An insight into the accounting challenges broking consolidators face
Broking Business - Summer 2024
Acquiring another broking business has accounting consequences. We provide an insight to help guide you through the complexities.
Our recent experience of advising and carrying out audits for consolidators in the broking sector has thrown up many accounting issues. Some are recurring and others more unusual. But most lead to accounting and audit challenges.
Valuation and allocation
The purchase price needs to be allocated to the individual assets and liabilities identified. This purchase price allocation (PPA) can be subjective, especially for complex assets with intertwined functionality. Intangible assets like brand value, customer relationships, and intellectual property (IP) require subjective judgement, so may not have a readily available market price.
In practice, not all consolidators use a professional valuer for the PPA. But, depending on materiality, a PPA carried out in-house can often lead to audit challenges. PPA timing is also important. It should coincide with when the acquisition is effective rather than at or after the financial reporting date. This is because it aims to allocate fair value of the net assets on acquisition, to be able to correctly calculate the goodwill at that date (see below). This is often overlooked and trying to value with hindsight may reduce the efficacy of the PPA process.
Goodwill
The difference between the purchase price and the fair value of the acquired net assets is recorded as goodwill. This represents the intangible value of an acquired brokerage. But it must be monitored for impairment on subsequent measurement. Assessing changes in the consolidated entity’s performance, market conditions, or the acquired broker’s outlook can be complex and may trigger an impairment charge on subsequent measurement.
Risk of cannibalisation can also trigger impairment charges in other parts of the existing business. For example, if the group plans to use the systems and IP of the acquiree in the rest of the existing group, the current systems might be impaired. On the other hand, as the acquiree is integrated into the acquirer’s systems and processes, some of the recently acquired assets could be impaired after the acquisition.
Certain accounting frameworks like IFRS require separate valuations for each identifiable intangible asset. But under UK GAAP practice varies, and often the residual goodwill captures certain intangible assets that would otherwise be recognised as separate under IFRS. So, typically, the goodwill under UK GAAP is higher than it is under IFRS.
What’s more, under UK GAAP goodwill, including negative goodwill, is amortised. But this is not the case under IFRS, where positive goodwill is assessed for impairment annually and negative goodwill is recorded directly to profit or loss. The amortisation period for goodwill under UK GAAP should not exceed 10 years, unless management can justify a longer period. But auditors are likely to challenge this.
These differences are particularly relevant for groups where the holding company is reporting under IFRS but the sub-group reports under UK GAAP, or where the acquirer and acquiree follow different accounting frameworks.
Contingent (‘maybe’) versus deferred (‘later’) consideration
Both contingent and deferred consideration involve delaying a portion of the purchase price in an acquisition. But they differ in the reason for the delay and the uncertainty surrounding the payment. The consolidator needs to properly account for these liabilities and adjust the PPA.
Contingent consideration is measured at fair value while deferred consideration is measured at present value (ie, on amortised cost basis). Deferred consideration isn’t generally complex as it involves less uncertainty and is simply a deferral of part of the agreed consideration.
On the other hand, determining the fair value of contingent consideration can be challenging. That’s because it relies on estimates of future events and involves a significant degree of judgement. Factors such as the likelihood of achieving performance targets, the timing of payments, and the discount rate used can have a great impact on the fair value. By nature, this estimate can be volatile and subject to notable fluctuations in fair value later, which affect the financial performance and position of the acquirer.
So, the initial measurement of any contingent consideration impacts the total consideration, and hence the value of the goodwill too. Practice in accounting for changes in the fair value of contingent consideration (ie, as a charge/income to profit or loss or an adjustment to goodwill) may vary. But note, too, that if the revised fair value of contingent consideration decreases, it can trigger an impairment charge to goodwill. This is because the overall value of the acquired company might be lower than initially thought.
Contingent liabilities
Under normal accounting rules, contingent liabilities are not recorded, as they don’t meet the ‘probable’ threshold required for recognition. But when accounting for an acquisition, a fair value is assigned to any contingent liabilities the acquiree may have. This means that in the due diligence process any unrecorded contingent liabilities, such as potential lawsuits or tax disputes with authorities, should be identified and a fair value assigned as part of the PPA. But this can be difficult to do in practice.
If these liabilities emerge later, they can negatively impact the acquirer’s financial performance. That’s why the acquiree’s previous owners may need to purchase an insurance policy for the benefit of the acquirer or provide a simple indemnification agreement instead. Often the previous owners are employed by the acquirer following the transaction. And this can lead to subsequent disagreements and disputes if such contingent liabilities are not disclosed and measured as part of the PPA.
Share-based payments
In the broking sector, it’s common for the previous owners to also be key employees of the acquiree who may in turn remain as employees of the acquired business. Indeed, these individuals might be a key reason for acquiring the business in the first place. Where they receive cash or share-based payments, it’s important to consider the economic substance of those payments to determine the accounting treatment.
Payments for employee services are post-combination expenses. By contrast, payments that are, in substance, consideration for the business acquired are part of the business combination’s cost. So, the accounting treatment should reflect the transaction’s commercial effect. This means for both the initial purchase consideration and subsequent payments, in the eyes of the acquirer and the seller.
It’s usually assumed that the post-acquisition payments are treated as expenses if payments depend on the individuals continuing to provide future services to the acquired entity (or the group). But arrangements that are not affected by employment ending might suggest that contingent payments are additional purchase consideration. Several other factors can impact this judgement, among them are:
- Length of required employment period
- Non-compete clauses
- Level of remuneration
- Incremental payments to former employees
- Linkage to the valuation
- Other side agreements.
Accounting for, and the valuation of, share-based payments can be complex and more so when they arise on an acquisition.
Revenue recognition and other accounting policy differences
An acquiree may well have used different accounting practices to the acquirer. These might apply, for example, in revenue recognition, capitalisation of intangibles, amortisation periods and presentation of insurance-related debtors, creditors, and client money. Many differences emerge as part of due diligence, but others may only be uncovered during a full scope audit of the acquiree.
It’s vital to identify and reconcile these differences early, especially for revenue recognition and estimates (eg profit commissions), to present a cohesive financial picture of the consolidated business. A group must apply consistent accounting policies to its subsidiaries.
The variations arise for several reasons. They may have made different accounting policy choices, both of which comply with accounting standards. Or the acquiree may have historically applied policies that do not comply with accounting standards. If the former, the group should still align the new subsidiary’s accounting policies with its own. If the latter, the accounting policies should be updated so they do comply with the relevant accounting standards.
In other cases, the acquirer might be reporting under IFRS and the acquiree under UK GAAP. Here, the acquiree does not need to change its reporting in standalone financial statements to IFRS. But some groups might prefer this option as the acquiree would still need to produce IFRS numbers for group reporting even if it continued to apply UK GAAP. Switching would avoid having to prepare two sets of numbers for solo and group reporting purposes.
Other integration costs
Various costs associated with integrating the acquired company, such as severance packages, lease terminations/renegotiations, system upgrades, data harmonisation and marketing strategy, must be accounted for. Restructuring provisions and/or onerous leases are not unusual following acquisitions, and accounting for these correctly can be challenging.
How the acquisition is structured and the location of the acquired business can also have significant tax and regulatory impacts on the group. Consolidators operating across different jurisdictions should be aware of local accounting standards, tax rules and laws and regulations.
Mitigation
A consolidator can implement certain measures to mitigate the impact of the accounting challenges we’ve highlighted. These include:
- Due diligence: a thorough review of the target company’s financials and operations is essential for uncovering potential issues and hidden liabilities.
- Experienced valuation professionals: engaging qualified professionals with expertise in valuing intangible assets, share-based payments and complex business models helps to produce a fair and accurate PPA in conjunction with the valuation of the whole business at the start.
- Clear communication and documentation: clear communication and documentation of valuation methodologies and allocation decisions creates transparency and reduces the risk of audit challenges and future disputes with the sellers. We recommend that you prepare comprehensive accounting papers to document your rationale on each of the applicable issues and get input from your auditors early in the process.
- Strong internal controls: implementing robust internal controls over the acquisition process helps mitigate the risk of errors and leads to proper accounting treatment for all transaction-related complexities.
So, it’s vital to proactively address these challenges and implement appropriate accounting practices. That way, broking consolidators can achieve an effective integration of their acquirees while maintaining sound financial reporting and optimising the business for sustainable growth.
Our accounting advisory, valuation and transaction services teams are familiar with all these issues and well equipped to help you further. If you have any questions on anything outlined in this article, please don’t hesitate to contact Satya Beekarry, Simoné Bester or Brian Were to discuss further.