You’re reading through the purchase agreement and there it is in black and white, contingent consideration. Your heart races as you realize you now have to account for this contingent payment! Luckily, there is guidance within ASC 805 to help you decide whether the contingent consideration should be included in or excluded from the transaction price of the business combination under U.S. GAAP. This week we are going to explore the fourth issue identified in a previous post noting the top 5 issues related to accounting for business combinations.
What is Contingent Consideration?
What is contingent consideration? If you encounter language within the purchase agreement that calls for some type of conditional payments subsequent to the closing date, it is likely that a contingent consideration provision exists within the purchase agreement. You will often hear these types of provisions referred to as “earn-outs.” The FASB defines contingent consideration as, “usually an obligation of the acquirer 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.”
Does the contingent consideration represent an unconditional obligation as of the acquisition date?
Now that we’ve identified the contingent consideration arrangement within the business combination, we need to figure out how to account for it. The first step is to determine if the contingent consideration arrangement represents an unconditional obligation as of the acquisition date. The key to this analysis is to understand why the purchase agreement includes the provision for contingent payments. Why? Because only certain contingent consideration payment provisions should be included within the purchase price, or consideration transferred, of the business combination.
A purchase agreement specifies a contingent payment to the former owner twelve months after the closing date. This contingent payment will only be made if the acquired business reaches a specific sales target.
A purchase agreement includes a contingent payment provision to incentivize the former owner to continue his employment after the acquisition. This contingent payment will only be made if the acquired business reaches a specific sales target and the former owner continues his employment for an additional twelve months.
Do these two scenarios differ? Yes! The nature and purpose of the contingent payment is different and, as we will see, this drives the accounting.
In Scenario 1, the provisional payment relates to the valuation of the business acquired and represents a payment to the former owner to obtain control of the business. Although the amount of the future payment is conditional based on future events, the acquirer’s obligation to pay the former owner under this scenario is unconditional. For the remainder of this blog post, we’ll refer to these types of contingent payments as unconditional contingent consideration.
In Scenario 2, the contingent payment represents compensation for future service and is not related to obtaining control of the business. Like the first scenario, the amount of the payment is dependent upon the sales target being reached. However, the acquirer’s obligation to pay is conditional on the future employment of the owner. In this situation, the obligation relates to future service and would not be included as part of the purchase price, but rather post-acquisition compensation expense.
It is doubtful the purpose of the contingent payment provision will be spelled out within the purchase agreement. Therefore, judgment is required. The good news is that the FASB provides numerous indicators within ASC 805-10-55-25 to assist accountants with this analysis.
What is the proper accounting for unconditional contingent consideration?
Unconditional contingent consideration is measured at fair value as of the acquisition date and included as part of the purchase price (consideration transferred) regardless of the probability of payment. Probability of payment is not ignored – instead it is reflected in the fair value. Fair value also mush reflect the time value of money. By included contingent consideration in the purchase price, it essentially increases the amount of goodwill recorded on the acquisition.
Estimating the fair value for contingent consideration requires significant judgment. Typically, the amount of the contingent payment is dependent on future results. When estimating fair value, the devil is in the details. You need to ensure the assumptions used are consistent with those that would be used by market participants to value the obligation.
The subsequent accounting depends on the classification of the contingent consideration. ASC 805-30-25-6 requires the acquirer to classify the contingent consideration as either liability or equity, based on the guidance in ASC 480-10, Distinguishing Liabilities from Equity, ASC 815-40, Derivatives and Hedging, or other GAAP if applicable.
If the contingent consideration is classified as a liability, it is reported at fair value each reporting period until the contingency is resolved. Any changes in fair value are recognized in earnings, unless the contingent payment provision represents a hedging instrument under ASC Topic 815. Since subsequent remeasurement, either up or down, goes through the P&L, it is imperative that fair value is accurately estimated each period to avoid the potential for earnings management.
If the contingent consideration is classified as equity, it is not subsequently remeasured. When the contingency is settled, it is accounted for within equity with no impact on profit or loss.
Avoid the pitfalls of accounting for contingent consideration in a business combination. Take the time to understand the nature and purpose of the contingent consideration, as this is what will ultimately determine the proper accounting for these obligations. When estimating fair value, be sure to use assumptions and probabilities of occurrence that would be used by market participants to value the obligation. Finally, as with any transaction – make sure you familiarize yourself with, and obtain a thorough understanding of, the applicable guidance within U.S. GAAP before you start the accounting!