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IFRS 3 business combinations (revised)

Mark Harwood
Head of Risk and Corporate Governance

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What is the probability of it being fair?

Background

The International Accounting Standards Board (IASB) released a revised standard on business combinations in January 2008 which is effective for annual reporting periods beginning on or after 1 July 2009.

The revision introduces several changes which will have a significant impact on the accounting for business combinations and the costs associated with them.  However, one of the key challenges is the accounting for contingent consideration.  This article examines closely the issues that directors will need to bear in mind when accounting for future acquisitions if part of the consideration is contingent on future events or circumstances.

Prior to the publication of IFRS 3 (Revised), contingent consideration was only recognised as part of the cost of the business combination if a transfer of economic benefit was probable and the amount could be reliably measured.  The cost of the combination and ultimately goodwill were adjusted post acquisition, when the final amount payable was determined or when revised estimates were made.

  • What exactly is the change?

    In future, contingent consideration (commonly referred to as an 'earn-out') will be measured at its acquisition-date fair value irrespective of the level of probability or measurement reliability. This reflects the view that the agreement between buyer and seller to contingent consideration is an obligating event even though the amount of the obligation is unknown. The obligation to settle the contingent consideration will be classified as a liability or equity on the basis of the definitions set out in IAS 32 ‘Financial Instruments: Presentation’.

    Post combination changes in the fair value of contingent consideration that are the result of the acquirer obtaining additional information about facts and circumstances that existed at the acquisition date and that occur within the measurement period (which cannot exceed one year from the acquisition date) are recognised against goodwill.

    Post combination changes resulting from events after the acquisition date that are not measurement period adjustments are accounted for separately from the business combination. Changes in fair value relating to obligations classified as financial liabilities within the scope of IAS 39 ‘Financial instruments: Recognition and Measurement’ are recognised either in profit or loss or other comprehensive income depending on their IAS 39 categorisation. Changes in the fair value of liabilities which are outside the scope of IAS 39 are recognised in profit or loss as the liability is accounted for under IAS 37 Provisions, Contingent Assets and Contingent Liabilities.  Contingent consideration classified as equity is not re-measured and its subsequent settlement is accounted for within equity. More volatility in post acquisition earnings is expected following the implementation of the revised standard.

    When accounting for contingent consideration as a financial liability, volatility of post acquisition earnings will arise because:

    • A difference will arise between the acquisition-date fair value and the actual payments made, regardless of the precision used in estimating the fair value.  This difference arises from the present value factor associated with the fair value calculation (often referred to as the time value of money concept)
    • The estimated provision is unlikely to equal the actual payments
    • Potential impairment losses may exist in respect of goodwill where there has been an overestimation in the value of the contingent consideration compared with the performance of the acquire.

  • Estimating fair value

    Fair value is defined as ‘The amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction.’

    Determining the acquisition-date fair value of contingent consideration will require careful examination of circumstances and details in order to assess the probable resolution of the contingency. This may involve estimating and developing forecast projections relating to sales or profitability, the likelihood of achieving relevant milestones, and the timing of potential payments.  Scenario analysis may be required, in addition to the application of different valuation models to establish a reliable fair value. Such valuations by their very nature have the potential for bias and errors and directors should ensure that they are based on credible assumptions and observable inputs.  Valuation models should be sufficiently robust to contend with auditor review and in sufficient detail to meet the ongoing measurement requirements.

    The information obtained in the negotiation process leading to the acquisition agreement may assist directors in assessing probabilities or estimating future projections and hence determine a fair value. This is because each party to the contract will have different opinions about the economic risks and future uncertainties of the entity being acquired and often these differences are reconciled through the issue of contingent consideration so that the risks are shared between the parties to the contract. Also given the existence of the negotiations, it is highly unlikely that in such situations an estimate of zero will be considered to be reliable.

  • Assessing fair value: Illustrative example

    Company A acquires all of the ordinary share capital of Company B for £1m.  In addition, the purchase agreement stipulates that a further payment will be required dependent on the earnings of Company B post acquisition.  The terms of the contract call for additional consideration to be paid in the event that Company B’s earnings exceed £0.5m in each of the next 2 years subject to an earnings cap of £4m.  For each £1 of earnings in excess of £0.5m, Company A is required to pay 20% of the excess to the previous shareholders.  In this situation, the minimum amount that could be paid is nil and the maximum could be £0.7m (£4m-£0.5m x 20%).

    • Management could use budgets / forecasts to obtain an estimate of Company B's earnings.  Discounting back to present value using an appropriate rate of return would be a method of estimating the fair value of the consideration payable. The appropriate rate of return may be the weighted average cost of capital, the internal rate of return implied by the transaction or the required return on equity and will depend on the specific circumstances of the acquisition.
    • Scenario analysis could also be used as a method of estimating the fair value especially when detailed forecasts have not been prepared or where management relied on numerous sets of projections when establishing the purchase price of the acquisition. The directors could model different earnings scenarios and assign probabilities in respect of their outcome.  Factors such as historic actual to budget achievement, new contract wins, customer retention and cost savings should be considered when assigning probabilities. The expected earn-out payments are then discounted back to their present value using an appropriate rate of return.
    • Management may decide to use a sophisticated valuation model to estimate the fair value. Models such as the Monte Carlo simulation model require inputs relating to the minimum and maximum cash outflows as well as assumptions such as likely growth rates and earnings margins. Assumptions should be sufficiently reliable to withstand auditor examination and should therefore take account of historical industry and company specific trends. 

  • The main challenges for businesses when assessing fair value?

    The accounting for business combinations should be considered by the acquirer when the transaction is being structured. Given the time it will take to collate the information required to make such fair value assessments for accounting purposes, it is important that companies start assessing their acquisitions earlier than they do at present.

    Considerations for Directors of entities entering into business combinations may include:

    The level of In-house expertise

    Accounts departments will now need to develop supportable bases for estimating uncertain future outcomes and prepare robust valuations which will withstand auditor examination. Directors will need to consider whether they have sufficient in-house expertise to prepare these valuations.

    Auditor assistance

    Listed companies, or significant affiliates of such entities, should be aware, that where in-house expertise is limited, reliance cannot be placed on their external auditors for assistance, as they are bound by a Code of Ethics which prohibits such services where the valuation would have a material effect on the financial statements. Other audited entities should also be aware that such services are prohibited where the valuation would involve a significant degree of subjective judgment and have a material effect on the financial statements.

    The availability of guidance

    Given the recent change in accounting practice, industry standards for estimating the fair value of contingent consideration do not yet exist.  However in June 2009, the IASB issued an exposure draft ‘Fair Value Measurement’ which, if adopted, will change the definition of fair value to one based on an ‘exit price’ and defined as ‘the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date’.

    The need for a professional valuation

    Directors should consider the need to appoint a professional valuer to assist in developing financial projections and quantifying contingencies in a way which will assist the financial reporting and auditing process. The inputs to models prepared by professional valuers must be supportable and sufficiently robust to withstand auditor examination.

    Disclosure changes

    Directors should also be aware that the disclosure requirements in respect of contingent consideration are much more onerous in the revised standard requiring details about the valuation techniques used, the key model inputs, the range of outcomes and reasons for changes thereto in the post acquisition period.