If you are an auditor or if you prepare financial statements, let me start by asking you a few questions. Which financial statement is your primary focus? Which is the last that you focus on? Undoubtedly, the statement of cash flows ends up pretty far down the list and is often the one that receives the least attention from both a preparation and an audit perspective. Yet, it is often the statement that receives the most attention from investors and analysts. It has also received quite a lot of focus in recent years from the SEC, ranking 2nd in frequency of issue occurrence in restatements according to a May 2016 study by Audit Analytics. The SEC has also issued numerous comment letters to companies regarding proper classification of cash flows and cited issues in this area in a number of speeches. Why? ASC 230, Statement of Cash Flows, was issued 30 years ago and hasn’t changed much since. On top of that, there really are only three ways to classify: investing, financing, or operating! Sounds pretty easy, so why all the issues? The reasons are many, but one key reason is that the guidance isn’t always clear, and there is a lot of gray area with certain types of cash flows. As a result, the FASB issued ASU 2016-15 Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments, to address eight areas that weren’t clear, leading to diversity in practice. The classification issues covered in ASU 2016-15 are:
- Proceeds from the settlement of insurance claims
- Debt prepayment or debt extinguishment costs
- Settlement of zero-coupon debt instruments
- Contingent consideration payments made after a business combination
- Proceeds from the settlement of corporate-owned or bank-owned life insurance policies
- Distributions received from equity method investees
- Beneficial interests in securitization transactions
- Separately identifiable cash flows and application of the predominance principle
It’s now time to walk the line and properly classify cash flows in the statement of cash flows. Let’s take a look at one of the eight issues recently addressed by the FASB in ASU 2016-15, contingent consideration payments made after a business combination. A separate blog is available for each of the other issues and can be accessed by clicking the items in the above list.
The best way to explore this cash flow classification issue is through a scenario followed by a series of questions and answers. But before we get started, let’s review a few things. According to the FASB Master Glossary, contingent consideration is usually an obligation of the acquirer in a business combination to transfer additional assets or equity interest to the former owners of an acquiree as part of the exchange for control of the acquiree if specified future events occur or conditions are met. Note that it can go the other way too, with contingent consideration giving the acquirer the right to the return of previously transferred consideration if specified conditions are met. The obligation for contingent consideration will either be liability classified or equity classified. Now that we’ve covered the background, it’s time for our scenario which will involve a quick review of the overall accounting for contingent consideration in a business combination along with the recent guidance on classification in the statement of cash flows.
Jackson Corp. acquired Solitary, Inc. in a business combination on October 17 for $300 million cash. In addition, if Solitary meets its forecasted results for each of the next two years, Jackson must pay an additional $25 million lump sum at the end of the two-year period. It is considered probable that Solitary will meet its forecasted results for the current year and the following year.
Question 1: What is the purchase price of this business combination of October 17?
Answer 1: $300 million plus the fair value of the contingent payments. Contingent consideration is included in the consideration paid (purchase price). The amount to include is measured at the acquisition date fair value, and not the expected payout at settlement date. The probability of meeting the forecasted results does not impact whether or not an amount is recognized, however, the estimate of fair value would take into consideration the probabilities of payment as well as the time value of money. The acquirer should classify an obligation to pay contingent consideration as a liability or equity in accordance other applicable GAAP. Since this example requires cash settlement, it would be liability classified. For purposes of this example, let’s assume that the fair value of the contingent consideration at acquisition is $23 million.
Question 2: How should the liability for the contingent consideration be subsequently accounted for?
Answer 2: It depends on what caused the change. If the change is as a result of additional information about facts and circumstances that existed at the acquisition date, then they are measurement period adjustments, assuming the change is within the measurement period. If the change results from events after the acquisition date, such as meeting an earnings target, this change should be accounted for as follows:
- Contingent consideration classified as equity should not be remeasured and its subsequent settlement should be accounted for within equity
- Contingent consideration classified as an asset or liability is remeasured to fair value at each reporting date until the contingency is resolved. Changes in fair value are recognized in earnings.
Question 3: Assume the targets are met and the contingent consideration liability is settled at the end of year two. How should this be accounted for?
Answer 3:The contingent consideration liability (which is has been remeasured to fair value) will be reversed and the cash payment made (Dr. Liability $25M, Cr. Cash $25M). Note that the FV on the date of settlement would be the payment of $25M.
Question 4: How should this cash outflow be classified in the statement of cash flows?
Answer 4: Prior to the issuance of ASU 2016-15 there was diversity in practice. ASU 2016-15 clarifies the classification of this payment and the guidance can best be summarized in a flowchart:
Soon after is defined as a relatively short time but an explicit timeframe is not given in the standard. However, it is generally considered three months or less. In our example, $23M would be classified as financing outflow and $2M as an operating cash outflow since the payment was not made soon after the acquisition date.
We’ve now addressed one of the eight cash flow classification issues in ASU 2016-15. Check out the additional blogs in this series for more cash flow classification issues and answers!
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