Closing the GAAP in options

Remember last year, when the securities market regulator SEBI asked acquirers and sellers to remove the call and put option clauses from the deal terms of mergers and acquisitions? According to recent reports, after much debate, SEBI has agreed to revisit its zero-tolerance stand towards such put and call options embedded in M&A deals. Companies have much to cheer in this. The options provide flexibility to deals, as the buyer and seller can contractually agree to acquire a right or assume an obligation to buy and sell additional shares based on the future performance of the business.

The regulator along with the Ministry of Finance is likely to draft regulations that allow listed companies to use options in their shareholder agreement that create rights and obligations for acquirers and sellers to buy and sell shares from the minority shareholders (or non-controlling interest) of the acquired business.

So far so good, but as an accountant it is difficult not to think about the effect such instruments may have on financial reporting. At present, under Indian accounting standards, there is little guidance on the treatment of such derivatives. The guidance predominantly applies to derivatives traded on exchange and forward contracts. In the absence of accounting and reporting guidance for these options, it will be difficult for users of financial statements to assess the extent of exposure for the buyer. Typically, in these options the acquirer writes a put option, which enables the seller to sell the minority shares at a future date for an agreed price. The price may be predetermined, or determinable using inputs linked to performance or share price at a designated future date or time. These written put options create an obligation on the buyer to buy additional shares from the seller at the agreed price, when the seller decides to exercise the option to sell.

Under International Financial Reporting Standards, the terms of these options should be analysed to assess whether the buyer has, in substance, assumed the risks and rewards of the ownership of the shares held by minority shareholders. The accounting treatment under IFRS is dependent on whether in-substance risks and rewards have been transferred to the acquirer. If “yes”, then no minority interest is recognised, and instead a liability for the put option is recognised. The transfer of risks and rewards of ownership usually takes place when the exercise price of the option is fixed. If, on the contrary, the exercise price is set at the fair value of the shares at the time of exercise, the transfer of risks and rewards of ownership is less likely, and, therefore, minority interest is recognised. Often, the evaluation of the transfer of risks and rewards of ownership require judgement, and is driven by the substance and terms of the transaction.

The put option liability is measured at present value using discounted cash flows.

At each reporting date, the liability is re-measured, as the value changes due to changes in the exercise price and/or accretion of the discount. There has been diversity in accounting for the movement in the value of these option liabilities at each balance-sheet date. Historically, some have recognised these movements in value in the profit or loss of each period, while others have recognised them directly in equity, thereby avoiding volatility in the income statement of each period.

However, the standard setters have shown inclination towards recognising these movements in the income statement.

Often, such written options are accompanied by call options, which gives the buyer the right to buy the minority shares from the seller at a future date for an agreed price. The call option of the buyer, depending on the terms, is classified as a derivative or equity instrument. If the call option meets the definition of a derivative, it is marked to market, with changes recognised in profit or loss.

Therefore, to summarise, the application of existing international guidance may result in significant volatility in the income statement of the buyer and the assumption of a liability on the balance sheet.

It is only natural to expect that the stakeholders would like to know the obligation the company has assumed and the volatility it has exposed itself to. In the absence of clear accounting guidance under the current reporting framework, such arrangements may not get the attention they deserve. A reporting guidance on such complex matters would go a long way in enhancing the quality of financial reporting in India.

Rahul Chattopadhyay is Partner, Price Waterhouse & Co

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