“Revised accounting standards’ impact on earn-out arrangements” by Editha Viray-Estacio (January 31, 2011)

SUITS THE C-SUITE By Editha Viray-Estacio
Business World (01/31/2011)

Oftentimes, business acquisitions include both an up-front payment and contingent payments, or “earn-outs,” based on the achievement of future performance objectives.

For example, if an acquired business’s post-acquisition earnings or component of earnings, such as revenue, reach an agreed level over an agreed period, this will trigger the payment of additional consideration to the seller. Earn-out arrangements are commonly used when the parties do not agree on the exact value of the business, such as when they are uncertain about the earnings potential of the acquired business or the outcome of specific events.

Philippine Financial Reporting Standards 3 (Revised), Business Combinations, (PFRS 3R) changed the way an acquirer accounts for business acquisitions, including earn-outs. Accounting for earn-outs now depends on whether earn-outs are classified as remuneration or as contingent consideration.

This article focuses on earn-outs which are classified as contingent consideration rather than as remuneration.

Accounting under the old PFRS 3 and PFRS 3R

The key differences between the old PFRS 3 and PFRS 3R in accounting for contingent consideration are shown in the table below:

Under PFRS 3R, the contingent consideration is recognized at fair value, whether or not deemed probable, at the acquisition date or the date the acquirer obtains control of a business.

This is a significant change from the old PFRS 3 where contingent considerations were recognized only if settlement is probable and the amount can be reliably measured. The fair value should reflect a weighted average probability of potential future outcomes.

This poses a challenge in estimating the fair value of the contingent consideration at the time of acquisition and up until the date when the contingent consideration is finally settled.

Under the old PFRS 3, subsequent adjustments to earn-outs were recognized as goodwill, which does not affect post-acquisition profit or loss but only the balance sheet.

Under PFRS 3R, adjustments to earn-outs will depend on whether the contingent consideration is classified as liability or equity.

Earn-outs classified as liability, such as those payable in cash, are re-measured at fair value at every balance sheet date, with any changes in the fair value recognized in profit or loss. This accounting treatment results in volatility in post-acquisition income statements.

Subsequent changes to the contingent consideration also pose a challenge, because their impact on profit and loss is counter-intuitive. If an acquired business performs well and meets or exceeds performance objectives, the liability increases, resulting in additional expense. Conversely, if performance objectives are not met and no settlement occurs, the liability is reversed through profit or loss, which results in a gain.

On the other hand, earn-outs classified as equity, such as those payable in a fixed number of shares, do not require re-measurement. Compared to cash earn-outs, this results in less volatility in post-acquisition profit or loss.

However, from a business risk perspective, earn-outs that are payable by subsequent delivery of a fixed number of shares may end up more expensive when there is an increase in the acquirer’s share price post-acquisition.

The management of acquiring entities must fully understand the financial reporting implications of PFRS 3R on earn-out arrangements and incorporate key considerations into pre-deal structuring and negotiations, including:

• Determining fair value at the date of acquisition — The acquirer’s ability to determine the probability of achieving performance objectives at the acquisition date will impact post-acquisition earnings volatility. This may require the involvement of external advisers such as accountants and valuation professionals.

• Managing the impact on accounting-based measures such as debt covenants — Discussions with banks and other creditors may be warranted to clarify how the liability for contingent consideration and the impact on profit or loss is taken into account, especially since the impact on profit or loss is counterintuitive. In some cases, this may require re-negotiating arrangements with banks and other creditors.Ultimately, the changes in PFRS are designed to streamline the financial reporting process and to promote a uniform set of regulations that comply with international standards. This, of course, will require some adjustment.

But, as with PFRS 3R, prudent consideration and careful preparation are essential to fully realizing the benefits of the new standards. Acquiring entities will benefit from and will be able to manage the impact of PFRS 3R on their business dealings by performing more in-depth pre-deal analysis and due diligence as well as involving external advisers as part of its acquisition deal team.

(Editha Viray-Estacio is a Partner of SGV & Co.)

This article was originally published in the BusinessWorld newspaper. It is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.