Yvonne Kam, partner in PricewaterhouseCoopers’ (PwC) Accounting Consulting Services (ACS) in China, and Thierry James, senior manager in PwC’s ACS in Hong Kong, look at how contingent consideration under the new business combinations standard could impact merger and acquisition (M&A) deals.
The economic downturn has created opportunities for M&As in many industries around the world. Struggling companies have been devalued and those with healthy balance sheets are looking for bargains. The financial reporting implications are now a key consideration when formulating M&A strategies. The revisions of IFRS 3, Business Combinations (IFRS 3R), applicable to calendar year companies from January 1, 2010, have made this even more important.
Acquisition accounting under IFRS 3R may have different and even counterintuitive effects on earnings and equity when compared with existing IFRS 3 (IFRS 3 (2004). Management should avoid nasty surprises by analyzing the potential impact of IFRS 3R on transactions that are in the pipeline and, if necessary, make changes to the structure of the deals.
Earn-outs are adjustments to consideration, often arising because of uncertainties over the value of the acquired business. These adjustments relate to events or conditions that might trigger the settlement of additional consideration. For example, if an acquired business’s post-acquisition earnings reach a certain level, this will trigger the payment of additional purchase consideration to the vendor ― hence, the name earn-outs. The inverse could also happen, where consideration is refunded to the acquirer if certain conditions are not met.
Earn-outs were recognized under IFRS 3 (2004) only to the extent that their settlement was probable and the amounts reliably measurable. Under IFRS 3R, all types of purchase consideration (for example, cash, common or preferred equity instruments, warrants, options and other assets) are measured at fair value on the date the acquirer takes control of a business. This includes an estimate of contingent consideration or earn-outs, whether or not deemed probable at the date of acquisition. The probability of the earn-out will not impact whether the earn-out should be recognized or not, but it will impact how much is recognized.
Adjustments to earn-outs are made against goodwill under IFRS 3 (2004); it is only a balance sheet issue. IFRS 3R prohibits the acquirer from recording subsequent changes of earn-outs through goodwill other than measurement period adjustments. There could be a significant impact to the acquirer’s post-acquisition profit and/or loss.
There seems to be an incentive for performing a more accurate assessment of the fair value of earn-outs, given that remeasurements after the acquisition date are recognized in the income statement for earn-outs classified as financial liabilities. The more the acquired business exceeds the performance projections underpinning the initial fair value, the greater the charge against the post-acquisition income statement. The inverse is also true, with poor performance resulting in a reduction of the recorded liability and a credit in the income statement. The results could be counterintuitive, depending on how earn-outs are structured. It is, therefore, essential to measure reliably the fair value of earn-out clauses at the acquisition date. Appropriate structuring of deals and accurately fair valuing earn-outs at initial recognition may reduce or eliminate earnings volatility over the subsequent years.
Earn-outs may be settled through the acquirer’s additional equity securities instead of in cash. These share-denominated earn-outs will fall within either the classification of liability or equity instruments, depending on their contractual terms.
The earn-outs are classified as a liability if they fail to qualify as an equity instrument under the “fixed-for-fixed” criteria in IAS 32. If classified as liability instruments, they are initially recognized at fair value. They are remeasured at fair value at each reporting period, with changes in fair value going through the income statement.
Earn-outs classified as equity instruments are recognized at fair value and are not subject to remeasurement. This reduces volatility and may be a more palatable alternative for all parties when compared to cash earn-outs. However, payment in shares of the acquirer may result in the transfer of more benefit to the seller than the acquirer had intended. For example, if the combination has a positive effect on the acquirer’s share price, the seller benefits from the market’s assessment of post-combination synergies.
Earn-outs might be paid to the selling shareholders who remain as employees after the transaction. For example, additional payments will be made if the vendor remains employed three years after the acquisition. In another example, the acquirer may be renting property from the vendor subsequent to the transaction, and rental payments are above or below fair value. Determining whether these arrangements are part of the business combination or a separate transaction requires judgment.
An earn-out that is forfeited if employment terminates is remuneration for post-combination services. Earn-outs to employees or selling shareholders are not affected by employment termination and are more likely to be consideration for the acquired business but require careful analysis.
IFRS 3R may have significant effects in the year of and years following an acquisition. Earnings volatility in subsequent years will be driven by a buyer’s ability to assess, at the acquisition date, the probability of achieving the pre-defined performance objectives on which additional payments are based. An accurate estimate will reduce the amount of subsequent changes and volatility. This area might be a challenge for CFOs and valuers and may well result in more equity-settled arrangements or fewer earn-outs altogether.
The simplest way to limit volatility is to eliminate cash earn-outs and contingent consideration. However, management will need to consider how the transactions are structured. Equity instruments eliminate volatility but may not be acceptable to the sellers or may represent too high a cost to the acquirers. Management could also ensure that due diligence is thorough and it has a full understanding of the risks before determining if contingent consideration is the right approach. Long-term volatility might be reduced by shortening the duration of the earn-out clauses; although, this solution would mostly suit entities operating in mature markets; it is unlikely to be appropriate for entities operating in fast-growing markets or for start-up entities.
Structuring M&A deals requires early analysis and an in-depth knowledge of the financial reporting implications. There are few practical solutions available; management of an acquisitive entity needs to understand the financial reporting implications to reach the best possible solution for the business.
The IASB agreed last month to retain the existing requirements in IAS 39 for financial liabilities as follows:
The fair value option with three existing eligibility criteria will still be available, as noted in IFRS News, March 2010, page 2. However, an entity that elects the fair value option will be required to separately record the amount attributable to own credit risk in other comprehensive income (rather than profit or loss). Amounts will not subsequently be recycled from other comprehensive income; although, if the instrument is held to its maturity, the changes would offset to zero over the instrument’s life.
The Board does not expect the identification of fair value changes relating to own credit to have a significant impact in practice, given that IFRS 7 currently requires this amount to be disclosed in the notes to the financial statements.
The IASB and FASB have published an exposure draft (ED) on the concept of a reporting entity as part of their joint conceptual framework project. The ED addresses some of the comments arising from the discussion paper issued last May, including proposing what a reporting entity is and when one entity controls another entity.
Comments on the ED are invited by July 16, 2010.
The consolidation project, now a joint project with the FASB, continues to wend its way through due process and further Board discussions at the IASB.
The IASB has decided to issue a single disclosure standard that will encompass all disclosures relevant for a reporting entity’s involvement with other entities. It will include consolidation-related disclosures as well as those for joint activities, associates and structured entities that the reporting entity does not control. The disclosure standard is expected in Q4 of 2010.
There may be a draft of the IASB’s consolidation standard available in Q2 of 2010; although, it will not be finalized until much later in the year. The IASB expects to publish the FASB’s ED on consolidation with a “wrapper” requesting comments from its constituents. The consolidation standards are expected to be converged in key principles, although, not using the same text.
One key change in the IASB’s consolidation standard may also require re-exposure. The IASB decided, with the FASB, that an investment company should carry all of its assets at fair value, even if some of those assets are controlled entities. The staff at both Boards are developing a definition of an investment company.
The Board (IASB) has decided to extend the comment period for the ED, Measurement of Liabilities in IAS 37, to May 19, 2010.
The extension gives respondents more time to understand the recognition requirements of the standard that will replace IAS 37 before they finalize their comments on the revised measurement proposals.
The ED is expected in Q2 of 2010; the final standard is expected by the end of the year.
The EU has endorsed the amendment to IFRS 2, Share-based Payment, on group cash-settled transactions effective for accounting periods beginning January 1, 2010. These amendments provide a clear basis to determine the classification of share-based payment awards in both consolidated and separate financial statements. The EU has also endorsed the Annual Improvements, issued in April 2009, which amended 12 standards.Most of the amendments are effective January 1, 2010. For more information, see A practical guide to new IFRSs for 2010 on pwc.com/ifrs.
Kyung Ho Lee is a partner in PwC’s Accounting Consulting Services group in Korea. He talked to IFRS News on his recent two-month stay in London about progress in Korea in moving to IFRS
One of the biggest challenges for companies in Korea is moving from the requirement to present individual financial
statements to presenting consolidated financial statements. This will also involve a change to the systems capturing the data, an especially onerous task for entities in the financial services sector.
The move to fair value accounting is also a big shift for us. As more fair value measurements are required under IFRS, companies will have to be familiar with valuation techniques and use independent appraisers. It will also be a more time-consuming exercise than in the past.
The issue of presenting consolidated financial statements mentioned above is a significant change. What should be consolidated and what should not? Korean GAAP is very prescriptive about this and provides bright-line rules. However, IAS 27 and SIC 12 require judgment as to who has the control, risk and reward. These different criteria mean that some entities that were consolidated under Korean GAAP will no longer qualify, and others will be consolidated where they previously were not. IFRS requires entities to be consolidated if the entity has more than 50% of ownership; under Korean GAAP it’s a 30% and majority shareholder threshold. There are also more criteria to be considered under Korean GAAP that are not present in IFRS.
Another big difference is the format of the financial statements. Korean GAAP has a standard format that includes operating income. IFRS, again, provides only guidelines and requires judgment. Management will have to consider whether operating income should go in the income statement or not.
This change from a rules-based framework to principles-based is a theme that runs throughout and is a cultural shift. The regulators, of course, are concerned about management’s use of judgment; it is a culture change for the regulators, too. The regulator has not issued any official interpretations yet, but the regulator has recently set up a discussion panel in response to calls from the market. We expect to see some activity there soon.
Other significant differences between Korean GAAP and IFRS are:
The impact of these changes will be significant. We are talking with the investment community to communicate how the financial statements may change and raise awareness of where there may appear to be volatility in the financial statements as a result of the move to IFRS. They may struggle initially with the new format of the financial statements. They may also need to be aware of the disappearance in some reports of the operating income figure and how this will affect the apparent comparability between entities. Users will have to use judgment, as well as the preparers.
The transition to IFRS for large companies is now nearly done, and some large companies early adopted, such as Samsung and LG in 2010. Some of the smaller companies are less well prepared; we are encouraging them in their efforts to start preparations.
It is important to consider how company law, tax law and other regulations might need to change in order to accommodate IFRS requirements. Korea is still adapting its legislation in this regard.
I would also emphasize the importance of seeing the move to IFRS not just as an accounting change. It affect IT systems, company philosophy, staffing. It needs to be looked at holistically.
We established IFRS Center of Excellence (CoE) in July 2005, two years before the announcement of the IFRS Roadmap, and have supported the regulators, the standard setter and our major clients. In July 2008, IFRS was diverged from IFRS CoE to focus on providing IFRS technical services.
We provide engagement teams with an IFRS toolkit. It comprises our conversion checklist and publications based on global materials but tailored for the local market, such as first-time adoption guidance based on the firm’s Manual of Accounting, hedge accounting guidance and comparison of similarities and differences between Korean GAAP and IFRS. We also issue technical updates and newsletters.
We have also been running internal and external training programs. We have made global P2P IFRS and IFRS e-learning training in Korean available online. We provide IFRS update training and regular IFRS workshops, internally and externally, which are topic-based. We also provide 1-2 day, classroom-style training sessions externally that can be tailored to clients’ needs.
Thirteen companies made the transition to IFRS in 2009. Feedback from the market shows some concern around the differing formats of the financial statements under IFRS because of the principles-based rather than rules-based approach that users are accustomed to under Korean GAAP. For example, there is some confusion around where users can now find operating income.
IFRS has also resulted in very different results for some companies ― for example, because of changing the functional currency.
We are making progress and expect to have preparers and users ready for the change by 2011.