Indemnification assets

Indemnification assets – Dictionary meaning of Indemnification is ‘indemnification is the part of an agreement that provides for one party to bear the monetary costs, either directly or by reimbursement, for losses incurred by a second party’.

Indemnification of an asset essentially provides kind of guarantee to the other party about the downside of any risk associated with such asset/ liability. On broader perspective such indemnification could be against any asset/ liability or part thereof while making Business combinations under IFRS 3. Indemnification assets are recognised and measured, separately from goodwill, as at the acquisition date as part of the recognition and measurement of identifiable assets acquired, the liabilities assumed and any non-controlling interest in the acquiree.

Indemnification assets

Indemnification assets are an exception to the recognition and fair value measurement principles. They are recognized and measured differently from contingent assets. Indemnification assets (sometimes referred to as “seller indemnifications”) may be recognized if the seller contractually indemnifies, in whole or in part, the acquirer for a particular uncertainty. Contractual indemnities are common for litigation contingencies and uncertain tax positions. Indemnification assets Indemnification assets

The recognition and measurement of an indemnification asset is based on the related indemnified item. The acquirer should recognize an indemnification asset at the same time that it recognizes the indemnified item. The indemnification asset is measured on the same basis as the indemnified item, subject to collectibility or any contractual limitations.

The acquirer should recognize an indemnification asset at its fair value on the acquisition date if the indemnification relates to an asset or a liability that is recognized at the acquisition date and measured at its fair value. A separate valuation allowance for credit risk is not necessary if an indemnification asset is measured at fair value. The fair value measurement will reflect any uncertainties in future cash flows. Indemnification assets Indemnification assets

Seller indemnifications may relate to indemnified items that are not recorded at the date of acquisition. For example, a contingent liability might not be recognized at the acquisition date because it cannot be reliably measured. The contingent liability is recognized when it subsequently becomes reliably measurable. An indemnification asset is recorded at the same time and on the same basis (subject to contractual limitations on the indemnified amount and management’s assessment of collectibility) as the contingent liability, regardless of whether the recognition is within the measurement period. Indemnification assets Indemnification assets Indemnification assets

Indemnification assets continue to be measured on the same basis as the related indemnified item, giving effect to the collectibility and contractual terms. Final measurement occurs when the indemnified item is collected, sold, or cancelled, or when the entity otherwise loses the right to it in the post acquisition period.

An indemnification asset might relate to any asset, 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 should measure the indemnification asset on the same basis as the related indemnified item, subject to any restrictions in the contractual terms. Restrictions include ceilings on the amount payable and adjustments for the creditworthiness of the seller.

The indemnified item might be a contingent liability. The contingent liability would be remeasured only if an outflow of resources embodying economic benefits to settle the liability is probable within the meaning of IAS 37 (i.e., more likely than not to occur) and was accounted for under that standard.

The difference between the previously recorded amount and the best estimate of the future outflow would be recorded as an increase in the liability and the indemnification asset if the full amount of the contingency was subject to the indemnity and the outflow of resources became probable.

The contingent liability also might be derecognized without payment. Derecognition of the contingency without payment would occur if the entity was released from the obligation. Both the indemnification asset and the liability would be derecognized then.

Some Q&A

Q: How should a buyer account for an indemnification from the seller when the indemnified item has not met the criteria to be recognized on the acquisition date?

IFRS 3 states that an indemnification asset should be recognized at the same time as the indemnified item. Therefore, if the indemnified item has not met the recognition criteria as of the acquisition date, an indemnification asset should not be recognized. indemnification assets indemnification assets

If the indemnified item is recognized subsequent to the acquisition, the indemnification asset would then also be recognized on the same basis as the indemnified item subject to management’s assessment of the collectibility of the indemnification asset and any contractual limitations on the indemnified amount. This accounting would be applicable even if the indemnified item is recognized outside of the measurement period. indemnification assets indemnification assets

Q: Does an indemnification arrangement need to be specified in the acquisition agreement to achieve indemnification accounting?

Indemnification accounting can still apply even if the indemnification arrangement is the subject of a separate agreement. Indemnification accounting applies as long as the arrangement is entered into on the acquisition date, is an agreement reached between the acquirer and seller, and relates to a specific contingency or uncertainty of the acquired business, or is in connection with the business combination. indemnification assets indemnification assets indemnification assets

Q: Should acquisition consideration held in escrow for the seller’s satisfaction of general representation and warranties be accounted for as an indemnification asset?

General representations and warranties would not typically relate to any contingency or uncertainty related to a specific asset or liability of the acquired business. Therefore, in most cases, the amounts held in escrow for the seller’s satisfaction of general representations and warranties would not be accounted for as an indemnification asset. indemnification assets

EXAMPLE – Recognition and measurement of an indemnification asset
As part of an acquisition, the seller provides an indemnification to the acquirer for potential losses from an environmental matter related to the acquiree. The contractual terms of the seller indemnification provide for the reimbursement of any losses greater than CU100 million. There are no issues surrounding the collectibility of the arrangement from the seller.

A contingent liability of CU110 million is recognized by the acquirer on the acquisition date using similar criteria to ASC 450-20-25-2 because the fair value of the contingent liability could not be determined during the measurement period. At the next reporting period, the amount recognized for the environmental liability is increased to CU115 million based on new information.

How should the seller indemnification be recognized and measured?

Analysis
The seller indemnification should be considered an indemnification asset and should be recognized and measured on a similar basis as the related environmental contingency. On the acquisition date, an indemnification asset of CU10 million (CU110–CU100), is recognized. At the next reporting period after the acquisition date, the indemnification asset is increased to CU15 million (CU115 less CU100), with the CU5 million adjustment offsetting the earnings [profit or loss] impact of the CU5 million increase in the contingent liability.

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Accounting for an asset acquisition versus a business combination

Topic Business combinations Asset acquisition under US GAAP Asset acquisition under IFRS
Indemnifications Indemnification assets are recognized and
measured based on the related indemnified
item [ASC 805-20-30-18, IFRS 3 27].
Indemnifications provided outside of a business combination  are generally measured at fair value [ASC 450]. Indemnifications provided outside of a business combination are generally measured at fair value.

Disclosure requirements

For indemnification assets, all of the following: Indemnification assets Indemnification assets Indemnification assets Indemnification assets

  1. The amount recognized as of the acquisition date Indemnification assets Indemnification assets Indemnification assets Indemnification assets
  2. A description of the arrangement and the basis for determining the amount of the payment
  3. An estimate of the range of outcomes (undiscounted) or, if a range cannot be estimated, that fact and the reasons why a range cannot be estimated. If the maximum amount of the payment is unlimited, the acquirer shall disclose that fact. [IFRS 3 B64(g)]
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The rules in summary

Let’s have a look at the term,  indemnification assets, with reference to relevant parts of IFRS 3: Indemnification assets Indemnification assets Indemnification assets Indemnification assets

  • [IFRS 3 27] ‘The seller in a business combination may contractually indemnify the acquirer for the outcome of a contingency or uncertainty related to all or part of a specific asset or liability. For example, the seller may indemnify the acquirer against losses above a specified amount on a liability arising from a particular contingency; in other words, the seller will guarantee that the acquirer’s liability will not exceed a specified amount. As a result, the acquirer obtains an indemnification asset.  …’ indemnification assets
  • [IFRS 3 28] ‘In some circumstances, the indemnification may relate to an asset or a liability that is an exception to the recognition or measurement principles. For example, an indemnification may relate to a contingent liability that is not recognised at the acquisition date because its fair value is not reliably measurable at that date. Alternatively, an indemnification may relate to an asset or a liability, ….’
  • [IFRS 3 57] At the end of each subsequent reporting period, the acquirer shall measure an indemnification asset that was recognised at the acquisition date on the same basis as the indemnified liability or asset, subject to any contractual limitations on its amount and, for an indemnification asset that is not …’ indemnification assets

In summary the following considerations are of importance relating to indemnification assets:Indemnification assets

  1. The indemnification can be used either for an Asset or a liability while making a deal of acquiring business as covered within IFRS 3,
  2. Indemnification mainly refers to some kind of uncertainty or contingency where the selling entity provides a kind of assurance to protect the value which is being bought by a buying entity during the business acquisition,
  3. A typical example could be a legal court case where the selling entity agrees to indemnify an amount which may relate to an outcome of such court case (because the selling entity knows the case and the risks),
  4. There could be a situation where any regulatory approval pending for any segment of a business which is being acquired and for that the selling entity agrees to compensate for any negative outcome encountered in such regulatory approvals,
  5. Another common example could be a tax litigation case where some decisions are pending at the time of making such business acquisitions and hence the selling entity agrees to compensate to the buying entity for any losses/ negative decisions which might come in future (again because the selling entity knows the case and the risks),
  6. The underlying principal is that in respect of the recognition of the indemnification assets relating to asset(s) / liabilty(ies), the same recognition method is used, as for those indemnified assets/liabilities. For example if an indemnification is related to an asset which is recognised against fair value at the time of such business acquisition then, the related indemnified asset will also be recognised basing on fair value,
  7. It is interesting to note that major part of the assets/liabilities acquired at the time of the business acquisition covered under IFRS 3 are normally valued at fair value except some cases where it could be either at cost or in some cases nothing is recognised while doing such business acquisitions, for example – deferred tax would be valued as per IAS 12 etc. The subsequent measurement of the indemnified assets other than at fair value is subject to the collectiblity test, along with the management estimates to realise actual amounts out of such indemnified assets,
  8. Such indemnification is being used only in case of specific liabilities/assets which are to be compensated to a buying entity and hence would not be used in other normal business transactions like warranties etc.
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BACKGROUND – The Basis for Conclusions relating to indemnification assets under IFRS 3

BC301 A few constituents asked about the potential inconsistency if an asset for an indemnification is measured at fair value at the acquisition date and the related liability is measured using a different measurement attribute. Members of the FASB’s resource group raised the issue primarily in the context of FASB Interpretation 48, which requires an entity to measure a tax position that meets the more-likely-than-not recognition threshold at the largest amount of tax benefit that is more than 50 per cent likely to be realised upon ultimate settlement with a taxing authority.

BC302 The boards understand that a business combination sometimes includes an indemnification agreement under which the former owners of the acquiree arIndemnification assetse required to reimburse the acquirer for any payments the acquirer eventually makes upon settlement of a particular liability. If the indemnification pertains to uncertainty about a position taken in the acquiree’s tax returns for prior years or to another item for which the revised standards provide a recognition or measurement exception, not providing a related exception for the indemnification asset would result in recognition or measurement anomalies.

For example, for an indemnification pertaining to a deferred tax liability, the acquirer would recognise at the acquisition date a liability to the taxing authority for the deferred taxes and an asset for the indemnification due from the former owners of the acquiree. In the absence of an exception, the asset would be measured at fair value, and the liability would be measured in accordance with the pertinent income tax accounting requirements, such as FASB Interpretation 48 for an entity that applies US GAAP, because income taxes are an exception to the fair value measurement principle.

Those two amounts would differ. The boards agreed with constituents that an asset representing an indemnification related to a specific liability should be recognised and measured on the same basis as that liability.

BC303 The boards also provided an exception to the recognition principle for indemnification assets. The reasons for that exception are much the same as the reasons why the boards exempted deferred tax assets and liabilities and employee benefits from that principle. Providing an exception to the recognition principle for indemnification assets clarifies that the acquirer does not apply that principle in determining whether or when to recognise such an asset. Rather, the acquirer recognises the asset when it recognises the related liability. Therefore, the revised standards provide an exception to the recognition and measurement principles for indemnification assets.

Indemnification assetsIndemnification assets    Indemnification assets

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