How do you value favourable and unfavourable contracts in a PPA?

Full Explanation

In a business combination, the acquired company's existing contracts may have terms that differ from current market conditions. A favourable contract provides better terms than what could be negotiated today — for example, a below-market lease, a supplier contract with locked-in pricing below current rates, or a customer contract with above-market pricing. An unfavourable contract is the opposite. Under IFRS 3, both must be identified and measured at fair value. The valuation approach compares the contractual terms to current market terms over the remaining contract life. For a favourable supply contract, the value is the present value of the cost savings relative to current market prices for the remaining contractual period. For a favourable customer contract, the value is the present value of the above-market revenue relative to what the market would currently pay. Unfavourable contracts are recognised as assumed liabilities at fair value, reducing the net assets acquired and potentially increasing goodwill. The discount rate reflects the specific risk of the contract cash flows, which may be lower than the rate for other intangibles given the contractual certainty. These assets and liabilities are amortised over the remaining contract term. Favourable contracts are sometimes overlooked in PPAs because they are embedded within operating agreements rather than standing as separate assets, but they can be material — particularly in industries with long-term fixed-price contracts like energy, telecommunications, or real estate.

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