A European example of applying basic principles of financial instruments to a situation involving non-controlling interests
Here’s another of the issues from some extracts of enforcement decisions recently issued by the European Securities and Markets Authority (ESMA) (for more background see here):
- “The issuer has a history of growth through acquisitions and frequently acquires a majority shareholding in a business together with an option on the remaining non-controlling interest (‘NCI’) to be exercised later. In 2011 the issuer acquired the remaining NCI from a business combination that occurred in 2009.
- The payment for the NCI was structured so that it contained a fixed initial payment and a series of contingent amounts payable over the following three years. The contingent payments were to be based on the future EBITDA of the acquired business, up to a maximum amount.
- The issuer recognized the fixed initial payment as an equity transaction, in accordance with paragraph 30 of IAS 27 – Consolidated and Separate Financial Statements. The contingent payments were not accounted for at that date. Instead, the issuer considered them to be contingent liabilities and disclosed them in accordance with paragraph 86 of IAS 37 – Provisions, Contingent Liabilities and Contingent Assets. The disclosure included the estimated timing of the payments and the directors’ estimate of the amounts to be settled.”
Definitions of financial liabilities
The enforcer (as ESMA likes to term it) disagreed that the contingent payments were to be treated as contingent liabilities, taking the view they should be recognized as financial liabilities and measured at fair value at initial recognition. As the report documents it, the payments meet the definition of a financial liability under IAS 32.11 in that the issuer has an obligation to pay cash to the vendor of the NCI under the terms of a contract, and it’s not within its control to be able to avoid that obligation. It goes on: “The amount of the contingent payments depend on the EBITDA of the acquired business, which itself depends on a number of factors which are outside of the issuer’s or vendor’s control, such as customer demand. Paragraph 25 of IAS 32 is clear that a contingent obligation to pay cash that is outside the control of both parties to a contract meets the definition of a financial liability that shall be initially measured at fair value. Since the contingent payments relate to the acquisition of the NCI, the offsetting entry would be recognised directly in equity. “
This might be an example of an issuer having tangled itself up in technicalities rather than focusing on the contracts and obligations it actually entered into. The payments may have seemed like something other than financial instruments because they relate to tying up loose ends on a deal carried out in the past. The amount of uncertainty over whether anything would ultimately have to be paid on the contingent payments, and if so how much, may have seemed to make a case for deferring their recognition until the amounts could be better pinned down. But the accounting for assets and liabilities isn’t driven by the story which gave rise to them, but rather by what they are. In this case, as the report sets out, there was no question that the issuer had entered into a contract under which it was obliged to deliver cash to the counterparty, under an amount to be determined by applying a formula. There’s no conceptual juggling in this world that can keep such amounts off the balance sheet, albeit that their calculation may be subject to significant estimation and measurement uncertainty (which of course should be disclosed).
Challenges of non-controlling interests
The accounting for non-controlling interests is certainly a frequent source of technical questions of one kind or another. For example, IFRIC recently considered, in response to a request, the treatment of puttable instruments issued by a subsidiary but not held, directly or indirectly, by the parent, and specifically whether these should be classified as equity or liability in the parent’s consolidated financial statements. But the committee concluded there was nothing there to add to the agenda. Puttable instruments are classified as equity – as a specific exemption to the definition of a financial liability – when all the conditions in IAS 32.16 are met. But again, IAS 32.AG29 already specifies that this exemption doesn’t extend to classifying non-controlling interests in consolidated financial statements, so it’s already clear that the instruments should be classified as financial liabilities at that level.
Nevertheless, questions on the area will likely continue to come up from time to time. Although all practitioners can likely agree in general terms on what non-controlling interests represent in financial statements, the concept has evolved significantly over the years, and there are no doubt many aspects of it that may or may not accord with one’s intuitions.
The opinions expressed are solely those of the author