number of shares or other consideration transferred can change between the agreement
date and the acquisition date. [IFRS 3.BC342].
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Measuring the fair value of an entity’s own equity issued on or close to the agreement
date would not result in a consistent measure of the consideration transferred. The fair
values of all other forms of consideration transferred are measured at the acquisition date
as are the fair values of the assets acquired and liabilities assumed. [IFRS 3.BC338-BC342].
The acquisition-date fair value of the acquiree’s equity interests may be more reliably
measurable than that of the acquirer’s equity interests. In that case, IFRS 3 requires
goodwill to be calculated using the fair value of the acquiree’s equity interests rather
than the fair value of the equity interests transferred. [IFRS 3.33].
IFRS 3 gives additional guidance if no consideration is transferred by the acquirer. This
is discussed at 7.4 below.
7.1 Contingent
consideration
Contingent consideration generally arises where the acquirer agrees to transfer
additional consideration to the former owners of the acquired business after the
acquisition date if certain specified events occur or conditions are met in the future,
although it can also result in the return of previously transferred consideration.
[IFRS 3 Appendix A].
When entering into a business combination, the parties to the arrangement may not
always agree on the exact value of the business, particularly if there are uncertainties as
to the success or worth of particular assets or the outcome of uncertain events. They
therefore often agree to an interim value for the purposes of completing the deal, with
additional future payments to be made by the acquirer. That is, they share the economic
risks relating to the uncertainties about the future of the business. These future payments
may be in cash or shares or other assets and may be contingent upon the achievement of
specified events, and/or may be linked to future financial performance over a specified
period of time. Examples of such additional payments contingent on future events are:
• earnings above an agreed target over an agreed period;
• components of earnings (e.g. revenue) above an agreed target over an agreed period;
• approval of a patent/licence;
• successful completion of specified contract negotiations;
• cash flows arising from specified assets over an agreed period; and
• remaining an employee of the entity for an agreed period of time.
An arrangement can have a combination of any of the above factors.
While these payments may be negotiated as part of gaining control of another entity,
the accounting may not necessarily always reflect this, particularly if these payments
are made to those who remain as employees of the business after it is acquired. In the
latter case, depending on the exact terms of the arrangement, the payment made may
be accounted for as remuneration for services provided subsequent to the acquisition,
rather than as part of the consideration paid for the business.
These payments are also often referred to as ‘earn-outs’. The guidance in IFRS 3 for
determining whether the arrangements involving employees should be accounted for
as contingent consideration or remuneration is discussed further at 11.2 below.
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The IASB clarified in June 2009 that pre-existing contingent consideration from a prior
business combination of an acquiree does not meet the definition of contingent
consideration in the acquirer’s business combination. It is one of the identifiable
liabilities assumed in the subsequent acquisition. Usually it makes no difference
whether the pre-existing contingent consideration is treated as contingent
consideration or as an identifiable liability as they are both financial liabilities to be
accounted for under IFRS 9.40 As discussed further below, they are initially recognised
and measured at fair value at the date of acquisition, with any subsequent
remeasurements recognised in profit or loss in accordance with IFRS 9.
7.1.1
Initial recognition and measurement
Contingent consideration is recognised at its fair value as part of the consideration
transferred in exchange for the acquiree. [IFRS 3.39].
IFRS 13 has specific requirements with respect to measuring fair value for liabilities. An
entity has to determine the price it would need to pay to transfer the liability to a market
participant at the measurement date. An entity must assume that the market participant
would fulfil the obligation (i.e. it would not be settled or extinguished). [IFRS 13.34(a)]. The
specific requirements are discussed in detail in Chapter 14 at 11. In light of these
requirements, it is likely that the fair value of contingent consideration will need to be
measured ‘from the perspective of a market participant that holds the identical item as an
asset at the measurement date’. [IFRS 13.37]. That is, the entity measures the fair value of the
liability by reference to the fair value of the corresponding asset held by the counterparty.
The initial measurement of the fair value of contingent consideration is based on an
assessment of the facts and circumstances that exist at the acquisition date. Although
the fair value of some contingent payments may be difficult to measure, it is argued that
‘to delay recognition of, or otherwise ignore, assets or liabilities that are difficult to
measure would cause financial reporting to be incomplete and thus diminish its
usefulness in making economic decisions’. [IFRS 3.BC347]. Information used in
negotiations between buyer and seller will often be helpful in estimating the fair value
of the contingent consideration. [IFRS 3.BC348].
An estimate of zero for the fair value of contingent consideration would not be reliable.
[IFRS 3.BC349]. Equally, it would be inappropriate to assume an estimate of 100% for the
acquisition-date fair value of the obligation to make the payments under the contingent
consideration arrangement.
The fair value of contingent consideration will be measured in accordance with IFRS 13
which does not limit the valuation techniques an entity might use. However, there are
two commonly used approaches to estimating the fair value of contingent consideration
that an entity might consider:
• the probability-weighted average of payouts associated with each possible
outcome (‘probability-weighted payout approach’); or
• the payout associated with the probability-weighted average of outcomes
(‘deterministic approach’).
Entities should consider the relationship between the underlying performance metric
or outcome and the payout associated with that metric or outcome to determine
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whether a probability-weighted payout or deterministic approach should be used. A
contingent consideration arrangement can be characterised as having either a linear or
non-linear relationship between outcomes and payouts. With a linear payout, the
relationship between the underlying outcomes and the associated payouts is constant
whereas in a non-linear pa
yout the relationship between the underlying outcomes and
the associated payouts is not constant. In situations where the payout structure is non-
linear, using the deterministic approach is unlikely to give a reliable result.
The method that arguably gives the most reliable result in all circumstances is the
probability-weighted payout approach. This method requires taking into account the
range of possible outcomes, the payouts associated with each possible outcome and the
probability of each outcome arising. The probability-weighted payout is then
discounted. This approach is illustrated in the following example.
Example 9.13: Contingent consideration – applying the probability-weighted
payout approach to determine fair value
Entity G acquires Entity H and as part of the arrangement, Entity G agrees to pay an additional amount of
consideration to the seller in the future, as follows:
• if the 12 month earnings in two years’ time (also referred to as the trailing 12 months) are €1 million or
less – nothing will be paid;
• if the trailing 12 months’ earnings in two years’ time are between €1 million and €2 million – 2 ×
12 month earnings will be paid;
• if the trailing 12 months’ earnings in two years’ time are greater than €2 million – 3 × 12 month earnings
will be paid.
At the date of acquisition, the possible twelve-month earnings of Entity H in two years’ time are determined
to be, as follows:
• €0.8 million – 40%
• €1.5 million – 40%
• €2.5 million – 20%
The probability-weighted payout is:
(40% × €0) + (40% × €1.5 million × 2) + (20% × €2.5 million × 3) = €2.7 million
This €2.7 million is then discounted at the date of acquisition to determine its fair value.
Since the liability must be measured at fair value, selecting the discount rate to be
applied also requires significant judgement to assess the underlying risks associated with
the outcomes and the risks of payment (see 7.1.1.A below for further discussion). The
entity’s own credit risk will need to be taken into account when measuring fair value,
which could include adjusting the discount rate. In addition, IFRS 13 indicates that in
those situations where the identical item is held by another party as an asset, the fair
value of the liability should be determined from the perspective of a market participant
that holds this asset. This guidance applies even if the corresponding asset is not traded
or recognised for financial reporting purposes. As such, when determining the fair value
of a contingent consideration liability, one should consider market participants’
assumptions related to the item when held as an asset. The IASB and the FASB indicated
that ‘in an efficient market, the price of a liability held by another party as an asset must
equal the price for the corresponding asset. If those prices differed, the market
participant transferee (i.e. the party taking on the obligation) would be able to earn a
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profit by financing the purchase of the asset with the proceeds received by taking on
the liability. In such cases, the price for the liability and the price for the asset would
adjust until the arbitrage opportunity was eliminated.’ [IFRS 13.BC89].
IFRS 3 also recognises that, in some situations, the agreement may give the acquirer the
right to the return of previously transferred consideration if specified future events
occur or conditions are met. Such a right falls within the definition of ‘contingent
consideration’, and is to be accounted for as such by recognising an asset at its
acquisition-date fair value. [IFRS 3.39-40, Appendix A].
7.1.1.A
Estimating an appropriate discount rate
As discussed at 7.1.1 above, determining the appropriate discount rate to be applied
requires significant judgement and requires that an entity consider the risks and
uncertainty related to the asset or liability being measured.
Market participants generally require compensation for taking on the uncertainty
inherent in the cash flows of an asset or a liability. This compensation is known as a risk
premium. IFRS 13 states that in order to faithfully represent fair value, a present value
technique should include a risk premium. The standard acknowledges that determining
the appropriate risk premium might be difficult. However, the degree of difficulty alone
is not a sufficient reason to exclude a risk premium if market participants would demand
one. [IFRS 13.B16].
Depending on the present value technique used, risk may be incorporated in the cash
flows or in the discount rate. However, identical risks should not be captured in both
the cash flows and the discount rate in the same valuation analysis. For example, if
the probability of default and loss given default for a liability are already
incorporated in the discount rate (i.e. a risk-adjusted discount rate), the projected
cash flows should not be further adjusted for the expected losses (see Chapter 14
at 21.2 for further discussion).
When determining the discount rate to use in measuring the fair value of contingent
consideration, an entity should consider the risks associated with:
• the underlying outcome;
• the nature of the payout structure (e.g. a constant, fixed payment on achievement
of the contingency versus a variable payment based on a multiple of earnings); and
• the ability of the holder to collect the contingent consideration payment
(i.e. credit risk).
The first risk, which is associated with the underlying outcome, is generally
represented as the required rate of return on the capital necessary to produce the
outcome. For example, if the outcome is based on a measure such as revenue or
EBIT, the required rates of return on the debt and equity capital used to generate
the outcome should provide the starting point for estimating the discount rate. In
this case, a weighted-average cost of capital may be an appropriate rate of return.
On the other hand, if the outcome is based on net income, the cost of equity may
be a more appropriate rate of return because the debt capital has already received
its return via the interest payment. Furthermore, since the contingent consideration
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will be based on the target’s performance, the risk should reflect the uncertainty
specific to the target, rather than to a hypothetical market participant.
The second risk is inherent in the nature of the payout structure. In some
circumstances, the risk of the underlying outcome may be captured in a weighted-
average cost of capital or cost of equity. However, they may understate the discount
rate. In particular, when the payout structure is non-linear, there may be additional
risks that need to be considered. In other words, the contractual features that define
the structure of the earn-out could make it a riskier arrangement. For example,
assume there is an earn-out with the following characteristics: the payout is three
times EBIT if more than €1 million; there is a 50% probability of EBIT being
€1 million; and a 50% probability of EBIT being €2 million. The risk of EBIT bein
g
€1,000,000 versus €1,000,001 is small. That is, it represents only a fraction of a
percentage. However, for the earn-out, there is incremental risk associated with
that last € of EBIT. If EBIT is €1,000,000, the earn-out is not triggered, but if it is
€1,000,001, the payout is required.
The third risk is the ability of the holder to collect the contingent consideration
payment (i.e. credit risk of the buyer). Contingent consideration arrangements generally
do not represent a direct claim on the cash flows from the underlying outcome (such as
a specified portion of the target’s earnings), but rather a subordinate, unsecured claim
on the buyer. The credit risk of the buyer should be considered, taking into account the
seniority of the contingent consideration claim in the buyer’s capital structure and the
expected timing of the payout. The buyer’s own credit risk is considered in determining
fair value because IFRS 13 presumes the liability is transferred to a market participant
of equal credit standing. [IFRS 13.42].
As discussed at 7.1.1 above, the fair value of a contingent consideration liability will
likely need to be measured from the perspective of a market participant that holds
the identical instrument as an asset. If the risk premium of the contingent
consideration arrangement were to increase, the fair value would decline (i.e. due
to a higher discount rate) for the holder of the contingent consideration asset. This
increase in the risk premium would have a symmetrical effect on the liability (i.e.
the discount).
7.1.2
Classification of a contingent consideration obligation
Most contingent consideration obligations are financial instruments, and many are
derivative instruments. Some arrangements oblige the acquirer to deliver equity securities
if specified future events occur, rather than, say, making additional cash payments.
The classification of a contingent consideration obligation that meets the definition of
a financial instrument as either a financial liability or equity is to be based on the
definitions in IAS 32 (see Chapter 43). [IFRS 3.40].
These requirements, and the impact of subsequent measurement and accounting
(which is discussed further at 7.1.3 below), are summarised in the diagram below.
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International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 128