Financial Instruments

Business acquisitions and mergers are key strategic steps that can sustainably strengthen a company’s competitiveness and market penetration. However, because business combinations are not part of the core business for many companies, those involved often enter unfamiliar technical territory. To actually realize the potential of a transaction, financial and accounting risks must be identified at an early stage and managed carefully.

One of the central risks arises from the impact of the business combination on the acquiring company’s key performance indicators and financial covenants. These risks do not result from uncertain planning assumptions, but from the mandatory accounting requirements applicable to business combinations themselves. The accounting treatment of financial instruments plays a particularly significant role in this context, as it can have a substantial effect on the amount of goodwill recognized. This becomes especially critical when a high level of goodwill arises at the acquisition date and subsequently has to be written down as part of impairment testing.

A key driver of the amount of goodwill is the measurement of acquired original financial liabilities at fair value. This article highlights central accounting issues that should be considered both before the acquisition date and during the business combination itself.

Even before the actual business combination, two key areas need to be addressed:
(1) obligations arising from pre‑acquisition agreements, and
(2) the treatment of foreign currency hedges for the purchase price payment.

1.1 Obligations arising from pre‑acquisition agreements
A business combination is typically preceded by a binding contractual offer for the shares. Such pre‑acquisition agreements can already have accounting consequences at the reporting date. In these cases, a derivative often arises that must be recognized through profit or loss.

If the acquirer can directly control the exercise – for example, by acquiring a call option over the majority of the voting rights – this may result in obtaining control even before the actual closing. As a consequence, full consolidation may already be required at that stage.

1.2 Currency derivatives to hedge the purchase price
Currency derivatives are frequently entered into to hedge a purchase price payable in a foreign currency. However, hedge accounting can only be applied once a firm commitment or a highly probable transaction exists, meaning that a binding obligation has been established. It is therefore essential to clearly document from which point in time the acquisition becomes binding or at least highly probable.

When subsequently releasing the hedging relationship recognized in OCI, a distinction must be made between transactions treated as the acquisition of a financial item (for example, an equity investment without control) and those treated as the acquisition of a non‑financial item (the acquisition of a controlled business). In the latter case, the release from OCI generally affects the amount of goodwill recognized.

At the acquisition date, goodwill is determined by comparing the purchase price with the fair value of the net assets acquired. In this context, original financial liabilities are particularly relevant when translating the target company’s carrying amounts into fair values.

2.1 Measurement of original financial liabilities at fair value
Financial liabilities are measured at fair value at the acquisition date. As quoted market prices are often not available, valuation is typically performed using a discounted cash flow approach. Expected cash flows are discounted using a credit‑risk‑adjusted interest rate from the perspective of the creditor.

If the business combination is already known to the market at the valuation date, the changed credit risk is reflected in this measurement. A liability that was previously considered to bear a “fair” interest rate may therefore appear over‑ or under‑interest‑bearing in the new context.

• Over‑interest‑bearing liabilities have a fair value above their nominal amount.
• Transaction costs of the target company that have previously been accrued are not part of the fair value and are therefore not carried forward.
• Embedded derivatives in acquired liabilities must be assessed to determine whether separation is required. Often, it is, as the subsequent carrying amount regularly differs significantly from the repayment amount (that is, the exercise price of termination options).

2.2 Impact on existing hedging relationships
The cash flow hedge reserve is not part of the net assets acquired and therefore cannot be carried forward (IFRS 3.31). Existing derivatives of the target company must either be:

• designated into a new hedging relationship, or
• subsequently measured as stand‑alone derivatives through profit or loss.

For derivatives with multiple settlement dates – such as interest rate swaps or cross‑currency swaps – redesignation is particularly complex.

Within the group, accounting and measurement policies must be harmonized. This applies in particular to accounting‑relevant matters from both entities that, following the business combination, must be presented consistently – especially where both companies are of a material size.

For these reasons, business combinations should be closely supported by the accounting and financial reporting function from the very outset. Financial instruments, in particular, frequently give rise to critical accounting issues that should already be identified and actively addressed during the planning phase. At the latest, accounting experts should be involved when structuring the contractual arrangements – otherwise, accounting can only reflect the facts as they stand.

We would be pleased to discuss with you the key questions that arise in the accounting and measurement of financial instruments in the context of business combinations and how these challenges can be addressed in the most effective way.