Indemnification assets

Last update 13/12/2019

Indemnification assets – Dictionary meaning of Indemnification is ‘indemnification is the part of an agreement that provides for one party to bear the monetary costs, either directly or by reimbursement, for losses incurred by a second party’.

Indemnification of an asset essentially provides kind of guarantee to the other party about the downside of any risk associated with such asset/ liability. On broader perspective such indemnification could be against any asset/ liability or part thereof while making Business combinations under IFRS 3.

Let’s have a look at the term with reference to relevant parts of IFRS 3:

[IFRS 3 27] ‘The seller in a business combination may contractually indemnify the acquirer for the outcome of a contingency or uncertainty related to all or part of a specific asset or liability. For example, the seller may indemnify the acquirer against losses above a specified amount on a liability arising from a particular contingency; in other words, the seller will guarantee that the acquirer’s liability will not exceed a specified amount. As a result, the acquirer obtains an indemnification asset. …’
[IFRS 3 28] ‘In some circumstances, the indemnification may relate to an asset or a liability that is an exception to the recognition or measurement principles. For example, an indemnification may relate to a contingent liability that is not recognised at the acquisition date because its fair value is not reliably measurable at that date. Alternatively, an indemnification may relate to an asset or a liability, ….’
[IFRS 3 57] At the end of each subsequent reporting period, the acquirer shall measure an indemnification asset that was recognised at the acquisition date on the same basis as the indemnified liability or asset, subject to any contractual limitations on its amount and, for an indemnification asset that is not …’

In summary the following considerations are of importance relating to indemnification assets:

The indemnification can be used either for an Asset or a liability while making a deal of acquiring business as covered within IFRS 3,
Indemnification mainly refers to some kind of uncertainty or contingency where the selling entity provides a kind of assurance to protect the value which is being bought by a buying entity during the business acquisition,
A typical example could be a legal court case where the selling entity agrees to indemnify an amount which may relate to an outcome of such court case (because the selling entity knows the case and the risks),
There could be a situation where any regulatory approval pending for any segment of a business which is being acquired and for that the selling entity agrees to compensate for any negative outcome encountered in such regulatory approvals,
Another common example could be a tax litigation case where some decisions are pending at the time of making such business acquisitions and hence the selling entity agrees to compensate to the buying entity for any losses/ negative decisions which might come in future (again because the selling entity knows the case and the risks),
The underlying principal is that in respect of the recognition of the indemnification assets relating to asset(s) / liabilty(ies), the same recognition method is used, as for those indemnified assets/liabilities. For example if an indemnification is related to an asset which is recognised against fair value at the time of such business acquisition then, the related indemnified asset will also be recognised basing on fair value,
It is interesting to note that major part of the assets/liabilities acquired at the time of the business acquisition covered under IFRS 3 are normally valued at fair value except some cases where it could be either at cost or in some cases nothing is recognised while doing such business acquisitions, for example – deferred tax would be valued as per IAS 12 etc. The subsequent measurement of the indemnified assets other than at fair value is subject to the collectiblity test, along with the management estimates to realise actual amounts out of such indemnified assets,
Such indemnification is being used only in case of specific liabilities/assets which are to be compensated to a buying entity and hence would not be used in other normal business transactions like warranties etc.