Currently, IFRS does not provide an answer to the fundamental question of whether a financial liability arises from an obligation for contingent consideration that depends on the future performance of the acquirer in relation to the acquired asset, unless it involves a business combination. As a result, the practice in this area varies, and the acquisition of property, plant and equipment or an intangible asset in exchange for such contingent consideration may not appear at all in the statement of financial position. Is it reasonable, for example, not to recognise a liability for contingent consideration when acquiring an investment in an associate (as opposed to a business combination), which could lead to recognition of a bargain purchase gain (“negative goodwill”)? Consistent with the proposed amendment to IAS 37 that changes the definition of “present obligation” and with the updated Conceptual Framework, there is a need to recognise a liability in these cases and reflect the true economic picture to investors.
The acquisition of an intangible asset in exchange for royalties from its future performance is not currently required to be recognised in the financial statements under IFRS. This is because there is no clear answer to the fundamental question of whether contingent consideration that depends on the future performance of the acquirer derived from the acquired asset, such as payments based on sales or outputs from the underlying asset, meets the definition of a financial liability or provision. Such payments are also common in license agreements, such as acquiring a license (intangible asset) in exchange for royalties calculated as a fixed percentage of sales derived from the license. Other examples include contingent consideration paid if the acquirer achieves a specific milestone using the acquired asset in a pharmaceutical research and development project.
The accounting difficulty relates to the question of initial recognition of a financial liability in accordance with IAS 32 and lies in the issue of identifying the event that creates the obligation – whether it is the acquisition of the asset itself or alternatively at a later date – the date on which the activity for which payment is required was performed. A consequential question that arises is, if such liability has been recognized, how should it be measured after initial recognition – whether at fair value through profit or loss or alternatively based on the expected amount while updating the cost of the asset itself, including a possible impact on the classification of the payment in the statement of cash flows.
It is important to emphasize that unlike the acquisition of a single tangible or intangible asset, for more than a decade in the case of business combinations with cash-settled contingent consideration, there is an explicit requirement in IFRS 3 to recognize a liability at its acquisition-date fair value and subsequently measure it at fair value through profit or loss. Accounting for the contingent consideration differently would lead to severe distortions in the calculation of goodwill, and possibly even to recognition of a bargain purchase gain (“negative goodwill”). Incidentally, the “methodology” of the standard on business combinations is interesting, because it does not directly refer the accounting treatment to the standards on financial instruments but establishes specific recognition and measurement rules for the contingent consideration liability.
The IFRIC Call to the IASB
Returning to the existing absence of guidance regarding a single asset (or more precisely, a group of assets that does not meet the definition of a business), the IFRIC, which is essentially the interpretation body of IFRS, discussed this topic extensively already in 2016 but could not reach a decision. To be precise, the IFRIC thought then that the decision on the matter should be left to the standard-setting institution itself, believing that it is a principle-based rather than interpretive decision. Nevertheless, to this day the issue has not been formally resolved, and therefore practice is diverse – there are companies that recognise a liability and there are those that do not, even when payment to the seller for the contingent consideration is expected.
What further highlights the problematic nature of this practice is, as mentioned, the issue of subsequent measurement – because given that a liability is recognised, the question of measurement of that liability after initial recognition arises – fair value through profit or loss similar to business combinations or capitalization as part of the cost of the asset. Therefore, the comparability problem among companies is not only in the statement of financial position but also in the measurement of results.
The Theoretical Infrastructure is Ready
It is appropriate to make an amendment as soon as possible to clarify that a financial liability or provision must be recognised even if it depends on the future performance of the acquirer in relation to the acquired asset. This is based on the definition of a liability in the Conceptual Framework, since the event for which the obligation is created is the acquisition of the asset, creating a potential for the transfer of economic resources to the seller. Ignoring the question of why the proposed amendment to IAS 37, which updates the definition of a present obligation in accordance with the updated Conceptual Framework, does not also update the requirement of “probable” as a condition for recognising a provision, at least in cases where payment for the contingent consideration is expected, we believe a liability should be recognised. Such an amendment is required in order to present to investors the complete picture of the assets and liabilities of the reporting entity, and to include in the statement of financial position a contractual obligation that currently constitutes off-balance sheet financing for some companies, including the impact on their leverage ratios. Moreover, this amendment will create important coherence in the accounting treatment regardless of the type and nature of the asset acquired as well as in relation to the accounting treatment in business combinations.
Just to illustrate the magnitude of the distortion, it is sufficient to note that according to current IFRS, if an investment in an associate (which includes a business) is acquired for contingent consideration, there is no requirement to recognise a liability, while if control was acquired in the same company – the liability would be recognised. Beyond the coherence problem regarding the accounting treatment of an acquisition of an investee depending on whether control is obtained, the existing distortion regarding an associate can even lead to the recognition of a virtual bargain purchase gain (“negative goodwill”) at the time of acquisition.
The importance of clarifying the guidance on the acquirer’s side can also be demonstrated through the mirror image of the guidance on the seller’s side. In accordance with IFRS 15, the seller is required to recognise revenue/income for variable consideration on the sale of an asset at an amount that is highly probable not to reverse in the future, other than sales-based or usage-based royalties that relate to a license of intellectual property. Except for the higher probability threshold on the seller’s side in line with the prudence principle, it is worth emphasizing that the accounting treatment we propose will lead to coherence in reporting by both parties to the same transaction.
PRACTICAL ABILITY
It is important to note that the fact that the acquirer of the asset controls its future performance, and can theoretically/contractually avoid paying the contingent consideration by avoiding generating revenue, should not lead to the conclusion that the liability will not be recognized. Consistently with the withdrawal of IFRIC 21 under the proposed amendment to IAS 37, the relevant test from an economic perspective is whether there is a practical ability to avoid payment.
In this context, many financial reporting standards determine that liabilities should be recognized due to the lack of practical ability to avoid payment, despite the fact that the reporting entity can contractually avoid that payment. Among other things, a liability should generally be recognised for an employee bonus based on a percentage of two-year profit and conditional on a minimum profit threshold, even if the threshold was not crossed at the end of the first year. Also, a liability should be recognised for cash-settled share-based payment over the vesting period, although the grant can contractually be cancelled and vesting prevented. Moreover, the non-recognition of a lease liability for variable lease payments dependent on the future revenue of the lessee is due to cost-benefit considerations, rather than a position based on the definition of a liability.
In conclusion, the IASB should take advantage of the opportunity and leverage the proposed amendment to IAS 37 regarding the identification of a present obligation arising from a past event as a condition for recognising a provision. According to the proposed amendment, a present obligation exists when the reporting entity has received economic benefits in the past, and as a result has no practical ability to avoid transferring economic resources to a third party. Since a transaction of acquiring an asset for consideration contingent on the asset’s future performance is common and widespread, it would be a historic miss if IAS 37 were amended as stated without clarifying that the important principle in the amendment regarding present obligation will also apply to the acquisition of an asset for consideration contingent on the asset’s future performance.
(*) Written by Shlomi Shuv
## Appendix
(1) Despite the contractual ability to avoid paying the consideration by deferring revenue of the acquired business, a liability should be recognised due to the economic compulsion to continue generating revenue
(2) Despite the contractual ability to avoid paying royalties by ceasing operations and deferring revenue, a liability should be recognised due to the economic compulsion to continue generating revenue
(3) Despite the contractual ability to avoid cash payment by reducing revenue and/or increasing expenses, a liability should be recognised due to the economic compulsion to benefit from 90% of operating profit
(4) Despite the ability to reduce tax payments by selling the item, assuming the capital gains tax rate is lower, the liability should be measured assuming recovery through use where that is expected
(5) Despite the ability to reduce current tax payments in the first quarter by deferring revenue in subsequent quarters, the liability should be measured based on the expectation that annual profit will reach a higher tax rate
(6) Despite the contractual ability to avoid bonus payment by reducing profit and/or terminating the employee, a liability should be recognised due to the economic compulsion to generate profit and continue employment
(7) Despite the contractual ability to cancel the grant and prevent vesting, a liability should be recognised due to the economic compulsion to continue employing the worker throughout the vesting period
(8) Despite the contractual ability to avoid cash payment by not exercising the option, a lease liability should be recognised for the option period when it is reasonably certain that the option will be exercised
(9) Despite the contractual ability to avoid paying rent by not generating revenue from the leased asset, it would be appropriate to recognise a liability due to the economic compulsion to continue generating revenue. However, for cost-benefit reasons, it was determined that a lease liability should not be recognised for this component