How pre-acquisition contingencies and indemnification assets are recognized under IFRS 3 and ASC 805

Graziano Stefanelli
5 hours ago
5 min read

Targets often have contingent liabilities—legal claims, tax exposures, warranties—or sellers may promise indemnities against those exposures. IFRS 3 and US GAAP (ASC 805) require the acquirer to recognize present obligations at fair value when they arise from past events and are reliably measurable, and to recognize indemnification assets when the seller contractually reimburses the exposure. Getting this right affects goodwill, subsequent P&L volatility, and disclosures about measurement uncertainty.

·····

.....

Why contingencies and indemnities matter in a purchase price allocation

Business combinations surface issues that ordinary reporting may not: pending lawsuits, environmental remediation, uncertain tax positions, product warranties, or regulatory probes. If these obligations existed before the acquisition date, they belong in the PPA. When sellers grant indemnities, the acquirer records a separate asset that mirrors the covered liability—usually measured on the same basis, subject to collectibility and any contractual limits (caps, baskets, time bars).

Key effects:

Goodwill increases for recognized liabilities and decreases for recognized indemnification assets.
Post-combination earnings can be volatile if liabilities are remeasured through P&L without a matching change in the indemnification asset.

·····

.....

IFRS 3 mechanics for contingencies and indemnification assets

Contingent liabilities (IFRS 3.23–28):

Recognize a present obligation at the acquisition date fair value if it stems from a past event and its fair value can be measured reliably, even if an outflow is not probable (a key difference from IAS 37 day-two rules).
After day one, apply IAS 37: remeasure when there is a change in best estimate; derecognize when outflow is no longer probable.

Indemnification assets (IFRS 3.27–28):

Recognize an asset concurrently with the related item (e.g., contingent liability, tax uncertainty), measured on the same basis (generally the same fair value), subject to credit risk and contract terms.
Subsequent measurement mirrors the underlying item except when limited by the contract (caps, time limits) or collectibility deteriorates.

Goodwill interaction:

Recognizing a contingent liability increases goodwill.
Recognizing the matching indemnification asset reduces goodwill.

·····

.....

US GAAP mechanics under ASC 805 and ASC 450/740

Contingencies (ASC 805-20-25; ASC 450):

At the acquisition date, recognize a contingent liability at fair value if it is a present obligation and the amount can be reasonably estimated. If fair value cannot be estimated, disclose and recognize when criteria are later met (within the measurement period, adjustments go to goodwill).
After day one, apply ASC 450: record changes in the liability in earnings as facts evolve.

Indemnification assets (ASC 805-20-25-27):

Recognize an indemnification asset at the same time as the indemnified item, measured on the same basis (generally fair value), subject to collectibility and contractual limitations.
Subsequently, adjust the asset consistently with the indemnified liability; changes flow through earnings unless within the measurement period and tied to acquisition-date facts.

Tax-related contingencies (ASC 740 / FIN 48):

Apply ASC 740-10 to uncertain tax positions; recognize and measure at acquisition; any seller indemnity creates a separate indemnification asset measured consistently, with changes post-period generally in earnings.

·····

.....

Comparative framework — IFRS 3 vs ASC 805 at a glance

Topic	IFRS 3 / IAS 37	ASC 805 / ASC 450 / ASC 740
Day-one recognition threshold	Present obligation; recognize at fair value if reliably measurable (probability not required)	Present obligation; recognize at fair value if reasonably estimable
Post-combination model	IAS 37 best-estimate model; changes → P&L	ASC 450/740; changes → earnings
Indemnification asset	Recognize concurrently, same basis as liability, net of collectibility/limits	Same; measured on same basis, subject to collectibility and caps
Goodwill effect	Liability ↑ goodwill; indemnity ↓ goodwill	Same principle
Measurement period	12 months; acquisition-date facts adjust goodwill	12 months; acquisition-date facts adjust goodwill

·····

.....

Worked example A — legal claim with seller indemnity (IFRS)

Facts (€, acquisition date):

Best-estimate fair value of pending litigation = €6,000,000 (present obligation).
Seller grants 100% indemnity up to €5,000,000; acquirer assesses no credit risk.

Day-one entries:

Dr Identifiable Assets (FV) …………………… xx
Dr Goodwill ……………………………………… xx
Cr Contingent Liability — Legal ………… 6,000,000
Cr Cash / Equity / NCI ………………………… xx
Dr Indemnification Asset ………………… 5,000,000
Cr Goodwill ……………………………………… 5,000,000

Net goodwill impact: +€1,000,000 (liability 6m less indemnity asset 5m).

Year 1 update (IAS 37): The court narrows damages; best estimate drops to €4,500,000.

Dr Contingent Liability — Legal …… 1,500,000
Cr Gain on Re-measurement ……… 1,500,000

Indemnity mirrors down to the cap:

Cr Indemnification Asset ………………… 1,500,000
Dr Loss on Indemnity Change ……… 1,500,000

Net P&L impact: zero (perfect mirror), unless contract limits or credit risk break symmetry.

·····

.....

Worked example B — uncertain tax position with partial indemnity (US GAAP)

Facts ($):

Uncertain tax position (UTP) recognized at $8,000,000 under ASC 740-10.
Seller indemnifies 75% of the exposure; collectibility considered high.

Day-one entries:

Dr Intangible/PPE/etc. (FV) ………………… xx
Dr Goodwill ……………………………………… xx
Cr UTP Liability (ASC 740) …………… 8,000,000
Cr Cash / APIC / NCI …………………………… xx
Dr Indemnification Asset ………………… 6,000,000
Cr Goodwill ……………………………………… 6,000,000

Year 2 resolution: Pay $5,000,000 to tax authority.

Dr UTP Liability …………………………………… 5,000,000
Cr Cash ………………………………………………… 5,000,000

Recover indemnity (75% of settlement, limited to remaining asset):

Dr Cash ………………………………………………… 3,750,000
Cr Indemnification Asset ……………………… 3,750,000

If the indemnity is time-barred for remaining $3,000,000 liability, the residual flows through earnings.

·····

.....

How caps, baskets, and time limits affect measurement symmetry

Indemnities almost never cover 100% forever. Common constraints:

Caps (e.g., up to €10m): indemnification asset cannot exceed cap.
Baskets/deductibles: first €500k not reimbursable; measure asset net of basket.
Survival periods: asset expires after, say, 24 months; cease recognition when unenforceable.
Offset rights: recovery taken against escrow or holdback; presentation may be a receivable or contra-consideration depending on terms.

Always include collectibility (credit risk of the seller/escrow) in measurement.

·····

.....

Journal entries summary

Day one (both frameworks):

Dr Net identifiable assets at FV ………… xx
Dr Goodwill ………………………………………… xx
Cr Contingent liability (FV) ………………… xx
Cr Consideration / NCI …………………… xx
Dr Indemnification asset (mirror) …… xx
Cr Goodwill ………………………………………… xx

Subsequent:

Changes in liability → P&L (IAS 37 / ASC 450/740).
Indemnity mirrors changes subject to caps/credit; asymmetry goes to P&L.
Settlement: derecognize both and record cash paid/received.

·····

.....

Disclosure requirements that investors expect

Nature of significant contingencies assumed and related indemnities.
Carrying amounts at period end of contingent liabilities and indemnification assets.
Key terms: caps, baskets, survival periods, escrow arrangements.
Measurement uncertainty and sensitivity (scenarios, ranges, or qualitative).
Rollforwards of indemnification assets and liabilities when material.
Measurement period adjustments that affected goodwill.

Clear disclosures help users separate legacy risks of the target from post-combination performance.

·····

.....

Impact on financial performance and ratios

Goodwill: rises with recognized contingencies; falls with matching indemnities.
Earnings volatility: mis-matched caps, expiries, or collectibility issues create P&L noise.
Cash flows: escrow releases and indemnity receipts may be investing or operating based on policy and substance.
Leverage and covenants: large recognized contingencies can affect net debt-like analytics and headroom.

Analysts often adjust EBITDA for non-operating remeasurement gains/losses tied to acquisition-date contingencies.

·····

.....

Operational considerations for deal and reporting teams

Draft indemnities with symmetry in mind: duration, caps, baskets, and recovery mechanics that align with accounting.
Build tracking schedules linking each contingency to its indemnity, cap, and expiry; automate reminders before survival periods lapse.
Evaluate credit risk of sellers/escrows; impair indemnification assets when collectibility deteriorates.
Document measurement period judgments; route qualifying adjustments through goodwill consistently.
Coordinate tax, legal, and FP&A to forecast settlement timing and cash impacts.

Robust policies for contingencies and indemnities keep the PPA clean, reduce earnings surprises, and maintain transparent links between legacy risks and post-deal performance.

·····

.....

DATA STUDIOS

.....

[datastudios.org]