– the invisible risk
The put option of non controlling interests (NCI) refers to the duty of a corporation to purchase business interests (e.g. shares) of NCI when the NCI offer these interests for sale. Frequently, the right of the NCI can be exercised at a fixed date in the future, after which it lapses. From the perspective of the company that extends this right, it is in economic terms a short position on treasury shares, i.e. a written put option on the underlying ‘own share’. This potential buyback duty of the company is frequently discussed in the literature on the accounting treatment of the obligated company under the term ‘put option’ (or ‘puttable instruments’).
These put options can be observed relatively often in practice in a variety of contract constellations. This is also true for companies that would actually like to have nothing to do with derivatives and especially with options. In the majority of cases, put options are not found openly in the form of individual contracts, but as passages in other contracts, for example in the context of business combinations (within the meaning of IFRS 3).
Sometimes, however, the intention of contractual passages of this kind is also to enable market access. In these cases, a company needs, for example, a local business partner who brings with them the right contacts, who knows how the business works, or who enables the entrepreneurial action to be conducted legally in the first place (e.g. in China). In these cases, put options are typically also incorporated in service agreements and similar contracts.
Put options of NCI represent a ‘popular’ source of error in transactions, as several aspects have to be assessed. The resulting errors sometimes lead to significant mispostings in the IFRS consolidated financial statements and the key indicators derived from them. As the equity capital and the financial liabilities are regularly valued or recognised incorrectly in the event of an error, a considerable number of typical financial covenants are also affected (the net debt ratio, for example).
Frequently, the put options regulate the exit of an NCI separately or have to be taken into consideration directly in the presentation of business combinations under IFRS 3 (for example as part of the determination of the consideration transferred), or they are incorporated in share-based compensation (IFRS 2) (e.g. NCI are granted to employees). The field of application must already be analysed in depth for that reason.
As share-based compensation has already been the subject of various articles in this series of newsletters, these cases will not be discussed in the following. At the time of the full consolidation of a company, the shares of which are also held by minorities, the group has to (fully) consolidate the assets and liabilities of the subsidiary and to recognise the shares that are held by external shareholders as ‘non controlling interests’ openly in the equity capital.
In addition to the recognition of the put option (on the credit side), the counter entry (on the debit side) sometimes causes a stir when it is first recorded, and for that reason both the issues will be illuminated in brief and simplified terms below.
On the recognition of the put option
Although the put option may have the valuation profile of an option in actuarial terms, it is not recognised at this value (IAS 32.18 in conjunction with IAS 32.23). Under IFRS, the obligation arising from the put option is by definition not a derivative, but a financial liability (IAS 39.9), which must initially be recognised at the discounted repayment amount (IAS 32.23).
For classic put options, this does not therefore give rise to the recognition of a liability in the amount of the fair value of the option, but to the recognition in the amount of the cash value of the exercise price itself. If the carrying amount of this special liability has to be adjusted using the general subsequent measurement principles for financial liabilities, then there is here in principle an option, to be constantly exercised, to carry out the change in value of the liability in the result (P&L) or recognised directly in the equity of the corporation. This option is of course limited to liabilities arising from the puttable instruments described here.
If, for example, the right exists to sell the shares in two years at the fair value at that time, the put option has a mathematical option value of zero, as the following always applies on the exercise date: market value of the interests = exercise price. A contract of this kind accordingly features neither an intrinsic nor a fair value. In contrast, the amount of the liability for the put option is determined by the expected sale price (and the specific discounting).
On the counter posting of the first recording of the put options:
In principle, a derecognition of the NCI or a direct reduction of the part of the (group) equity to be attributed to the parent company can come into consideration (depending on the context and contract, a change in the amount of the recognised goodwill is also conceivable). In terms of the decision, it must first be assessed whether the NCI has already in fact lost its ownership position (‘present access’).
The assessment is based on the overall circumstances and has to be appreciated on a case-by-case basis. In our opinion, participation in positive and negative value changes in the shares and access to dividends have to be taken into consideration in this process. The ownership position has not factually been lost, for example, if the shares can be sold at maturity at their fair value existing at that time and the NCI continue to be entitled to dividends in the meantime.
If the non-controlling shareholders continue to hold the ownership position in economic terms, this leads at the company that has extended the put options to a choice of methods with the option to record the debit posting in the consolidated equity or in the NCI. If present access no longer exists, the anticipated acquisition method must necessarily be applied, and the debit posting must thus necessarily be carried out against the NCI. Only a residual difference (liability </> NCI) would be recorded against the consolidated equity.
On the day that the put option is exercised, the right is either exercised (generally against the cash and cash equivalents) or it lapses. In the event that the right lapses, the derecognition of the liability is made directly against the consolidated equity.
For the reasons given above, a forward-looking contract design will protect against ‘unpleasant surprises’. In any event, the accounting implications of a put option should be assessed and, if appropriate, simulated before it is granted in order to avoid undesirable effects on the key balance sheet figures.
Source: KPMG Corporate Treasury News, Edition 58, August 2016
Author: Felix Wacker-Kijewski, Manager, Finance Advisory, firstname.lastname@example.org
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