IFRS 3 Escrow agreement on acquisition

IFRS 3 Escrow agreement on acquisition – How should the buyer account for funds placed in escrow?

Amounts paid to a third party or the seller’s escrow account may be contingent consideration if the release of the funds is contingent on whether specified future events occur or conditions are met. The arrangement may be remuneration for post-combination services if the payment has the indicators discussed in ‘IFRS 3 Continuing employment‘.

The escrow amount is not contingent consideration if the release of the funds is contingent on verifying conditions that existed at the acquisition date. An escrow arrangement is accounted for as a measurement period adjustment if the payment relates to new information about circumstances that existed at that acquisition date [IFRS 3 45].

IFRS 3 Escrow agreement on acquisition

Example 1 – Consideration held in escrow for general representations and warranties

Pharma Group A acquires a laboratory, which is a business under IFRS 3. The laboratory’s head-scientist and sole owner is Z. All the employees working in the laboratory, including Z, sign new employment contracts with Pharma Group A.

The contractual acquisition price consists of two components:

  • A fixed amount of C1,000 is paid to Z on the closing date; and
  • An additional amount of C200 is transferred to an escrow account.

Z has the legal title to the escrow account. The escrow amount will be paid to Z only if the general warranties and representations (that is, the laboratory has been withholding income tax from its employees and remitting that money to the government, etc.) contained in the purchase agreement are satisfied. The whole amount is released to Pharma Group A if the general warranties and representations contained in the purchase agreement are not satisfied.

Is the escrow payment treated as upfront consideration or contingent consideration?

Simplifying assumption(s): The arrangement is not linked to providing services.

Solution

The general warranties and representations are verifying conditions that existed at the acquisition date. The escrow payment would be included in the upfront acquisition consideration because it is expected that the general warranties and representations would be satisfied, at which point the escrow funds would be released to the Z.

The following journal entry is recorded on the acquisition date for the transfer of consideration and escrow payment:

Net assets and goodwill

1,200

Cash

1,200

To record consideration paid for business combination.

Example 2 – Consideration held in escrow for working capital adjustments

Pharma Group A acquires a laboratory, which is a business under IFRS 3. The laboratory’s head scientist and sole owner is Z. All the employees working in the laboratory, including Z, sign new employment contracts with Pharma Group A.

The contractual acquisition price consists of two components:

  • A fixed amount of C1,000 is paid to Z on the closing date; and
  • An additional amount of C200 is transferred to an escrow account.

Z has the legal title to the escrow account. The escrow will be used to give Pharma Group A a working capital adjustment so that the acquisition date working capital is at the level specified in the purchase agreement.

Is the escrow payment treated as upfront consideration or contingent consideration?

Simplifying assumption(s): The arrangement is not linked to providing services. Pharma Group A expects that the full amount of the escrow will be provided to Z.

Solution

A working capital adjustment is typically included in a purchase and sale agreement as a means of agreeing on the amount of working capital that existed (and was acquired) on the acquisition date. The subsequent determination of working capital that existed on the acquisition date does not relate to future events or conditions (that is, events occurring or conditions being met after the acquisition date).

This escrow payment would be included in the upfront acquisition consideration similarly to general representation and warranty provisions. Payments or receipts for changes in provisional amounts for working capital would therefore adjust consideration transferred by the buyer in its acquisition accounting.

The following journal entry is recorded on the acquisition date for the transfer of consideration and escrow payment:

Net assets and goodwill

1,200

Cash

1,200

To record consideration paid for business combination.

Example 3 – Escrow arrangement with contingent consideration

Pharma Group A acquires a laboratory. The laboratory’s head-scientist and sole owner is Z. The laboratory is integrated into Pharma Group A.

The contractual acquisition price consists of two components:

  • A fixed amount of C1,000 is paid to Z on the closing date; and
  • An additional amount of C200 is transferred to an escrow account.

Z has the legal title to the escrow account. The escrow amount will be paid to Z only if EBITDA increases by at least 5 % per year over the 2 years following the acquisition. The whole amount is released to Pharma Group A if the EBITDA target is not met.

Is the escrow payment treated as upfront consideration or contingent consideration?

Simplifying assumption(s): The arrangement is not linked to providing services. The fair value of Pharma Group A’s right to the C200 escrow based on EBITDA is C150 at the acquisition date. Ignore the time value of money impact. The laboratory is a business under IFRS 3.

Solution

The fixed amount of C1,000 is consideration transferred to Z for obtaining control over the acquired laboratory. The additional C200 of the acquisition price is contingent consideration regardless of the fact that the funds have already been transferred to an escrow. The contingent right to the funds placed in Z’s escrow account is a financial asset of the acquirer because the escrow arrangement represents a contract that provides the buyer with a right to receive cash or other financial assets when a contingency is resolved.

Future changes in the fair value of the contingent consideration based on expectations of meeting the target are recognised in the income statement.

The following journal entry is recorded on the acquisition date for the transfer of consideration and escrow payment:

Net assets and goodwill

1,050

Financial asset

150

Cash

1,200

To record consideration paid for business combination and a financial asset.

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IFRS 3 Escrow agreement on acquisition

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