IFRS 3 Continuing employment

IFRS 3 Continuing employment – Contingent arrangements payable to former shareholders that continue in employment may be linked to the different future performance metrics of the acquired business. What indicators help differentiate consideration from remuneration of post-combination services? IFRS 3 Continuing employment

Contingent arrangements payable to selling shareholders that continue providing services should be assessed to determine if there is an element of payment for post-combination services (‘remuneration’). This assessment requires management to understand why the contingent arrangement is included in the agreement, which party (the seller or the buyer) initiated the arrangement and when the parties entered into the arrangement [IFRS 3 B54]. IFRS 3 Continuing employment

The nature of the arrangement will dictate whether contingent payments to employees (or selling shareholders) are:

  1. contingent consideration in a business combination or IFRS 3 Continuing employment
  2. separate transactions for remuneration. IFRS 3 Continuing employment

Separate transactions for remuneration are typically expensed in the post combination period. IFRS 3 B54-B55 provides indicators that should be considered if it is unclear whether an arrangement for payments to employees or selling shareholders is part of the consideration in exchange for the acquire or is a separate transaction for remuneration. These criteria need to be applied to all arrangements for payments to employees or selling shareholders, including cash payments and share-based arrangements.

The contingent payment will be recognised in the income statement over the service period if it is deemed to be remuneration. A contingent payment that is deemed to be consideration becomes part of the acquisition and increases goodwill at initial recognition.

Some of the important considerations are: IFRS 3 Continuing employment

  • Continuing employment; IFRS 3 Continuing employment
  • Duration of continuing employment; IFRS 3 Continuing employment
  • Level of remuneration (excluding contingent payment); IFRS 3 Continuing employment
  • Incremental payments to employees; IFRS 3 Continuing employment
  • Number of shares owned; IFRS 3 Continuing employment
  • Linkage to the valuation (that is, is the contingent payment compensating for low upfront consideration?); and
  • Formula for determining consideration. IFRS 3 Continuing employment

Management should consider all of the indicators in IFRS 3 B54-B55. However, not all indicators have equal weight. Contingent payments that are forfeited if employment ceases are accounted for as remuneration regardless of whether other indicators point towards the payment being classified as consideration. Contingent payments that are not automatically forfeited if employment ceases may be remuneration but require further analysis. The conclusions in the examples that follow may change as factors indicating consideration are changed to indicators of remuneration. Management needs to exercise judgement where there are factors indicating both consideration and remuneration. IFRS 3 Continuing employment

Classification determination framework

The flow chart and table of indicators below illustrate the framework to determine whether a payment to shareholders is consideration, remuneration or both. This analysis should be applied to all arrangements with selling shareholders, including both cash payments and share-based arrangements. All of the indicators in IFRS 3 B54-B55 should be considered when analysing whether arrangements are consideration or are remuneration for post-combination services. An arrangement may contain both consideration and remuneration for post-combination services and therefore the payments should be allocated between consideration and remuneration. IFRS 3 Continuing employment

IFRS 3 Continuing employment

Example 1 – Profit sharing

Entity A, an advertising agency, is owned by a single shareholder, X, who is also the chief executive officer (CEO). Entity A is acquired by Entity B (the buyer) for cash consideration of C25m. X will become a key account manager of the advertising agency within Entity B after the acquisition.

An independent valuation performed at the time of the acquisition placed a value on the business of C20m – C25m, based on a multiple of earnings before interest, taxes, depreciation and amortisation (EBITDA).

X will receive additional payments from Entity B based on the following terms:

  • During year 1: X will receive cash of 20% of the new contract margin for any new contracts he negotiates in Year 1.
  • During Year 2: X will receive cash of 10% of the new contract margin for any new contracts he negotiates in Year 2.

Are the additional payments consideration or remuneration?

Solution

The contingent payments are not automatically forfeited if employment of X ceases, so management should analyse the additional indicators.

The commercial substance of the arrangement incentivises X to remain employed to negotiate new contracts and appears to compensate for services in the post-combination period. The contingent payment does not appear to compensate for low upfront consideration because the purchase price of C25m was at the high end of the independent valuation. The formula for the contingent payment does not relate to the valuation approach. All these factors indicate that the arrangement is consistent with a profit share or an incentive paid to a sales person rather than a payment made to X as part of the exchange for Entity A. It is therefore accounted for as remuneration to reflect the post-combination employee services of X.

Example 2 – Client retention

Entity A, a cable television company, is owned by a single shareholder, X, who is also the chief executive officer (CEO). Entity A is acquired by Entity B (the buyer) for cash consideration of C20m.

Entity B will make additional payments to X based on the percentage of customers of Entity A retained, as follows: C3m paid if 90% of Entity A’s customers at the acquisition date are retained for the 3 years following the acquisition. C2m paid to X if 80% of Entity A’s customers at the acquisition date are retained for the 3 years following the acquisition. C1m paid to X if 70% of Entity A’s customers at the acquisition date are retained for the 3 years following the acquisition.

There is no requirement for X to remain employed with Entity A in order to receive additional payments under the contingent arrangement.

There will be a new CEO in charge of the acquired operations to make all major operating decisions. X will be a vice-president of operations and will not have responsibilities that directly affect Entity A’s customer retention.

X will receive remuneration that is reasonable in relation to other senior management personnel (excluding the additional payments) if X remains employed.

An independent valuation performed at the time of the acquisition placed a value on the business of C20m – C25m, based on a number of customers.

Is the additional payment consideration or remuneration?

Solution

The contingent payments are not automatically forfeited if employment of X ceases, so management should analyse the additional indicators.

The commercial substance of the arrangement does not incentivise X to remain employed because X will have little influence on the retention of customers. The contingent payment does not appear to be remuneration because X is receiving reasonable remuneration for the employment services in relation to other senior management personnel (excluding the additional payments).

The contingent payment appears to be additional consideration because the purchase price of C20m is at the low end of the independent valuation range. The formula for the contingent payment relates to the valuation approach. There are no other factors that indicate remuneration. All this indicates that the arrangement is consideration paid to X as part of the exchange for Entity A. It is therefore included in the purchase price at fair value.

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Contingent arrangements may include a period of employment that differs from the contingent consideration period. How should the amount of contingent consideration or remuneration be determined?

IFRS 3 Continuing employment

The arrangement is likely to be remuneration if the employment period is the same as, or longer than, the contingent payment period. There may be a combination of remuneration and consideration when the period of employment is less than the contingent payment period. The present value of the payment at the end of the required employment may be compared to the present value of a payment at the end of the contingent arrangement period to determine the amount that is linked to post-combination services. This issue may arise when the contingent payment is made sooner if the employment continues. IFRS 3 Continuing employment

Example 3 – contingent payment accelerated if employee does not resign

Professional services firm Entity A is owned by a single shareholder, X, who is also the chief executive officer (CEO). Entity A is acquired by Entity B (the buyer) for cash consideration of C20m.

Entity B believes that retaining the services of X for at least 3 years is helpful to transitioning Entity A’s ongoing business. Entity B will pay X an additional C5m in 3 years if X remains employed for the 3 years and the acquired Entity A business achieves its EBITDA target. If the EBITDA target is achieved but X resigns before the end of the 3-year period, the C5m will still be paid but in 5 years’ time (that is, deferred for an additional 2 years).

If the acquired Entity A business does not achieve its EBITDA target, there will be no payment; X’s employment status is irrelevant. X will have limited influence on EBITDA by providing services during the 3 years because X will focus on transitioning Entity A’s ongoing business rather than growing the business.

An independent valuation performed at the time of the acquisition placed a value on the business of C20m – C25m, based on a multiple of EBITDA.

Is the additional payment consideration, remuneration or both? Can the payment be allocated between consideration and remuneration?

Simplifying assumption(s): C5m has a 3-year discounted present value of C4.4m, and a 5-year discounted present value of C4m.

Solution

The contingent payments are not automatically forfeited if X’s employment ends, so management should analyse the additional indicators.

X has limited influence on the outcome of the EBITDA target and so has fewer incentives to remain employed. The contingent payment appears to compensate for lower upfront consideration because the purchase price of C20m is at the low end of the range of valuations. The formula for the contingent payment relates to the valuation approach. These factors indicate that the arrangement is consideration paid to X as part of the exchange for Entity A.

The timing of the payment is sooner if X remains employed over the 3-year period. The commercial substance of the accelerated payment creates an incentive for X to remain employed and indicates post-combination remuneration. The arrangement therefore contains both remuneration and consideration.

It is reasonable for the discounted present value of the payment that X will receive, irrespective of whether X remains employed, to be considered consideration for the business. The amount that is linked to service, C0.4m, would be accounted for as remuneration. This is calculated as the difference between the discounted present value of the C5m to be paid in 3 years time (that is, C4.4m), and the discounted present value of the C5m to be paid in 5 years’ time (that is, C4m).

The C5m payment is accounted for as follows: C4m as consideration on acquisition; C.4m as post-combination remuneration expense over the 3-year period; C.6m to be accreted as interest expense over the 3-year period.

This assumes that the EBITDA target is expected to be achieved and X is expected to remain as an employee of the combined business for the 3-year service period following the acquisition. In practice, a range of outcomes would be taken into account using a probability weighted average − see IFRS 3 Fair value of contingent consideration’. The impact of using a probability-weighted average approach would typically result in a lower amount being recognised on the acquisition date and income statement volatility in the post-acquisition period.

To the extent that this estimate changes over the period, the present value of the C5m liability is revised based on the revised expectation of the timing and probability of the payment.

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A contingent cash pool to be shared among the individual selling shareholders may change in amount or in amounts allocated to the shareholders when shareholders leave employment. Does the forfeit of the payment by one or more of the shareholders upon leaving employment make the contingent payment is remuneration?

Management should assess all indicators to determine whether the purpose is consideration for the business acquired or to remunerate the selling shareholders for performance in the post-combination period. Scenarios where the contingent payment will be made regardless of whether the selling shareholders remain employed should have commercial substance in order to be considered an indicator that the arrangement is consideration. Contractual terms that lack commercial substance, should not result in the desired accounting outcome.

Example 4 – No link to continuing services

Entity A is acquired by Entity B for cash consideration of C100m. C10m is payable by the buyer to the selling shareholders if Entity A achieves pre-determined sales volumes each year for the 3 years following the acquisition. The payment would be made at the end of the 3-year period and would be paid to all of the previous shareholders of the seller in proportion to their relative previous ownership interests.

The shareholders were all key employees of Entity A prior to the acquisition and continue as employees of the combined business with similar salary levels as the other employees at their level. The shareholders do not have the ability to influence the sales volume target even if they continue as employees. None of the shareholders are required to remain employed by the combined business during the 3-year period following the acquisition date in order to receive their portion of the additional payment.

An independent valuation performed on Entity A at the time of the acquisition placed a value on the business of between C100m – C110m based on a multiple of EBITDA.

Is the additional payment consideration or remuneration?

Simplifying assumption(s): There are no other factors that indicate remuneration.

Solution

The contingent payments are not automatically forfeited if employment of the selling shareholders ceases, so the additional indicators should be analysed.

The level of remuneration, without the additional payments, is reasonable compared to the other employees. The contingent payment appears to compensate for low upfront consideration because the purchase price of C100m is the low end of the range of the independent valuation. The formula for the contingent payment partially relates to the valuation approach. These factors indicate the arrangement is consideration paid to selling shareholders as part of the exchange for Entity A. Therefore, it would be included in the purchase price at fair value.

Example 5 – Cash distributed among multiple shareholders linked to retention

Entity A is owned by four shareholders as follows:

  • Shareholder 1: 40% holding;
  • Shareholder 2: 30% holding;
  • Shareholder 3: 20% holding; and
  • Shareholder 4: 10% holding.

Entity A is acquired by Entity B (the buyer) for cash consideration of C250m. Entity B must pay additional amounts to the selling shareholders in the event that Entity A achieves pre-determined sales volumes each year for the 3 years following the acquisition, as follows: 5% of gross sales if Entity A achieves sales revenue of C50m during year 1 following the acquisition; 5% of gross sales if Entity A achieves sales revenue of C60m during year 2 following the acquisition; and 5% of gross sales if Entity A achieves sales revenue of C70m during year 3 after the acquisition.

Any additional amounts payable will be made at the end of the 3-year period and will be paid to all of the four previous shareholders in proportion to their relative previous ownership interests. The four shareholders were all key employees of Entity A before the acquisition date and continue as employees of the combined business following the acquisition by Entity B, with low salary levels compared to other employees. The four shareholders will be able to influence the sales revenue if they continue as employees.

If an employee resigns during the 3-year period, that employee forfeits their portion of the additional payments, which is redistributed among the previous shareholder employees who remain over the 3-year period.

The additional payment is distributed to all four of the previous shareholders in proportion to their previous ownership interests if none of the previous shareholders remain employed at the end of the 3-year period but the relevant sales targets are still achieved.

Is the additional payment consideration or remuneration?

Simplifying assumption(s): There are no other factors that indicate remuneration.

Solution

The contingent payments are not automatically forfeited if all the selling shareholders cease employment, but each individual selling shareholder controls their ability to earn their portion of the additional payment by continuing employment.

The 4 shareholders receive low salary levels compared to other employees at their level and have the ability to influence the sales revenue if they continue as employees.

The commercial substance of the agreement incentivises the shareholder to continue in employment. The scenario where all shareholders cease employment lacks commercial substance because the last shareholder remaining in employment would not likely forfeit the entire pool of additional payment. Therefore, the additional payment would be accounted for as remuneration reflecting the post-combination employee services of the shareholders due to the combination of factors.

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IFRS 3 Continuing employment

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