Chapter 16: Exceptions to general measurement principle

Re-acquired rights

Re-acquired rights are identified as an exception to the fair value measurement principle. The value recognised for re-acquired rights is not based on market participant assumptions. Contractual renewals are not taken into account in determining fair value, even if market participants would expect renewals. The value of a re-acquired right is usually determined based on the estimated cash flows over the remaining contractual life.

Income taxes

Deferred income taxes are measured in accordance with IAS 12. Tax assets and liabilities are measured from the perspective of the combined entity

Assets held for sale

Assets (or disposal groups) held for sale at the acquisition date, in accordance with IFRS 5, are measured at fair value less costs to sell.

Employee benefit plans

Employee benefit plans are an exception to the fair value measurement principle; assets and obligations are measured in accordance with the guidance in IAS 19.

The acquirer should use the present value of the defined benefit obligations, less the fair value of any plan assets, to determine the net employee benefit assets or liabilities to be recognised.

Regulatory deferral account balances

Regulatory deferral account balances of the acquiree at the acquisition date are measured in accordance with IFRS 14. The acquirer continues to apply its previous GAAP accounting policies for the measurement of such regulatory deferral account balances.

Indemnification asset

The indemnification asset is initially measured at the same amount as the indemnified asset or liability. The indemnification asset represents, in substance, a receivable from the perspective of the acquirer; it is subject to recoverability considerations. A valuation allowance (provision for a doubtful recoverability of the receivable) might be included in the indemnification asset’s carrying value. The indemnification asset’s value is adjusted to reflect any contractual limitations on the indemnified amount.

Indemnification asset

Indemnified liability not measured at fair value

Entity G buys entity H in 20X8. Entity H is in dispute with local tax authorities over its tax return for 20X5. Entity G receives an indemnity from the seller of entity H to cover the outcome of the tax dispute. Entity G ascertains that an outflow in relation to the tax case is probable, and it estimates the amount expected to be paid as C2.5 million, which is the full amount claimed by the tax authorities.

The fair value of the liability is C1.74 million. In the business combination accounting, a liability of C2.5 million is recognised, in accordance with IAS 12. If the tax authorities require this amount to be paid, the seller of entity H will pay the full C2.5 million to entity G.

Entity G considers that the seller’s creditworthiness means that the indemnification asset is fully collectable. Entity G recognises an indemnification asset of C2.5 million, which is measured on the same basis as the indemnified liability, because no adjustment has been required for collectability or contractual limitations on the indemnified amount.

Re-acquired rights

Re-acquired rights are amortised over the remaining contractual period at the acquisition date. This is consistent with the measurement basis of such rights. If the right is subsequently sold or re-issued, it is derecognised, and the carrying amount is included in any gain or loss on sale. A re-acquired right can be perpetual if there are no contractual renewals and the remaining contractual life is not limited

Income taxes

The potential benefit of the acquiree’s unused tax losses or other deferred tax assets might not satisfy IAS 12’s criteria for separate recognition in the initial accounting for a business combination, but it could be subsequently realised.

If the change to the likelihood of recovery is a measurement period adjustment, the deferred tax asset is adjusted against goodwill. If goodwill is reduced to zero, any further adjustment is recognised in profit or loss as a bargain purchase gain. A change to the deferred tax assets that is not a measurement period adjustment is recognised in profit or loss (or outside profit or loss, as required by IAS 12) as a tax item.

Deferred tax asset crystallises after acquisition

Entity A acquired a subsidiary, entity B, which had deductible temporary differences of C500. The tax rate at the time of the acquisition was 30%. The resulting deferred tax asset of C150 was not recognised, because entity A did not believe that it was recoverable. Nine months after the acquisition, entity A assessed that the future taxable profit would probably be enough for the group to recover the benefit of all of the deductible temporary difference.

How does entity A account for the change in the estimate of recoverability of the asset?

Entity A first considers whether the circumstances that gave rise to the recovery of the benefits becoming probable existed at the acquisition date. If they did, entity A recognises a deferred tax asset of C150 and reduces goodwill by C150.

The adjustments are rolled back to the acquisition date; if the acquisition was in the previous accounting period, the comparative information in the financial statements is restated, if material. If the circumstances that gave rise to the recovery of the benefits becoming probable arose after the date of the business combination, entity A recognises a deferred tax asset of C150 and tax income of C150. Goodwill is not adjusted.

Contingent liabilities

A contingent liability within the scope of IAS 37 that was recognised in a business combination that is not settled, is not cancelled or expires is measured at the greater of:

• the amount that would be recognised under IAS 37; and
• the amount initially recognised in the business combination, less the cumulative amount of income recognised in accordance with the principles of IFRS 15.

A contingent liability’s value will only increase if an outflow of economic benefits becomes probable. Until a contingent liability becomes probable, and it meets the IAS 37 recognition criteria, it continues to be measured at the amount at which it was recognised on the date of the business combination, less the cumulative amount of income recognised in accordance with IFRS 15 (if appropriate).

Amortisation in accordance with IFRS 15 is appropriate for financial guarantee contracts.

Indemnification assets

Indemnification assets recognised at the acquisition date continue to be measured on the same basis as the related indemnified item, subject to collectability and contractual terms, until they are collected, sold or cancelled or expire in the post-combination period.

Subsequent accounting for indemnification assets

An indemnification asset might relate to any liability or contingent liability of the acquired business. The indemnified item might be an employee benefit obligation measured under IAS 19, a provision under IAS 37, or an uncertain tax position. The entity measures the indemnification asset on the same basis as the related item, subject to any restrictions in the contractual terms, such as a ceiling on the amount payable or any adjustment for the seller’s creditworthiness.

Measurement on the same basis includes recognising any gains or losses appropriately.

For example, if the indemnified liability is a defined benefit pension liability, the indemnification might be remeasured partly through other comprehensive income and partly through profit or loss. The indemnified item might be a contingent liability. The contingent liability is remeasured if it becomes probable and, therefore, is reclassified and measured as a provision under IAS 37.

If the full amount of the contingency is subject to the indemnity and it becomes probable, the difference between the previously recorded amount and the best estimate of the future outflow is recorded as an increase in the liability and the indemnification asset. The contingent liability is de-recognised if the seller is released from the obligation without payment (for example, if the contingency does not crystallise). Both the indemnification asset and the liability are derecognised. Adjustments for changes in the value of the indemnification asset and the indemnified item can be offset in the statement of comprehensive income.

That is, net presentation in the statement of comprehensive income is acceptable in this situation. However, if the indemnified item is a tax liability, netting would not be appropriate. Tax expense is a defined term in IAS 12 . The movement in the indemnification asset related to an indemnified tax item does not meet the definition of tax expense and, as such, should not be netted within tax expense. Seller indemnifications might relate to indemnified items that are not recorded at the date of acquisition.

For example, a contingent liability might not be recognised at the acquisition date, because it cannot be reliably measured. If the contingent liability subsequently becomes a liability, it is recognised. An indemnification asset is recorded at the same time and on the same basis as the liability (subject to contractual limitations on the indemnified amount and management’s assessment of collectability), regardless of whether the recognition is within the measurement period.

Contingent consideration

Changes in the fair value of liability-classified contingent consideration that are not measurement period adjustments are reflected in the income statement. The changes resulting from events such as meeting an earnings target, reaching a specified share price or reaching a milestone on a research and development project are not measurement period adjustments.

There is an exception for contingent consideration arising in a business combination before 2009, accounted for under the previous version of IFRS 3. Changes in the value of such contingent consideration agreements are adjusted against goodwill.

Contingent consideration that is classified as an equity instrument is not remeasured. Contingent consideration that is not classified as equity should be remeasured at fair value through the income statement.

The Annual Improvements to IFRS 2010-2012 Cycle clarified subsequent measurement at fair value for contingent consideration that is not classified as equity. The option to recognise gain or loss from remeasurement in other comprehensive income was removed. This clarification did not significantly affect existing practice.

Monetary contingent consideration that the acquirer is due to pay or receive is within the scope of IFRS 9.

Contingent consideration payable to be settled in cash or another financial asset is a financial liability, and it is measured at each reporting date at fair value. IFRS 9 has been amended to include ‘contingent consideration of an acquirer in a business combination to which IFRS 3 applies’ in the definition of a financial asset or financial liability at fair value through profit or loss, to make it clear that amortised cost measurement cannot be used. Changes in the fair value of the liability are included in the income statement.

Contingent consideration receivable from the seller is not frequently observed in practice. However, contingent consideration receivable (that is, contingently returnable consideration) to be settled in cash or another financial asset is a financial asset and is classified under IFRS 9.

Previously, the most likely classification would have been as an available-for sale (AFS) financial asset. However, in view of the recent amendments to IFRS 9, contingent consideration can no longer be classified as an AFS financial asset.

Contingent consideration is seldom expected to be a non-financial asset or a non-financial liability, because it almost invariably arises from a contractual requirement to transfer cash or another financial asset. However, if contingent consideration receivable or payable is non-financial − possibly because it relates to non-financial assets or arises from some form of constructive obligation − it is recognised at fair value and is subsequently remeasured to fair value each reporting period, with changes in fair value recognised in profit or loss.

Changes in the fair value of contingent consideration

IFRS 3 does not contain any guidance as to where changes in the fair value of contingent consideration should be presented in the income statement. IFRS 9 is also silent on this subject. The fair value could change for a number of reasons – for example, changes in assumptions regarding the future profit levels on which the contingent consideration payable will be based, or the unwind of the discount to reflect the time value of money.

Various alternative approaches might be acceptable. The presentation of the fair value movement should ideally follow the nature and purpose of the contingent consideration. Classification within operating profit as a whole might be appropriate if the fair value has moved primarily due to changes in assumptions about future profit levels, because the fair value movement is directly linked to the group’s trading performance.

If the subsidiary acquired is performing better than originally expected, the increased operating profit from the subsidiary’s trading would be partially offset by the increase in value of the contingent consideration. If the fair value has moved primarily as a result of the time value of money, it might be appropriate to present the fair value movement as a whole within finance costs. Contingent consideration receivable from the seller is seldom observed in practice. However, contingent consideration receivable to be settled in cash or another financial asset is a financial asset and is classified under IFRS 9.

It is unlikely that the cash flows associated with the contingent consideration receivable will represent payment of solely principal plus interest. It is important to understand why the cash flows of the contingent consideration receivable would change and, whilst not determinative, the trigger of the contingent event might also need to be considered.

The contingent consideration receivable generally changes, based on operating performance or other factors. This is not a characteristic of a basic lending arrangement. The most likely classification for contingent consideration receivable under IFRS 9 would be fair value through profit or loss (FVTPL).

Contingent consideration is seldom expected to be within IAS 37’s scope, because it almost invariably arises from a contractual requirement to transfer cash or another financial asset. However, if contingent consideration receivable or payable is within IAS 37’s scope − possibly because it was related to non-financial assets or arose from some form of constructive obligation − it is recognised at fair value, and subsequent changes are accounted for under IAS 37. A liability within IAS 37’s scope is measured at the best estimate of the amount to be paid, discounted to the balance sheet date. Changes in the liability from the accretion of the discount are accounted for as interest expense, and they are recorded in earnings. Changes in the expected cash outflows are recorded in earnings.

Presentation of changes in the fair value of contingent consideration

IFRS 3 does not contain any guidance as to where changes in the fair value of contingent consideration should be presented in the income statement. IFRS 9 is also silent on this subject.

The fair value could change for a number of reasons – for example, changes in assumptions regarding the future profit levels on which the contingent consideration payable will be based, or the unwind of the discount to reflect the time value of money. Various alternative approaches could be acceptable.

The presentation of the fair value movement should follow the nature and purpose of the contingent consideration. Classification within operating profit as a whole might be appropriate if the fair value has moved primarily due to changes in assumptions about future profit levels, because the fair value movement is directly linked to the group’s trading performance.

If the subsidiary acquired is performing better than originally expected, the increased operating profit from the subsidiary’s trading would be partially offset by the increase in value of the contingent consideration. If the fair value has moved primarily as a result of the time value of money, it might be appropriate to present the fair value movement as a whole within finance costs.