Chapter 7: Consideration transferred in a reverse acquisition

In a reverse acquisition, the equity interests are usually issued by the accounting acquiree (the legal parent). The value of the consideration transferred by the accounting acquirer is based on the number of equity interests that the accounting acquirer (legal subsidiary) would have had to issue to the owners of the accounting acquiree (legal parent) in order to give the owners of the legal parent the same percentage of equity interests in the combined entity that results from the reverse acquisition.

Consideration in a reverse acquisition

Reference to standard: IFRS 3 para B20

Entity B, a private entity, acquires entity A, a public entity, in a reverse acquisition. The transaction is a business combination. Immediately before the acquisition date:

• Entity A has 100 shares outstanding.
• Entity B has 60 shares outstanding.

On the acquisition date:

• Entity A issues 150 shares in exchange for entity B’s 60 shares.
• The shareholders of entity B own 60% (150/250) of the new combined entity.
• The shareholders of entity A own 40% (100/250) of the new combined entity.
• The market price of a share of entity A is C16.
• The estimated fair value of a share of entity B is C40.

What is the consideration for the acquisition of entity A by entity B? The fair value of the consideration transferred should be based on the most reliable measure. [IFRS 3 para 33]. The fair value of entity A’s shares is likely to be more reliably measurable, because entity B is a private entity. The consideration transferred of C1,600 is measured using the market price of entity A’s shares (100% of entity A acquired, which is 100 shares times C16). Another method of estimating the fair value of the consideration transferred would be to use the number of entity B’s shares that would have been issued to the owners of entity A. Entity B would have had to issue 40 shares to entity A’s shareholders, increasing entity B’s outstanding shares to 100 shares (60 shares/60%) × 40% = 40 shares). Consideration transferred would be C1,600 (40 shares times the fair value of entity B’s shares of C40).

Contingent consideration

Contingent consideration is “usually, an obligation of the acquirer to transfer additional assets or equity interests to the former owners of an acquiree as part of the exchange for control of the acquiree if specified future events occur or conditions are met”. Contingent consideration can also take the form of a right of the acquirer to the return of previously transferred assets or equity interests from the sellers of the acquired business.

Contingent consideration is recognised, whether it is probable that a payment will be made or not. An acquirer’s right to receive contingent consideration (that is, contingently returnable consideration) is classified as an asset.

Accounting for contingent consideration

Contingent payments to or from the acquirer and the selling shareholders are analysed to determine if they are compensation, contingent consideration or indemnity related. A payment to or from the buyer and seller that is related to a future event could be either an indemnity or contingent consideration. If the settlement of the arrangement is related to an existing specific asset or liability of the acquiree, it is an indemnification and an obligation of the seller. Other contingent payments are either compensation or consideration. Accounting for contingent consideration poses various challenges for entities undertaking business combinations under IFRS 3:

What form does the consideration take?

All contingent consideration is measured at fair value at the acquisition date. So, goodwill is not affected by the form of the consideration, whether it is debt, equity or some other asset or liability. But accounting for contingent consideration after the acquisition date is different, depending on how it has been classified at the acquisition date. How is contingent consideration valued? Valuation might be a difficult issue. Many forms of contingent consideration are based on entity-specific variables that are not observable in any market but are measured at fair value. There is no exemption for impracticability, and there is no reliable measurement criterion.

Are amounts to be treated as contingent consideration or employee compensation?

Arrangements are often made with sellers who are also employees of the acquired business. An analysis is needed to determine whether payment arrangements are payments to the sellers in their capacity as shareholders or in their capacity as employees.

Measurement of consideration

Consideration transferred is generally measured at fair value at the acquisition date (except for the measurement of share-based payment awards. Fair value of the consideration transferred is the sum of fair values of the assets transferred, the liabilities incurred by the acquirer to the former owners of the acquiree, and the equity interests issued by the acquirer to the former owners of the acquiree.

Where cash settlement of part of the consideration is deferred, the fair value of that deferred component should be determined by discounting the amounts payable to their present value at the date of exchange, taking into account any premium or discount likely to be incurred in settlement.

Contingent consideration is measured at fair value at the acquisition date.

Interest-free loan treated as deferred consideration

Entity A acquired the entire share capital of entity B for C400,000. Entity A paid C100,000 in cash and issued an interest-free C300,000 loan payable to the seller in 10 years. The loan issued is measured at fair value. [IFRS 3 para 37]. The face value of C300,000 specified in the contract is not its fair value. The debt should be valued at C167,518 (that is, its net present value discounted at a rate of 6%). Entity A has paid C267,518 for entity B, although a different amount is specified in the purchase contract. The rate of 6% is the rate at which entity A could issue the same amount of debt in a separate market transaction.

Measurement of contingent consideration

Measuring contingent consideration at fair value at the acquisition date could be complicated, depending on the facts. Entities will need to consider the key inputs of the arrangement and market participant assumptions when developing the assumptions used to determine the fair value. This will include the need to estimate the likelihood and timing of achieving the arrangement’s relevant milestones. Entities will also need to exercise judgement when applying a probability assessment for each of the potential outcomes.

Measurement of share-based payment awards

Share-based payment awards, whether part of consideration or not, are measured in accordance with IFRS 2 and not at fair value.

One difference between the IFRS 2 measure and fair value is that non-market-based vesting conditions are not included in the value of the award. But they are used to adjust the number of equity instruments included in the measurement of any amounts recognised.

The amount that is accounted for as consideration is the IFRS 2 measure of the acquiree’s awards multiplied by the ratio of completed service to the greater of the original or the new total vesting period. The vesting period and vesting conditions are defined in IFRS 2.

Non-monetary assets and liabilities, including a business or a joint venture, of the acquirer might be transferred as part of the purchase consideration in some business combinations. The difference between the fair value and the carrying value of these other assets or liabilities is typically recognised as a gain or loss in the financial statements of the acquirer at the date of acquisition.

The transferred assets or liabilities might remain within the combined entity after the business combination (for example, because the assets or liabilities were transferred to the acquiree rather than to its former owners). The acquirer retains control of them. The acquirer measures those assets and liabilities at their carrying amounts immediately before the acquisition date.

The acquirer does not recognise a gain or loss in profit or loss on assets or liabilities that it controls both before and after the business combination. The asset transferred will affect the amount of the non-controlling interest and goodwill that is recognised.

Business combination with non-monetary purchase consideration

Utility D owns a generating facility with a book value of C55. Entity E owns 60% of the voting rights in a power distribution business, entity F. On 31 December 20X2, utility D sold its generating facility to entity E and received, in exchange, entity E’s interest in entity F. The fair value of the generating facility, determined by an independent valuation, is C150. The fair value of entity F’s identifiable net assets, determined by an independent valuation, is C200. Utility D has given up a non-monetary asset, the generating facility, to acquire a controlling interest in a distribution business, entity F.

The transaction is, for utility D, a business combination.

How does utility D account for the business combination? Utility D’s facility meets the definition of an asset held for sale in IFRS 5.

The reclassification as an asset held for sale has no immediate income statement impact, because fair value less costs to sell is higher than the carrying amount. Utility D should recognise the acquisition of entity F and a gain on disposal of the facility when the transaction occurs.

The consideration that utility D paid is calculated by reference to the fair value of the generating facility given up, which is C150. Utility D elects to measure non-controlling interest (NCI) at the NCI’s interest in the identifiable net assets, being C80 (200 × 40%). Goodwill is C30. The gain on disposal of the generating facility is the difference between the consideration received and the book value at the date of disposal. Calculation of goodwill:

Acquisition of a controlling interest for shares in another entity

The purchase consideration might take the form of other assets. For example, an entity has an investment in a listed entity and swaps that investment for a controlling interest in another entity. The consideration given is the shares in the listed entity. The acquisition date fair value of the holding in the listed entity is the consideration transferred for the acquisition of the new subsidiary. Exchanges of businesses or other non-monetary assets for an interest in a subsidiary are addressed in chapter 30 para 92.

Measurement of equity interests issued

The fair value of the acquirer’s equity interests issued is determined as consideration for the acquired business. Fair value will be the quoted share price, on the acquisition date, multiplied by the number of shares issued for publicly traded shares. The fair value of unlisted shares is measured using valuation techniques, typically either the market or the income approach.

The consideration exchanged might be only equity interests. The value of the acquiree’s equity interests might be more reliably measurable than the value of the acquirer’s equity interest. This might occur where a private entity acquires a public entity with a quoted and reliable market price. If so, the acquirer should use the acquisition date fair value of the acquiree’s equity interests instead of the acquisition date fair value of the equity interests transferred.

A business combination might be executed without the transfer of consideration. The fair value of the acquirer’s interest in the acquiree should be used as the measurement of consideration.

Financial assets and liabilities and equity instruments are defined by IAS 32. An equity instrument is a contract that evidences a residual interest in an entity’s assets, after deducting all of its liabilities. A financial liability is:

• a contractual obligation to deliver cash or another financial instrument, or to exchange financial assets or liabilities under conditions that are potentially unfavourable;
• or a contract that will or might be settled in its own equity instruments and is a: non-derivative for which an entity is or might be obliged to deliver a variable number of its own equity shares;
• or derivative that will or might be settled other than by exchange of a fixed amount of cash or another financial asset for a fixed number of its own equity instruments.

Classification of deferred consideration

The fair value of deferred cash consideration is accounted for by the acquirer as a financial liability.

The difference between the amount (fair value) at the acquisition date and the total amount payable is a finance cost. It is charged as interest expense in the acquirer’s post-acquisition income statement over the period when the liability is outstanding.

Deferred consideration is first classified by IAS 32 as a liability or equity. If the deferred consideration is an equity instrument, the fair value should be credited directly to shareholders’ funds. Deferred consideration should be disclosed under share capital, as a separate caption, with a heading such as ‘shares to be issued’.

The deferred consideration might be classified as a liability if the amount of deferred consideration payable is fixed at the acquisition date, and the number of shares issued to satisfy that consideration varies according to the market price of the shares at the date when the consideration is issued. The shares to be issued are shown as a financial liability, and not as equity.

Classification of contingent consideration

An acquirer’s obligation to pay contingent consideration that meets the definition of a financial instrument is classified as a financial liability or equity, based on IAS 32.

A contingent consideration arrangement that is required to be settled in cash or other assets should be classified as a liability.

A contingent consideration arrangement might be settled with an entity’s own equity shares, but it is accounted for as a liability (for example, a fixed amount to be paid in a variable number of shares).

Contingent consideration arrangements that will be settled in a fixed number of the issuer’s equity instruments are usually classified as equity. If the arrangement results in the delivery of a variable number of shares, it is classified as a liability.

Equity classification is precluded for contingent consideration arrangements that meet the definition of a derivative if the arrangement has a settlement choice (for example, net share or net cash), even if it is the issuer’s exclusive choice.

Classification of a contingent consideration arrangement including more than one performance target

A contingent consideration arrangement might include more than one performance target. The unit of account might be the overall contract, or separate units of account for each performance target within that overall contract. To be assessed as separate units of account, the performance targets must be readily separable and independent of each other, and they must relate to different risk exposures. If separable, these contracts might individually result in the delivery of a fixed number of shares, and so they would be classified as equity. Otherwise, the arrangement must be viewed as one contract that results in the delivery of a variable number of shares, and it would be classified as a liability, because the number of shares that will be delivered depends on which performance target is met.

The framework to determine the classification of contingent consideration arrangements

The following flow chart illustrates the framework to determine the classification of contingent consideration arrangements:

Contingent consideration payable in cash as a financial liability

Entity A is a large pharmaceuticals company. It buys entity B, a smaller biotech company, mainly to gain access to two significant in-process development projects. Entity A agrees to pay C20 million to the owners of entity B in cash. A further C30 million is payable if one of the development projects receives approval from the US Food and Drug Administration (FDA) within 10 years. How does entity A account for the contingent payment? Entity A has a contractual obligation to deliver cash to the owners of entity B. [IAS 32 para 11]. The contingent consideration is classified as a financial liability. It is recognised at its fair value at the acquisition date. Fair value will vary most significantly based on the probabilities of regulatory approval being achieved.

Contingent consideration paid in a fixed number of shares as equity

Entity C acquires entity D. Entity C agrees to issue 500,000 ordinary shares to entity D’s owners if profits are more than C2 million one year after the acquisition. How does entity C account for the contingent payment? Entity C has agreed to issue an equity instrument. There is no obligation to deliver cash or another financial asset to another entity, and the number of shares that will be delivered is fixed at 500,000. [IAS 32 para 11]. The contingent consideration is classified as equity. It is recognised at its fair value at the acquisition date. The fair value of the contingent consideration would take into account the share price at the date of acquisition and the probability of the contingent consideration becoming payable.

Contingent consideration paid in a variable number of shares as a financial liability

Entity C acquires entity D. Entity C agrees to issue, to entity D’s owners, 100 shares if revenues of at least C100 million are attained, and 200 shares if revenues of at least C200 million are attained. How does entity C account for the contingent payment? Entity C has agreed to issue shares. There is no obligation to deliver cash or another financial asset to another entity, and the number of shares that will be delivered is variable, at 100 or 200. There is one performance target of revenue, which can result in either 100 or 200 shares being issued. The targets relate to the same risk. As such, the contingent consideration is classified as a liability. It is recognised at its fair value at the acquisition date and subsequently remeasured to the income statement each reporting period. The fair value of the contingent consideration would take into account the share price at the date of acquisition and the probability of the contingent consideration becoming payable.

Contingent consideration paid in a variable number of shares as equity

Entity C acquires entity D. Entity C agrees to issue, to entity D’s owners, 100 shares if year 1 revenues are at least C100 million, 200 shares if year 2 revenues are at least C200 million, and 300 shares if year 3 revenues are at least C300 million. How does entity C account for the contingent payment, based on these three independent performance targets? Entity C has agreed to issue shares. There is no obligation to deliver cash or another financial asset to another entity, and the number of shares that will be delivered for each independent performance target is fixed at either 100, 200 or 300 shares.

The contingent consideration is comprised of three separate financial instruments that are each classified as equity. They are independent of each other, such that it is possible for each performance target to be met on its own. Each award is recognised at its fair value at the acquisition date but is not subsequently remeasured.

Arrangement is an indemnity and not contingent consideration

Entity E acquires entity F. Entity F is the defendant in a significant court case. The owners of entity F agree that they will refund part of the consideration paid by entity E if entity F loses the court case, up to a maximum amount of C2 million.

How does entity E account for the contingent payment?

This arrangement is not contingent consideration. It is an indemnity offered by entity F’s sellers. It is accounted for using the same assumptions as an indemnified contingent court case liability.

Escrow arrangements

Entity E acquires entity F for C10 million. Entity E seeks protection for false representations and warranties asserted by the sellers of entity F. Entity E will pay C9 million at the acquisition date, and it will place C1 million in an escrow account. Within one year after the acquisition date, the sellers will receive the C1 million if there were no violations of the representations and warranties. Is the C1 million in escrow accounted for as contingent consideration by entity E? No. Contingent consideration is defined in IFRS 3 as an obligation to transfer additional consideration if specified future events occur or conditions are met.

The funds in escrow are released to the sellers based on the validity of conditions that existed at the acquisition date and are not dependent on the future performance of entity F. This is not an indemnification asset, because the agreement is not indemnifying entity E in relation to an existing specific asset or liability of the acquiree. The C1 million payment made into the escrow account would be treated as part of the consideration for the business combination, impacting the goodwill recognised on the combination.

Any adjustments to the amount in escrow would be accounted for as a measurement period adjustment that impacts goodwill, given that they result from new information that is obtained after the acquisition date about facts and circumstances that existed as of the acquisition date.

Working capital adjustments

Entity E acquires entity F for C10 million. The purchase agreement provides that a closing balance sheet audit will be completed within 90 days of the acquisition date. If working capital at the acquisition date exceeds a specified minimum level, entity E will pay additional consideration to the seller. For instance, if entity F’s working capital is C1.1 million and the specified minimum level is C1 million, entity E will pay an additional C0.1 million. Does entity E account for the working capital adjustment as contingent consideration? No. Working capital adjustments are the result of new information about facts and circumstances that existed at the balance sheet date, and not about the performance of the acquiree after the acquisition date. [IFRS 3 para 45]. Any amounts paid for working capital adjustments would be accounted for as a measurement period adjustment.

Adjustments to consideration based on outcome of a general contingency or lawsuit

Entity E acquires entity F for C10 million. The purchase agreement provides that, if an existing lawsuit against entity F settles for more than C1 million, an adjustment to the purchase price will be made. Should this arrangement be accounted for as contingent consideration? No. The seller has provided an indemnification to entity E for entity F’s existing lawsuit. Therefore, entity E would account for the assumed liability as a contingent liability, and it would recognise an indemnification asset for the amount recoverable from the seller.

Contingent consideration of the acquiree

Entity A acquires entity B for C10 million in 20X6. If net profits exceeded C2 million in 20X8, additional consideration would be paid to the shareholders of entity B in 20X9. This was accounted for as contingent consideration by entity A in accordance with IFRS 3. Entity C acquired entity A in 20X7.

Should entity C account for the contingent consideration arrangement from entity A’s acquisition of entity B as contingent consideration or as an assumed liability?

It should account for the item as an assumed liability. Pre-existing contingent consideration does not meet the definition of contingent consideration in the acquirer’s business combination, because it is not paid to the sellers of the acquired business. It is an identifiable liability assumed in the subsequent acquisition. Existing contingent payment arrangements of the acquiree are contingent consideration under IFRS 3.

Contingent consideration arrangements of the acquiree would be liabilities (or, in some instances, assets) of the acquired business. These arrangements are established by contract and fall within the scope of IFRS 9, and so they are recognised at fair value on the acquisition date. The subsequent accounting would be driven by the classification of the asset or liability under IFRS 9.

Contingent consideration arrangement linked to the acquisition-date fair value

Entity A acquires entity B in a business combination by issuing 1 million entity A common shares to entity B’s shareholders. At the acquisition date, entity A’s share price is C40 per share. Entity A also provides entity B’s former shareholders with contingent consideration whereby, if the common shares of entity A are trading below C40 per share one year after the acquisition date, entity A will issue additional common shares to the former shareholders of entity B sufficient to make the current value of the acquisition-date consideration equal to C40 million (that is, the acquisition date fair value of the consideration transferred.)

However, the number of shares that can be issued under the arrangement cannot exceed 2 million shares. Entity A has sufficient authorised and unissued shares available to settle the arrangement after considering all other commitments. The shares to be issued meet all criteria for equity classification under IAS 32.

The common shares of entity A that have been issued at the acquisition date are recorded at fair value within equity. Since the guarantee feature of the contingent consideration arrangement would result in the issuance of a variable number of shares of entity A (that is, the number of shares to be delivered will vary depending on the issuer’s share price), the arrangement should be classified as a liability under IAS 32.