Contingencies – Best and complete 2 read

Contingencies

Contingencies are an interesting subject in accounting because for example within IAS 37 the term ‘contingent’ is used for liabilities and assets that are not recognised because their existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity.

So contingencies may exists as to the recognition or disclosure of assets and liabilities, but also for contingent consideration in IFRS 3 Business combinations, contingent settlement provisions included in financial instruments (arising on liquidation or in puttable instruments) and/or contingently issuable shares in IAS 33 Earnings per share, just to name a few.

Recognition criteria for provisions and contingent liabilities

Provisions can be distinguished from other liabilities (e.g. trade payables and accruals) due to the uncertainty concerning the timing or amount of the future expenditure required in settlement.

In a general sense, all provisions are contingent because they are uncertain in timing or amount. However, within IAS 37 the term ‘contingent’ is used for liabilities and assets that are not recognised because their existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity.

IAS 37.14 requires a provision be recognised when all of the following apply:

  • an entity has a present obligation (legal or constructive) as a result of a past event
  • it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation
  • a reliable estimate can be made of the amount of the obligation

Provisions are measured at the best estimate of the expenditure required to settle the present obligation at the reporting period:

  • including any considerations for risks and uncertainties
  • including time value of money (if material)
  • including future events when there is sufficient objective evidence that they will occur
  • excluding gains from the expected disposal of assets

Provisions are to be reviewed at the end of each reporting period and adjusted to reflect the current best estimate.

The provision is reversed where it is no longer probable that an outflow of resources embodying economic benefits will be required to settle the obligation.

A provision is used only for expenditures for which the provision was originally recognised; i.e. only expenditures that relate to the original provision are set against it.

When some or all of the expenditure required to settle a provision is expected to be reimbursed by another party, the reimbursement shall be recognised as a separate asset when, and only when, it is virtually certain that the reimbursement will be received if the entity settles the obligation. The maximum amount recognised as an asset is the amount of the provision.

IAS 37 stipulates that:

  • A provision must not be recognised for future operating losses;
  • If an entity has a contract that is onerous, the present obligation under the contract is recognised and measured as a provision; and
  • A provision for restructuring costs can only be recognised if specific present obligation requirements are satisfied (e.g. details formal plan and the entity has raised a valid expectation in those affected).

Note: The difference between a future operating loss and an onerous contract is in the present obligation.

With an onerous contract, there is a committed obligation to deliver the customer at a loss. A future operating loss does not have the equivalent present obligation; e.g. no obligation to continue at a loss; expected loss has not eventuated.

Contingent Liabilities

IAS 37 prohibits recognition of contingent liabilities given that they are either:

  • Possible obligations, as it has yet to be confirmed whether the entity has a present obligation that could lead to an outflow of resources embodying economic benefits; or
  • Present obligations that do not meet the recognition criteria (because either it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation, or a sufficiently reliable estimate of the amount of the obligation cannot be made).

This decision tree provides the questions and decisions for the recognition requirements of IAS 37 for provisions and contingent liabilities:

contingencies

Recognition criteria for contingent assets

IAS 37 prohibits the recognition of contingent assets since this may result in the recognition of income that may never be realised. Contingent assets usually arise from unplanned or other unexpected events that give rise to the possibility of an inflow of economic benefits to the entity (e.g. a claim that an entity is pursuing through legal processes where the outcome is uncertain).

To assist in this judgement assessment here is the definition of an asset (IAS 38.8):

  • controlled by an entity as a result of past events; and
  • from which future economic benefits are expected to flow to the entity.

Recognition criteria for contingent consideration

Many combinations include contingent consideration – defined as an obligation of the acquirer to transfer additional assets or equity interests to the acquiree’s former owners if specified future events occur or conditions are met. This can be a useful mechanism to enable the acquirer and the vendor to agree on terms of the business combination in the face of uncertainties that may affect the value and future performance of the acquired business.

IFRS 3 provides guidance on the recognition and measurement of contingent consideration:

  • contingent consideration is recognised and measured at fair value on the acquisition date (IFRS 3.39)
  • IAS 32 Financial Instruments: Presentation is applied to determine classification as a financial liability or as equity (IFRS 3.40)
  • where the purchase agreement includes a right to the return of previously transferred consideration if specified conditions are met, the acquirer classifies that right as an asset (IFRS 3.40)

When applying IFRS 3’s requirements on contingent consideration:

  • the amount recognised on the acquisition date directly impacts goodwill and reported liabilities or equity
  • classification either as liability or equity under IAS 32 affects post-combination reported results as follows:
    • a contingent consideration liability is subsequently remeasured at fair value through profit or loss until settled
    • contingent consideration classified as equity is not remeasured and its subsequent settlement is accounted for within equity
  • goodwill is not adjusted after the acquisition date to reflect changes in the fair value or settlement of contingent consideration except for adjustments qualifying as measurement period adjustments (see below) or arising from corrections of errors
  • some contingent consideration arrangements may include transactions that are accounted for separately from the business combination (see the narrative here).
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The following examples illustrate some of IFRS 3’s key principles on contingent consideration:

Deferred and contingent consideration

Company A acquires the entire equity of Company B for CU120,000. Company A also agrees to pay an additional amount that is the higher of CU1,500 and 25% of any excess of Company B’s profits in the first year after the acquisition over its profits in the preceding 12 months. This additional amount is due after two years. Company B earned profits of CU20,000 in the preceding 12 months but expects to make at least CU30,000 in the year after the acquisition date.

Analysis:

In this situation, contingent and deferred payments should be differentiated. Company A agrees to pay an amount that is the higher of two amounts. The additional amount of CU1,500 is the minimum amount payable by Company A and is not subject to any contingency. Accordingly, this amount is a deferred payment rather than a contingent payment. The contingent payment only relates to the portion that will be paid if Company B exceeds its profit target.

Consideration transferred consists of cash paid and both the deferred and contingent payment, measured at fair value:

  • cash at its face amount
  • deferred payment at its present value – determined by discounting it using a market rate of interest for a similar instrument of an issuer with a similar credit rating
  • contingent payment at its estimated fair value – determined taking into account the probability that Company B will earn profits above the level that triggers additional payment.

Contingent consideration payable in fixed number of shares

An acquirer purchased a business in the pharmaceutical industry. The sale and purchase agreement specifies the amount payable as:

  • cash of CU100 million to be paid on the acquisition date and
  • an additional 1,000,000 shares of the acquirer to be paid after 2 years if a specified drug receives regulatory approval.

Analysis:

The consideration transferred comprises the cash paid plus the fair value of the contingent obligation to pay 1,000,000 shares in 2 years’ time. The fair value of the contingent element would be based on a 2-year forward price and would be reduced by the effect of the performance conditions.

The classification of the contingent consideration is based on the definitions in IAS 32. Because this obligation can be settled only by issuing a fixed number of shares, it is classified as an equity instrument.

Accordingly, the initial fair value of the contingent consideration is credited to equity. There is no subsequent adjustment (although the credit might be reclassified within equity on settlement in shares or on expiry of the obligation).

Contingent consideration payable in variable number of shares

On 31 December 20X1, Company X acquired business Y. The consideration is 80,000 shares of Company X, plus an additional number of shares equivalent to CU100,000 (based on the fair value of Company X shares) if the average profits of Y in 20X2 and 20X3 exceed a target level. The additional shares will be issued on 7 January 20X4, if applicable. There are no other costs of the combination.

At the acquisition date, Company X’s management consider that it is 40% probable that Y will achieve its average profit target. At that date, the fair value of Company X’s shares is CU10. Also, the entity determines that the prevailing rate of return for financial instruments having substantially the same terms and characteristics of the contingent consideration is 5%.

Analysis:

To account for the business combination, Company X will include the contingent consideration in determining the total consideration transferred related to the purchase of Y. On the acquisition date, the consideration transferred will then be equal to CU836,281 which consists of:

  • the fixed amount of shares to be issued of CU800,000 (80,000 x CU10) plus
  • the fair value of the contingent consideration of CU36,281 (CU100,000 / (1.05)2 x 40%).

The contingent consideration requires the issuance of a variable number of shares equal to a fixed monetary amount. Accordingly, it is classified as a financial liability.

Notes:

The same accounting treatment will apply in situations where contingent consideration is payable in cash.

IFRS 3 does not specify a valuation technique for measuring fair value. A simple approach is used here but other valuation techniques may be more appropriate to use in practice.

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Many acquired businesses will contain contingent liabilities – for example, pending lawsuits, warranty liabilities or future environmental liabilities. These are liabilities where there is an element of uncertainty; the need for payment will only be confirmed by the occurrence or non-occurrence of a specific event or outcome. The amount of any outflow and the timing of an outflow may also be uncertain.

There is very little change to current guidance under IFRS. Contingent assets are not recognised, and contingent liabilities are measured at fair value. After the date of the business combination contingent liabilities are re-measured at the higher of the original amount and the amount under the relevant standard, IAS 37.

Measurement of contingent liabilities after the date of the business combination is an area that may be subject to change in the future.

Earn-outs

It is common for some of the consideration in a business combination to be contingent on future events. Uncertainty might exist about the value of the acquired business or some of its significant assets. The buyer may want to make payments only if the business is successful. Conversely, the seller wants to receive full value for the business. Earn-outs are often payable based on post- acquisition earnings or on the success of a significant uncertain project.

With contingent consideration that is a financial liability, fair value changes will be recognised in the income statement. This means that the better the acquired business performs, the greater the likely expense in profit or loss.

Contingent consideration in shares or cash

An earn-out payable in cash meets the definition of a financial liability. It is re-measured at fair value at every balance Contingenciessheet date, with any changes recognised in the income statement.

Earn-outs payable in ordinary shares may not require re-measurement through the income statement. This is dependent on the features of the earn-out and how the number of shares to be issued is determined. An earn-out payable in shares where the number of shares varies to give the recipient of the shares a fixed value would meet the definition of a financial liability. As a result, the liability will need to be fair valued through income. Conversely, where a fixed number of shares either will or will not be issued depending on performance, regardless of the fair value of those shares, the earn-out probably meets the definition of equity and so is not re-measured through the income statement.

Goodwill and contingent consideration

Regardless of how payments are structured, the consideration is recognised in total at its fair value at the date of the acquisition. Paying the same amount in today’s values in different ways will not make a difference to the amount of goodwill recognised.

Payments that are contingent and deemed to be part of the acquisition price will be measured at fair value and included in the business combination accounting on day 1. Equity instruments that are contingent consideration are not subsequently re-measured. Debt instruments are subsequently re-measured through the income statement.

Changes in the carrying amount of contingent consideration will often not be offset by profits and losses of the acquired subsidiary. A substantial payment to the previous owners may be required if an in-process research and development (IPR&D) project meets key approval milestones. The successful IPR&D project may generate substantial profits over 20 years. The increased amounts due under the contingent consideration arrangement are likely to be recognised as an expense in the income statement before the project generates any revenue at all.

12 month measurement period

An acquirer has a maximum period of 12 months to finalise the acquisition accounting. The adjustment period ends when the acquirer has gathered all the necessary information, subject to the one year maximum. There is no exemption from the 12-month rule for deferred tax assets or changes in the amount of contingent consideration.

Examples

Liability arising from a lawsuit

Company A purchased 100% interest of Company B. Company B is being sued over a personal injury allegedly caused by a faulty product. The claimant is suing for CU1 million in damages. The acquiree’s management acknowledge that the product was faulty and may have caused injury. However, they strongly dispute the level of damages being claimed. The acquiree’s legal advisers estimate such claims are usually settled for between CU100,000 and CU250,000.

Analysis:

Based on the available evidence, this is an example of a present obligation, which is consequently recognised as a contingent liability and measured at fair value. Company A will need to estimate the fair value of the liability which may involve weighting possible outcomes within the expected range using their associated probabilities.

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Indemnification asset

Company W acquires Company X from Company Y. The purchase price is CU1,000. Company X has a contingent liability in respect of litigation by a third party. Company Y agrees to reimburse Company W if these costs are incurred, up to a maximum of CU100. Company W’s management concluded that this is a present obligation and the fair value of the liability at the acquisition date is determined to be CU60.

Analysis:

In this situation, Company W will recognise a contingent liability of CU60 and an indemnification asset of CU60, measured and recognised on the same basis as the related contingent liability, less a valuation allowance if necessary.

Recognition criteria for contingent settlement provisions

A financial instrument containing a contingent settlement provision, under which the instrument would be classified as a financial liability on the occurrence or non-occurrence of some uncertain future event beyond the control of both the issuer and the holder, will usually be classified as a financial liability unless the part of the contingent settlement provision that indicates liability classification is not genuine; or the issuer can be required to settle the obligation in cash or another financial asset only in the event of liquidation of the issuer.

The ‘event’ may be within the control of the issuer or of the holder, or beyond the control of both.

If the issuer is able to control the outcome of the event that would otherwise trigger a payment obligation, it is able to avoid payment. Accordingly, no liability arises. Conversely, if the holder can control the outcome, the holder is effectively able to demand payment and the instrument is classified as a liability.

In many instruments, however, neither party controls the ‘event’ in question. Examples of such provisions are payments triggered by:

  • changes in a stock market or other index
  • changes in specified interest rate indices
  • taxation requirements
  • the financial results of the issuer (such as future revenues or net income).

Where a financial instrument contains such a provision, the issuer of the instrument does not have the unconditional right to avoid delivering cash or another financial asset. Therefore the contingent settlement provision results in a financial liability unless one of the following applies:

  • the part of the contingent settlement provision that indicates liability classification is ‘not genuine’
  • the issuer can be required to settle the obligation in cash or another financial asset (or such other way that would cause it to be a financial liability) only in the event of liquidation of the issuer
  • (in relatively rare circumstances) the instrument has all the features and meets the conditions relating to the exceptions for puttable instruments and obligations arising on liquidation (see Puttable instruments and obligations arising on liquidation).

Illustration of classification process for contingent settlement provisions

Classification process for an instrument containing an obligation arising only on the occurrence or non-occurrence of uncertain future events

contingencies

Ordinary shares redeemable in event of stock exchange listing

Entity A issues shares that are redeemable at par in the event of Entity A listing on a stock exchange.Contingencies

The possibility of Entity A listing on a stock exchange is a contingent settlement provision. However, it is not clear-cut whether this ‘event’ is within Entity A’s control.

The general opinion is that there is a reasonable argument that an entity is able to avoid listing on a stock exchange if it so chooses (the converse is perhaps more debatable, as obtaining a listing requires the involvement and approval of third parties such as exchange regulators). Under this view, the event in question is within Entity A’s control (and not the holder’s control). Hence the shares would be classified as equity instruments.

Note that the same analysis would not apply if redemption in the example was instead contingent on the sale of the company (via current shareholders selling their shares). Normally the sale of the company would be within the holders’ control meaning the shares would be classified as financial liabilities.

However, if redemption was only on the sale of the company’s assets, then this may be an event within the company’s control (and hence the shares would not be classified as financial liabilities).

What is within the control of the entity?

The examples above indicate some of the complexities involved in ‘drawing the line’ between what is within the control of the entity and what is not. Differing views exist however on where to draw this line in practice. A common practical issue concerns ‘obligations’ where payments must be approved by the shareholders in general meeting. The question is whether the shareholders are regarded as an extension of the entity in this situation. If so, the shareholders’ rights to approve or reject payments being made amount to a discretion of the entity to refuse payment.

Some commentators hold the view that the shareholders are not part of the entity even when voting as a collective body in general meeting. This view regards the shareholders as acting in their personal capacity as individuals when voting.

Other commentators make a distinction between actions of shareholders as a body under an entity’s governing charter and other individual actions of the shareholders such as selling their shares.

In summary, there is no clear consensus on this issue and judgement will need to be applied in evaluating each particular situation in practice.

Recognition criteria for contingently issuable shares

In IAS 33 EPS calculations (see EPS) shares are in the denominator of the calculation.

Contingently issuable shares are treated as outstanding and are included in the calculation of basic earnings per share only from the date when all necessary conditions are satisfied (e.g. the events have occurred). This excludes shares that are issuable solely after a period of time (e.g. event has not occurred and passage of time is a certainty).

In addition, the entity has to disclose:

instruments (including contingently issuable shares) that could potentially dilute basic earnings per share in the future, but were not included in the calculation of diluted earnings per share because they are anti-dilutive for the period(s) presented.

Disclosure example

An example in real life Financial statements is provided here: Contingencies


Contingencies

Contingencies

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