by John Hughes
As part of its activities, the European Securities and Markets Authority (ESMA) organizes a forum of enforcers from 30 different European jurisdictions, all of whom carry out monitoring and review programs similar to those carried out here by the Canadian Securities Administrators. ESMA recently published its 15th summary of extracts from its confidential database of enforcement decisions on financial statements, covering ten cases arising in the period from December 2012 to November 2013, “with the aim of providing issuers and users of financial statements with relevant information on the appropriate application of IFRS.” There’s no way of knowing whether these are purely one-off issues or more widespread, but some of them certainly have some relevance to matters discussed within Canadian entities once in a while. Here’s one:
- “The issuer is in the marketing and advertising industry and made a business acquisition where part of the consideration was contingent on the future performance of the acquired business. The amount of additional consideration payable was to be calculated at the end of an ‘earn-out’ period. The vendor had to remain an employee of the group during the earn-out period in order to be eligible for the contingent payments, otherwise the amounts would be forfeited.
- The issuer treated the contingent amounts arising from the acquisitions as contingent consideration, regardless of whether they were dependent on continued employment or not. The contingent consideration was initially recognized on the statement of financial position at fair value, with a corresponding amount in goodwill.
- The introductory sentence to paragraph B55 of IFRS 3 requests the issuer to consider eight indicators in determining whether payments are contingent consideration or separate transaction. The issuer explained that it considered all eight indicators, assumed that continuing employment should be considered together with the other seven indicators, and concluded that the contingent payments were additional consideration rather than remuneration for the employment.”
The enforcer (as ESMA likes to term it) disagreed with classifying the contingent payments as contingent consideration in this situation, instead requiring the issuer to expense them over the earn-out period as remuneration for services provided. It observes that this isn’t exactly an obscure point – IFRS 3.B55(a) says explicitly: “a contingent consideration arrangement in which the payments are automatically forfeited if employment terminates, is remuneration for post-combination services,” and IFRIC subsequently reasserted the point in a January 2013 agenda decision. The opposite doesn’t hold: if the contingent payments aren’t affected by employment termination, it doesn’t automatically mean they’re not remuneration, only that the substance of the arrangement has to be considered as a whole, taking into account the other seven indicators. But if a particular payment is solely meant to constitute consideration for a transaction that already happened, then why would the vendor ever allow it to be wiped out by the outcome of a subsequent employment contract?
Even though there’s no litmus test inherent in those other seven indicators, you can think of circumstances where a single indicator alone might go a long way to closing the argument. For example, the standard says that ”situations in which employee remuneration other than the contingent payments is at a reasonable level in comparison with that of other key employees in the combined entity may indicate that the contingent payments are additional consideration rather than remuneration.” To illustrate the converse, suppose the vendor’s employment contract with the combined entity, taking everything into account, only adds up to a very low percentage of his or her usual market value or bargaining power. All other things being equal, this would normally be a pretty clear signal that the vendor expects to be remunerated for those ongoing services in another way – that is, through the contingent payments. But of course, the very fact that the payments are contingent on that past transaction usually means there must be a bit more to it than that (for instance, I suppose it might mean that no one actually expects the vendor to do any work under that employment contract).
In other situations though, where the acquirer genuinely wants both to reserve the right to adjust the purchase price in the light of experience, and also to retain (to a meaningful degree) the services of the vendor, and negotiates the terms of both things at the same time without worrying too much about the accounting treatment, then the application of this aspect of IFRS 3 may be genuinely uncertain. I once wrote a memo on behalf of a company, analyzing a particular situation and concluding that the payments in question were entirely contingent consideration: I didn’t think I was stretching things at all. The company’s auditors though felt that some portion of the payments – around 50% as I remember – should be treated as remuneration. I never heard of any specific problem they had with the analysis, or how they came up with the percentage split – it seems they just thought that was a safer way to go, as if not recognizing any, or too little, expense would be inherently disreputable. Fortunately, I don’t think ESMA is trying to send that message…
The opinions expressed are solely those of the author