Non-controlling interests' put options under IFRS

Non-controlling interests (NCI) refers to the obligation of a group to buy its own shares (e.g. shares) from non-controlling shareholders if the NCI offer these shares (normally the so-called "issuer settlement option"). Often the NCI's right becomes exercisable at a fixed future date and expires thereafter. From the point of view of the company offering this right, it is economically a short position on own shares, i.e. a written put option with the underlying: own share. This potential repurchase obligation of the company is often discussed in the literature on the accounting treatment of the obligated company under the term puttable instruments.

These tender rights are frequently observed in practice in various contractual constellations. This also applies to companies that actually do not want to have anything to do with derivatives and especially options. In most cases, rights of tender are not openly found as individual contracts, but as contractual passages in other contracts, for example in the context of business combinations (in the sense of IFRS 3). Sometimes, however, the purpose of such contractual passages is to enable market access. In these cases, a company needs, for example, a local business partner who brings the right contacts, knows how the business works or makes the entrepreneurial action legally possible in the first place (for example, abroad). In these cases, tender rights are typically also included in service contracts or similar. 

NCI put options are a "popular" source of errors in financial statements, as several aspects have to be assessed. The resulting errors can sometimes lead to significant misstatements in the IFRS consolidated financial statements and the key figures derived from them. Since, in the event of an error, equity and financial liabilities are regularly incorrectly valued or reported, a significant number of typical financial covenants can also be affected (for example, the net debt ratio).

Often, put options have to be considered in the presentation of business combinations according to IFRS 3 (for example, in the context of determining the consideration transferred) or they are in the scope of IFRS 2 on share-based payments (IFRS 2) (for example, NCI granted to employees). A distinction is also difficult to make in that companies can also be beneficiaries of a share-based payment. 

Since share-based payments have already been the subject of various articles in this newsletter series, the following section describes rights of tender arising from acquisitions. At the time of acquisition, the group must (fully) consolidate the assets and liabilities of the subsidiary and show the shares held by outside shareholders as non-controlling interests (NCI), which it discloses in equity.

In addition to the recognition of the right of tender (on the credit side), the offsetting entry (on the debit side) at initial recognition has also caused a stir for some time, which is why both topics are briefly and simplistically examined below.

On the recognition of the right to tender: Although the right to tender has the payment and valuation profile of an option in financial terms, it is not accounted for at this value (IAS 32.18 in conjunction with IAS 32.23). Under IFRS, the obligation from the put option is usually (compare KPMG Insights into IFRS 19th 7.3.110.70 in conjunction with 7.3.150.10) not a derivative or equity, but a financial liability that must first be recognised at the discounted repayment amount (IAS 32.23). For the classic put options, a liability is therefore not recognised in the amount of the fair value of the option ([market value - exercise price/strike] plus the time value) but in the amount of the present value of the exercise price itself. If the book value of this specific liability has to be adjusted via the general subsequent valuation principles for financial liabilities, there is in principle an option, which can be exercised continuously, to carry out the change in value of the liability in the profit or loss (P&L) or in the equity of the group without affecting the profit or loss. The option is, of course, limited to liabilities from the put options described here. 

If, for example, the right exists to sell the shares of a group company to the same group in two years at the then fair value, then the put option has a mathematical option value of zero, since the following always applies at the time of exercise: 

Market value of the shares = exercise price 

and such a contract has neither an intrinsic value nor a time value. In contrast, the amount of the liability for the tender right is determined by the expected purchase price (and the specific discounting).

For the offsetting entry of the initial recognition of the put options: In principle, a derecognition of the NCI or a direct reduction of the part of the (group) equity attributable to the parent company comes into consideration (In the case of business combinations according to IFRS 3, goodwill also comes into consideration. This case will not be discussed further here). For the decision, it must first be assessed whether the NCI have already effectively lost their ownership position ("present access"). The assessment is based on the overall facts of the case and must be evaluated on a case-by-case basis. Participation in positive and negative changes in the value of the shares and access to dividends must be taken into account. For example, ownership is not effectively lost if the shares may be sold at maturity at their then fair value and the NCI continues to receive dividends in the meantime. If the non-controlling shareholders continue to hold the "ownership position" economically, this leads to a method option for the company that has issued the put options to record the debit entry in the group equity or in the NCI (but not in the case of business combinations). If so-called "present access" no longer exists, the so-called "anticipated acquisition" method (KPMG Insights into IFRS 19th 2.5.690.30) must be applied, and thus the debit entry must be made against the NCI. If "present access" exists, there is an option to apply this method. In practice, the anticipated acquisition method is often used.) Only a remaining difference (liability </> NCI) would be recorded against group equity.

At the exercise date of the put right, the right is either exercised (usually against cash) or forfeited. If the right expires, the liability is derecognised directly against group equity.

For the above reasons, forward-looking contract design protects against "unpleasant surprises". In any case, before granting a put option, its accounting implications should be assessed and, if necessary, simulated in order to avoid undesirable effects on the balance sheet ratios.

If you have any questions, please do not hesitate to contact the Finance and Treasury Management team.

Source: KPMG Corporate Treasury News, Issue 125, September 2022

Authors:

• Ralph Schilling, CFA, Partner, Head of Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG.
• Felix Wacker-Kijewski, Senior Manager, Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG