Chapter 10: Contingent liabilities

A contingent liability is recognised in a business combination if it meets the definition of a liability and if it can be measured reliably.

A contingent liability that is a possible obligation is not recognised in a business combination, because the definition of a liability is not met. A contingent liability that is a present obligation arising from past events is recognised, whether or not it is probable that an outflow of economic benefits will take place, but only if it can be measured reliably. An entity would not normally assume a significant contingent liability in a business combination without an assessment of the likelihood and magnitude of any potential outflow.

Thus, entities are usually able to determine fair value with sufficient reliability

Recognition requirements for contingent liabilities within and outside a business combination.

The table below illustrates the different recognition requirements for contingent liabilities within and outside a business combination:

Provision for litigation at acquisition date

It is not always clear whether certain items should be recognised as liabilities at the acquisition date or as post-combination events. Litigation provisions can be a challenging area. The following example illustrates the difficulties.

Example

An acquired publishing entity has a subsidiary that has been sued for libel. The entity’s counsel has advised that, in her opinion, the case could be successfully defended. No provision has been included in the acquired entity’s pre-combination financial statements.

The acquirer decides that the case should be settled out of court, in order to avoid a protracted court case and the risk that the entity could lose. How does the acquirer recognise the contingent liability at fair value?

The acquired entity’s financial statements reflected the best estimate of the liability’s fair value at the acquisition date. Although the case is expected to be successfully defended, the contingent liability will have a fair value, because there is some risk that the case might not be successfully defended. The contingent liability would be recognised as part of the business combination accounting if it can be reliably measured. The financial effect of the acquirer’s decision not to defend the case would be reflected as a current (that is, post-combination) event.

Indemnification assets

An acquirer might obtain an indemnification from a seller. This might relate to a contingency or an uncertainty of the acquired entity, and the seller agrees to make a payment to the buyer of all or part of a liability, or of a decrease in value of an asset, if the contingency occurs or the uncertainty is resolved. For example:

• The seller agrees to pay to the acquirer the settlement costs of an outstanding court case against the acquiree.
• The seller will pay to the acquirer an amount if an in-process research and development (IPR&D) project (capitalised by the acquirer) does not obtain regulatory approval.
• The acquired entity is the subject of an uncertain tax position and the seller agrees to reimburse the acquiree, up to a cap, if any costs are incurred as a result of the investigation.

These arrangements enable an acquirer to protect itself against some of the uncertain cash flows that might arise following a business combination.

Indemnification assets are recognised as an asset of the acquirer at the same time, and on the same basis, as the indemnified item is recognised as a liability of the acquiree. An indemnification asset is recognised by the acquirer at the acquisition date if it relates to an indemnified asset or liability that is recognised at the acquisition date.

Does an indemnification arrangement need to be specified in the acquisition agreement to achieve indemnification accounting?

An indemnification asset can still be recognised if it is not specified in the acquisition agreement. Indemnification accounting can still apply even if the indemnification agreement is the subject of a separate agreement. Indemnification accounting applies where the arrangement is entered into on the acquisition date, and it is an agreement reached between the acquirer and seller, and related to a specific contingency or uncertainty of the acquired business, or it is in connection with the business combination.

Indemnified liability measured at fair value

Entity E acquires entity F from group G. Entity F manufactures and sells food products. Entity F is the defendant in a class action court case, whereby a group of customers have alleged that entity F’s products have caused them liver damage. The claimants are suing entity F for damages of C20 million. Group G has indemnified entity E for the losses, up to an amount of C10 million. How should entity E account for the contingent liability and the indemnification asset? Entity E determines that the fair value of the contingent liability for the court case is C7 million. C7 million is recognised as an identifiable liability of entity F.

Entity E recognises a separate asset of C7 million on its consolidated balance sheet, because entity E considers that the C7 million will be fully collectable from group G. The net impact on goodwill, from the recognition of the contingent liability and associated indemnification asset, is nil. The liability is measured at fair value and the asset is measured on the same basis, because no adjustment has been required for collectability or contractual limitations on the indemnified amount.

Indemnified liability not recognised

In some cases, the indemnified item might not be recognised as part of the business combination accounting. An example of this is where a contingent liability exists, but it is not reliably measurable. In this situation, the indemnification asset would also not be recognised at the acquisition date.

Example

Entity J pays C120 million to acquire entity K from L group. Entity K is sued for a breach of patent. The litigation is at an early stage. L group agrees to indemnify entity J for the adverse results of a court decision, up to an amount of C80 million. Entity J makes an assessment of the litigation and decides that, due to the potential variance in outcomes, the contingent liability cannot be measured reliably. No amount is recognised in respect of the court cases. Entity J recognises no indemnification asset as part of the business combination accounting. If, in the post-acquisition period, circumstances change such that a liability is required to be recognised for the indemnified item, the indemnification asset is recognised concurrently.

Indemnified liability arising from insurance contract

IFRS 4 contains an example of an insurance contract that is a product warranty issued by another party for goods sold by a manufacturer, dealer or retailer. The warranty is an insurance contract, and it is excluded from IFRS 4’s scope because it is within the scope of IFRS 15 and IAS 37. An indemnification is similar to a warranty. Since there is not a specific scope exception in IFRS 4 for indemnifications, it could be viewed that an indemnification is within IFRS 4’s scope. We believe that the indemnification guidance in IFRS 3, and not IFRS 4, should be applied to direct seller indemnifications in a business combination.

This is the case, even if the acquisition involves insurance companies and the indemnification relates to a liability arising from the acquiree’s portfolio of insurance contracts (that is, the seller indemnifies the buyer for the acquiree’s insurance liability). We believe that the explicit guidance for indemnifications in IFRS 3 should be followed, whether the acquisition involves an insurance company or not.

The seller might subsequently transfer the indemnification to a third party, similar to purchased insurance, whereby the insurer pays the acquirer directly. In this case, the indemnification asset accounting for the acquirer might apply.

Recognition of liabilities related to restructuring or exit activities

Liabilities related to restructurings or exit activities of the acquiree are only recognised at the acquisition date if, from the acquirer’s perspective, an obligation to incur the costs associated with these activities existed at the acquisition date, in accordance with IAS 37. Otherwise, liabilities related to restructurings or exit activities and the related expense should be recognised in the post-combination period in the income statement.

Recognition of restructurings or exit activities

Entity B, the acquiree, has an existing liability related to a restructuring that was initiated one year before the business combination was contemplated. Entity A, the acquirer, identified several operating locations to close, and it selected employees of entity B to terminate, in order to realise synergies in the post-combination period. Six months after the acquisition date, the obligation for this restructuring action is recognised, because the recognition criteria under IAS 37 are met.

Can the restructurings be recognised, as part of the business combination, as a liability of the acquiree?

The acquirer accounts for the two restructurings as follows:

• Restructuring initiated by entity B: entity A recognises the previously recorded restructuring liability at fair value as part of the business combination, since it is an obligation of the acquiree at the acquisition date.
• Restructuring initiated by entity A: entity A recognises the effect of the restructuring in profit or loss in the post-combination period, rather than as part of the business combination. Since the restructuring is not an obligation at the acquisition date, it does not meet the definition of a liability, and it is not a liability assumed in the business combination.

Redundancy costs

Restructuring costs are presumed to be a post-combination cost. These costs arise as a result of management’s intention rather than a previous obligation. Including a plan for restructuring in the purchase agreement does not create a liability of the acquiree at the acquisition date. If the restructuring is done for the benefit of the acquirer, the acquirer should account for the restructuring separately from the business combination.

Example

Entity C has acquired entity D. Entity C has the management capacity to integrate entity D’s operations into its own operations, without taking on the majority of entity D’s head office employees. The purchase price for entity D of C20 million has been negotiated in contemplation of redundancy costs of C2 million being incurred after the acquisition. The employees to be made redundant, and their costs, had been identified during the course of negotiations, and a formal plan had been drawn up and agreed between the acquirer and the seller. The future redundancy costs are treated as post-combination costs in entity C’s consolidated income statement, because they are not identifiable liabilities of entity D at the acquisition date.

Contractual payments that the acquiree is required to make on a business combination

A payment that the acquiree is contractually required to make (for example, to its employees or suppliers in the event that it is acquired in a business combination) is a present obligation of the acquiree, and it is regarded as a contingent liability until it becomes probable that a business combination will take place. The contractual obligation is a recognised liability of the acquiree, in accordance with IAS 37, once a business combination becomes probable and the liability can be measured reliably. Therefore, when the business combination is effected, that liability is recognised as a liability of the acquiree. If the liability has not been settled by the acquisition date, it becomes an assumed liability as part of the business combination.

 Deferred or unearned revenue

The acquirer recognises a liability for deferred revenue only to the extent that the deferred revenue represents: an obligation assumed by the acquirer; an obligation to provide goods, services, or the right to use an asset; or some other concession or consideration given to a customer. The liability related to deferred revenue should be based on the obligation’s fair value on the acquisition date, which might differ from the amount previously recognised by the acquiree.

Deferred revenue

An IT supplier has a margin of 40% on product support, and it charges C100 per year in advance. Sub-contractors would be prepared to assume the obligation, for the same product support, for a price of C80. If the IT supplier is acquired, it is this latter value of C80 (adjusted for the period of service to be completed) that is the most appropriate measure of the fair value of deferred income.

Leases in which the acquiree is the lessee

An acquirer recognises right-of-use assets and lease liabilities for most leases identified in accordance with IFRS 16 in which the acquiree is the lessee. The acquirer is not required to recognise right-of-use assets and lease liabilities for leases that are normally exempt from IFRS 16, such as:

• leases for which the lease term ends within 12 months of the acquisition date; or
• leases for which the underlying asset is of low value.

An acquirer applies the IFRS 16 initial measurement provisions and recognises the acquired lease liability as if the lease contract was a new lease at the acquisition date.

The acquirer measures the right-of-use asset at an amount equal to the recognised liability. It might then be required to adjust the right-of-use asset to reflect any favourable or unfavourable terms of the lease relative to market terms. The off-market nature of the lease is captured in the adjustment (increase or decrease) to the right-of-use asset. The acquirer does not separately recognise an intangible asset or liability for favourable or unfavourable lease terms relative to market terms.

Property lease in which the acquiree is the lessee under IFRS 16

An acquired entity leases its head office. The rent for the next 15 years is fixed at a level that is in excess of the rents payable on leases of comparable buildings at the time of the acquisition. This is not an onerous lease under IAS 37, because the lease payments are recognised as a lease liability under IFRS 16 and therefore outside the scope of IAS 37.

How should the acquirer recognise the right-of-use asset and lease liability?

The acquirer recognises the acquired head office lease as if the lease contract was a new lease at the acquisition date. The acquirer applies IFRS 16’s initial measurement provisions, using the present value of the remaining lease payments at the acquisition date to determine the lease liability. The acquirer measures the right-of-use asset at an amount equal to the recognised liability, adjusted to reflect the unfavourable terms of the lease, relative to market terms. The off-market nature of the lease is captured in the downward adjustment of the right-of-use asset. The acquirer does not separately recognise a liability for the unfavourable lease terms relative to market terms. The acquirer’s measurement of the right-of-use asset, that is adjusted to reflect the unfavourable terms of the lease relative to market terms, reflects the fact that, in effect, it has received an incentive to take on such a lease, because the off-market lease should result in a reduction in the purchase consideration. The adjustment to reflect the unfavourable terms of the lease is not remeasured in subsequent years if market rentals change. Similarly, if the lease had been favourable compared with market terms, the acquirer would measure the lease liability at the present value of the remaining lease payments as if the acquired lease were a new lease at the acquisition date, and it would measure the right-of-use asset at the same amount as the lease liability, adjusted to reflect the favourable terms of the lease.

Restructuring costs incurred after acquisition

A contract that becomes onerous (or beneficial) as a result of actions taken by the acquirer is not included as an identifiable liability (or asset) at the acquisition date.

Example

An acquired entity had a distribution facility which the acquiring group rationalised, and the facility occupied by the acquired entity was vacated. The group is making provision for the associated restructuring costs.

Is this restructuring provision included in assessing the acquisition date fair values of the acquired entity’s assets and liabilities?

No, a liability is not recognised. The acquirer recognises liabilities for terminating or reducing the acquiree’s activities, as part of the business combination accounting, only when the acquiree has, at the acquisition date, an existing restructuring liability recognised in accordance with IAS 37.

The acquirer also does not recognise liabilities for future losses or other costs expected to be incurred because of the business combination. The property’s abandonment is accounted for as a post-combination event. The associated restructuring costs were not a liability of the acquiree at the acquisition date.

The fair value of an acquiree’s asset that is leased out under an operating lease includes the terms of any existing leases, whether they are at market rates or not. No separate asset or liability is recognised for such leases.

The balance sheet of an acquiree before the acquisition date might include deferred rent related to an operating lease in which the acquiree is the lessor. The recognition of deferred rent is the result of the requirement to generally recognise lease income under IFRS 16 on a straight-line basis if lease terms include increasing or escalating lease payments.

The acquirer should not use the acquisition method to recognise the acquiree’s deferred rent. The acquirer could record deferred rent, starting from the acquisition date, in the post-combination period based on the terms of the assumed lease. Additionally, an entity might have to adjust the fair value of the asset that is subject to the operating lease to the extent that the lease payments are more or less than market rates.

Leases in which the acquiree is the lessor

Classification of the contract, in which the acquiree is a lessor, as a finance or an operating lease under IFRS 16

There is an exception to the general principles in IFRS 3 for lease arrangements in which the acquiree is the lessor. The acquiree’s lease contracts in which it is the lessor are classified in the consolidated financial statements, based on the contractual terms and other factors at the inception of the contract or, if the terms of the contract have been modified in a manner that would change its classification, at the date of that modification. That modification might be the acquisition date.

Therefore, if the acquiree lessor has appropriately treated a lease as an operating or finance lease, the lease will also be treated as an operating or finance lease in the consolidated financial statements of the acquirer, regardless of the remaining lease term at the acquisition date. The fair value of an acquiree’s asset that is leased out under an operating lease includes the terms of any existing leases, whether they are at market rates or not. No separate asset or liability is recognised for such leases.

Recognition of deferred rent receivable

On the acquisition date, entity A assumes an acquiree’s operating lease. The acquiree is the lessor. The terms of the lease are: Four-year lease term. Lease payments:

• Year 1: C100.
• Year 2: C200.
• Year 3: C300.
• Year 4: C400.

The lease had a remaining contractual life of two years, and the acquiree had recognised a C200 asset for deferred rent receivable on the acquisition date.

This is calculated as follows: straight-line income of C500 ((C100 + C200 + C300 + C400)/4) × 2 years) less cash payments of C300 (C100 + C200) = C200.

How is the deferred rent receivable treated in the business combination? Entity A does not recognise any amounts related to the acquiree’s deferred rent receivable on the acquisition date. However, the terms of the acquiree’s lease will give rise to deferred rent receivable in the post-combination period. Entity A will record a deferred rent receivable of C50 at the end of the first year after the acquisition.

This is calculated as follows: straight-line income of C350 ((C300 + C400)/2) × 1 year) less C300 (year 3 of lease) = C50. Entity A might, however, have to adjust the fair value of the asset that is subject to the operating lease to the extent that the lease payments are more or less than market rates.

Leases in which the acquiree is the lessor under IFRS 16

The classification of the contract, in which the acquiree is a lessor, as a finance or an operating lease under IFRS 16 does not change on a business combination. Under IFRS 16, the asset subject to the lease would be recognised at its fair value as encumbered by the existing lease, if the acquire is a lessor in an operating lease.

Therefore, a separate intangible asset or liability associated with the favourable or unfavourable terms, and any value associated with ‘in place’ leases, would not be separately recognised, but it is included instead in the value of the leased asset. The acquired entity might also be a lessor in a lease other than an operating lease, such as a finance lease under IFRS 16. In those situations, the acquirer recognises and measures a financial asset that represents its remaining investment in the lease. Such investment would be recognised in accordance with IFRS 16, based on the nature of the lease arrangement. Additionally, an intangible asset might be recognised for any value associated with the relationship that the lessor has with the lessee.

The balance sheet of an acquiree before the acquisition date might also include deferred rent related to an operating lease under IFRS 16. The acquirer should not use the acquisition method to recognise the acquiree’s deferred rent, because it does not meet the definition of an asset or liability. The acquirer could record deferred rent, starting from the acquisition date, in the post-combination period based on the terms of the assumed lease.

Share-based payments

Liabilities and equity instruments on the acquiree’s balance sheet that relate to share-based payments are an exception from the general measurement principle in IFRS 3. These balances are measured in accordance with IFRS 2. This is the case whether the share-based payments awards have been replaced on the business combination or they are ongoing awards that have been unaffected by the business combination.