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Discounting and Unwinding: Answer 2-No, Deferred Consideration Is Not A Contingent Consideration Because It Does Not

Thank you for the additional examples and explanations on IAS 32 and IAS 37. This helps provide more context on how these standards relate to accounting for financial instruments and provisions, contingencies and events. Let me know if you have any other questions!

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0% found this document useful (0 votes)
118 views5 pages

Discounting and Unwinding: Answer 2-No, Deferred Consideration Is Not A Contingent Consideration Because It Does Not

Thank you for the additional examples and explanations on IAS 32 and IAS 37. This helps provide more context on how these standards relate to accounting for financial instruments and provisions, contingencies and events. Let me know if you have any other questions!

Uploaded by

M Azeem Iqbal
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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DISCOUNTING AND UNWINDING

If a liability (just an example) has been discounted to present value i.e. a provision of 100,000
payable in 3 years time at 5%, would be discounted to 86,430.
In subsequent years the discount will be unwound to move it closer, therefore the entries
would be

Year 1 - finance expense of 4,322 (86430 *5%) liabilities is now 90752


Year 2 - finance expense of 4538 (90752 * 5%) liability is now 95290
Year 3 - finance expense of 4765 (95290 * 5%) liability is now 100,000 (less a bit of rounding
etc). This liability will be cleared when the provision is paid out.

Basically you are unwinding the present value of the liability each year so that at the end of the
term the liability will equal the original provision.

Q: The parent company acquired 75% of subsidiary’s 80m share on 1 Jan 2006 it paid
3.50/share and agreed to pay a further 108m on 1 Jan 2008. The parent company’s cost of capital
is 8%.

1) My question is what will be the cost of investment while calculating goodwill on 31 dec2006,
and the treatment of unwinding of discount where this entire thing goes and what will be their
entries till 1 Jan 2008.under the old treatment.

2) And my second question is can a deferred consideration be contingent consideration?

Answer 2- No, Deferred consideration is not a contingent consideration because it does not
depend on the outcome of a particular condition. It has simply been deferred and will be paid
regardless of any conditions being met or not. Contingent is dependent on the outcome of a
certain event or condition. So both are two different things; however treatment of both is similar
in the old method.

Answer 1- Cost of investment will be

(80m X 75%) X 3.5 + Present value of 108m discounted using 8% cost of capital.

Double entry is

Dr Cost of investment
Cr Cash
Cr Deferred consideration

Unwinding of discount each year is calculated by multiplying deferred consideration X cost of


capital %

Double entry for this is


Dr Consolidated Reserves
Cr deferred consideration
(80m shares X 75%) X $3.5 = $210m
$210m is the immediate cash payment. The parent will FURTHER pay an amount of $108m.
Present value of $108m can’t be $180m.
How have you discounted it? What is the discount factor using 8% cost of capital?

Discount factor should be 0.8573 using 8% at year 2


Thus,

PV of deferred consideration is $108m X .8573 = $92.58m

Dr Cost of investment $302.6m


Cr Cash $210m
Cr Deferred consideration $92.6m
Unwinding year 1

92.58m X 8% = $7.4m

Dr Consolidated Reserves $7.4m


Cr deferred consideration $7.4m

Total deferred at end of year 1 is now (92.6+7.4) = $100m

Unwinding year 2

$100m X 8% = $8m

Dr Consolidated Reserves $8m


Cr deferred consideration $8m
Total deferred at end of year 2 is now (100+8) = $108m

Under old IFRS3 deferred and contingent consideration is accounted for in the same way.
Calculate the P.V and add it to the cost of consideration. Subsequent discounting effects
deferred/contingent consideration and consolidated reserves.

Under revised IFRS3 deferred consideration is accounted for using the same old PV method.
However a new treatment for contingent consideration has been introduced.

According to the revised IFRS3 contingent consideration should be recorded at its fair value.
Subsequent changes in fair value will affect goodwill (Most of the times).
Example: ********

A parent acquired 80% of subsidiary in 20X0. It paid $10m in cash and further agreed to issue
1m shares of parent company if the EPS of subsidiary exceeds by 5/share at the end of 20X3.
Fair value of parents share at the date of acquisition was $1/share. FV of net assets acquired was
$9m.

Cost of investment = $10m + (1m shares X 1) = $11m


Less: F.V of net assets acquired ($9m X 80%) = $7.2m

Goodwill = $3.8m
Double entries:

Dr Cost of investment $11m


Cr Cash $10m
Cr Contingent Consideration $1m
At the end of year 20X1 F.V of parents share is now $2/share. Thus, the F.V of contingent
consideration has changed

Dr Goodwill $1m
Cr Contingent consideration $1m

Total contingent consideration at the end of year 20X1 is now $2m

At the end of year 20X2 F.V of parents share is now $1.5/share. Thus, the F.V of contingent
consideration has changed again this time downward.

Dr Contingent consideration $0.5m


Cr Goodwill $0.5m

As you can see contingent consideration was recorded at its F.V initially and subsequent
changes to the F.V of contingent consideration (liability) effected goodwill by first increasing
and then decreasing it.

IAS37 comes into play here as the revised IFRS3 states that any contingent consideration
(liability) should be recognized in accordance with IAS37. Contingent consideration can also be
an asset for e.g. where the parent will get a part of its consideration back if the required condition
is not met. Furthermore parent may promise contingent consideration in form of compound
financial instrument in that case liability and debt component must be separated in accordance
with IAS32.

Note that goodwill above is calculated according to the old method which is still valid. A new
method for calculating goodwill is also introduced.
Some very good examples here by Sharjeel. I know on your email you said that you had
problems getting your study books in Pakistan - but to help you with the standards in the
meantime, could you not get Clare Finch’s book which I recommended to you via Amazon - this
will help you with your standards. There is also a free download available which gives details of
the IFRS 3/IAS 27 changes via Kaplan’s website (not sure where you would look on Kaplan’s
website).

I can give some simple illustrations of how IAS 32 and 37 as follows:

IAS 32 - bond issued debt/equity

Year end = 31/3/08, bond issued for $50m on 1/4/07 repayable 31 Mar 2012 for $60m BUT
instead of repayment, the bond holders could elect to receive shares in 2012 (for simplicity, let’s
assume the bond did not grant the right to the holers to receive interest). However, on 1 April
2007 without the conversion option the bond issue would have only raised $30m and the annual
rate of return at that date was 10%.

Under IAS 32 (Financial Instruments: presentation and disclosure) the bond should be presented
partly as equity and partly as debt (presented as debt if there is a redemption feature OR an
entitlement to receive annual interest payments). At 31/3/08 the debt component should be
$30m which is the amount of ACTUAL debt that could have been raised without granting an
option to convert the bonds into equity. You can then work out the finance cost of this
transaction by saying (30,000 x 10%) = 3,000 and this will be treated as finance cost in the
statement of comprehensive income.

So in other words, if the option to convert the bond into shares did not exist, the bond holders
would essentially only “lend” the company $30m and expect annual returns of 10%. This
represents an obligation to transfer cash to the holders, so it is a debt instrument under IAS 32
-thus $30m as a debt instrument, the balance of $20m is an equity instrument.

IAS 37

In terms of contingent consideration under the old requirements contingent consideration was
only measured if payment was probable - this is where IAS 37 links in (the IAS 37 criteria being
if payment was probable and it could be measured with reliance). However, the revision to IFRS
3 now states that the contingent consideration MUST be recognized at FAIR VALUE at the
acquisition date. If the contingent consideration is a liability it should be remeasured to fair value
at each year end (any changes going through the income statement).

Any adjustment to the contingent consideration, however, does not (normally) affect the
goodwill. If we take Sharjeel’s example where there is a condition to meet an earnings target. If
the contingent consideration is in the form of (say) cash or other assets, then any adjustment to
the contingent consideration is usually done via the income statement as opposed to adjusting
goodwill. IFRS 3 was changed to bring it more in line with the standard’s US equivalent which
adopts this method (I’m not quite sure what SFAS number the US equivalent is though!!)

Kind regards

Steve

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