have been addressed then such transactions will be within the scope of the Phase II Business Combinations project.

Transition - contingent consideration. The Board considered the transitional provisions in relation to contingent consideration as the current version of IFRS 3 requires that the accounting for a business combination be adjusted based on the outcome of contingent consideration agreements, while the future project will require that contingent consideration to be fair valued and included at acquisition date without subsequent amendment. The current version of IFRS 3 also requires that the initial accounting for a business combination be adjusted for deferred tax assets not recognised at the date of acquisition that subsequently prove to be recoverable. The Board considered the alternatives, and determined that they would converge with the FASB in requiring that business combinations occurring before the date of application of the Phase II standard should be adjusted for changes to the contingent consideration but not changes to the recoverability of tax balances.

Transition - contingent liabilities. The Board agreed that when the Phase II Business Combinations standard comes into effect any existing contingent liabilities recognised as part of a business combination in accordance with the current version of IFRS 3 that do not satisfy the revised recognition criteria should be derecognised immediately via an adjustment to goodwill. Where this would result in the creation of or increase of negative goodwill, the adjustment should be recognised directly in retained earnings.

Valuation techniques. The Board agreed that the Phase II Business Combinations document should include guidance on using valuation techniques (such as a market-based approach and an income approach) to measure the fair value of businesses acquired.

Bargain purchase. The Board agreed that where a business combination appears to contain a bargain purchase, any excess of the fair value of the acquirer's interest in the business acquired over the fair value of the consideration given for that interest should be recognised as a reduction in the total amount of goodwill until the goodwill is reduced to zero, and any excess remaining after the total amount of goodwill has been reduced to zero should be recognised immediately in profit or loss.