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, accounting for contingent consideration in accordance with ASC 805, that was 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.
Scenario 1
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.
Scenario 2
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.
Parting words…
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. And we can help you with that! Check out our ASC 805 training - 3 eLearning courses covering everything you need to know about business combinations!
Comments (36)
MONA JUMA:
Feb 02, 2018 at 03:02 AM
Hi, I am wondering if a company can retro EBITDA when making an acquisition. For example, we acquired 1/31, we would like to retro EBITDA to 1/1/17 but the contract was signed 1/1/17. The company we acquired was still in control but both parties have agreed to "retro", is this possible to do and stay GAAP compliant?
MONA JUMA:
Feb 02, 2018 at 03:02 AM
Hi, I am wondering if a company can retro EBITDA when making an acquisition. For example, we acquired 1/31, we would like to retro EBITDA to 1/1/17 but the contract was signed 1/1/17. The company we acquired was still in control but both parties have agreed to "retro", is this possible to do and stay GAAP compliant?
Michael Walworth:
Feb 02, 2018 at 08:46 AM
I get skeptical anytime the word "retroactively" is used when describing the acquisition date of a business combination. Here's what the guidance says:
805-10-25-6
The acquirer shall identify the acquisition date, which is the date on which it obtains control of the acquiree.
805-10-25-7
The date on which the acquirer obtains control of the acquiree generally is the date on which the
acquirer legally transfers the consideration, acquires the assets, and assumes the liabilities of the
acquiree — the closing date. However, the acquirer might obtain control on a date that is either earlier
or later than the closing date. For example, the acquisition date precedes the closing date if a written
agreement provides that the acquirer obtains control of the acquiree on a date before the closing date.
An acquirer shall consider all pertinent facts and circumstances in identifying the acquisition date.
So, it's all about control! When you get it, you have a business combination and on that day you need to fair value the assets acquired and liabilities assumed, its the date you figure out goodwill, and its the date you start consolidating. In short, its the date the "magic" happens! That being said, it's not always straightforward. Just make sure to document your conclusion so you have something to show your auditors or the SEC if they ever ask! Good luck!!
Tina:
Feb 21, 2018 at 06:37 AM
The continget consideration is a part of the whole purchase price? Or is it the purchase price itself?
Mike Walworth, CPA:
Feb 21, 2018 at 10:01 AM
The contingent consideration is part of the purchase price. Therefore, if you purchased a business for $100 and the fair value of the contingent consideration was $10, the total purchase price would be $110. In essence, the contingent consideration increases goodwill (Dr) with a corresponding liability (Cr). However, here's where it gets interesting! Contingent consideration needs to be revalued each reporting period. Therefore, the liability goes up or down, but the offset doesn't go to goodwill. It goes to P&L!
John Baer:
Feb 26, 2018 at 11:20 AM
Love the blog posts. Can estimated fair value of contingent consideration be valued at zero based on a "more likely than not" evaluation? If the sales or profit targets are considered so aggressive that in the client and auditors judgement, there is no way the contingent consideration will be triggered, can they safely conclude not to attach any value to the consideration? Thanks!
Mike Walworth, CPA:
Feb 26, 2018 at 01:38 PM
John, thanks for reading! It's always nice to hear a compliment!!
The "easy" answer to your question is that contingent consideration needs to be measured at fair value and that it should be recorded regardless of the likelihood that the targets will be met. Essentially that means if it were remote, there would be very little value attached to the contingent consideration. However, the subsequent account (and whether or not it needed to be remeasured) would depend on whether the contingent consideration were equity or liability classified.
Note that this is different from contingent consideration associated with an asset purchase (i.e. not classified as a business combinations) where the contingent consideration is only recorded if it is probable and reasonably estimable under ASC Topic 450.
The "hard" part of your answer is how to value contingent consideration. Do you use a deterministic or a probabilistic approach? Is your payout linear or non-linear? Both approaches would consider the likelihood of payout regardless of how unlikely that is. It gets really tricky really fast! Check out section 6.4.4.1 in EY's FRD on business combinations available at: http://www.ey.com/ul/en/accountinglink/current-topics-business-combinations for further discussion.
Jim Boland:
Mar 21, 2018 at 02:19 PM
How would you account for a scenario where the purchase price is completely contingent on future cash receipts? Specifically you agree to pay the prior owner 25% of cash receipts each year for the first 4 years post purchase (for their book of business, basically their referral). No consideration is exchanged upon signing of the deal, Payments are only required to be made at the end of each of the 1st 4 years and only apply to total cash receipts for that year from customers on the "referred" list from the "acquisition". Is this still an instance where you would estimate fair value of an asset purchase, or would the payment simply be recorded as an expense in each of the first 4 years? Thanks
Mike Walworth, CPA:
Mar 21, 2018 at 03:11 PM
Jim, thanks for your question.
Was the transaction the acquisition of a business (under ASC Topic 805) or an asset purchase. This is important because contingent consideration is accounted for differently if you are purchasing a business as compared to purchasing an asset.
If the transaction were considered the acquisition of a business, you would need to apply the principles within ASC 805 which states that any contingent consideration would need to be measured at fair value on the acquisition date. Essentially, this means at the acquisition date, you would need to estimate the amounts and probabilities of each of the expected payments over the next four years. Obviously, this estimate would change over time and, therefore, would need to be re-estimated each reporting date, with the "true up" getting recorded in the P&L. Not fun!
If the transaction were considered an asset purchase, U.S. GAAP is less clear and most likely such payments would be recorded when they are probably and reasonably estimable in accordance with ASC 450 (see previous comments).
Be sure to note that the definition of a business was recently revised by the FASB (see ASU 2017-01). Whether or not you are purchasing a "business" or just buying a group of assets, is the key to accounting for contingent consideration!
Hope this helps!
Doc:
May 10, 2018 at 11:32 AM
Can you treat the periodic valuation adjustment of the contingent liability related to the time value of money as interest expense or is it required to go through operating income?
Mike Walworth, CPA:
May 10, 2018 at 02:33 PM
Doc,
Thanks for your question. ASC Topic 805 is silent with respect to where within the P&L the remeasurement of contingent consideration should be classified. However, according to EY in their previously mentioned FRD, believes it should be within income from operations, not financing. Their FRD is available here:
http://www.ey.com/ul/en/accountinglink/frd-bb1616-business-combinations
Check out sections 6.4.6.2 and 8.3.2.2. Please note, however, the cash flow classification is split between financing and operating, as discussed by EY in section 8.3.2.2.
Hope this helps!
Stuart:
May 16, 2018 at 07:59 PM
If an asset purchase under ASC 805-50 includes future royalties related to the purchased technology would these royalties be considered contingent consideration and added to the acquisition cost?
Also, would the proportion of the change in the fair value of the royalty liability due to the passage of time be recognized as interest expense each quarter? I'm assuming the fair value would be a net present value of the expected royalty payments.
Mike Walworth, CPA:
May 21, 2018 at 10:06 AM
Thanks for your question, Stuart. Note that U.S. GAAP is not specific regarding the accounting for contingent consideration in an asset purchase. Within their handbook, KPMG notes:
"We believe that contingent consideration issued in a transaction accounted for as an asset acquisition should generally be recorded when probable and reasonably estimable in accordance with ASC Topic 450, Contingencies, unless it is an embedded derivative that must be bifurcated and measured at fair value under ASC Topic 815, Derivatives and Hedging."
Regarding your other questions, given that U.S. GAAP is silent, I don't really have any guidance to point you to. However, if you are only recording the liability when it is probably and reasonably estimable, I think the geography and FV methodology questions are more or less moot. That being said, see my previous reply above regarding P&L classification of the unwinding of the discount where EY believes it should be operations, not finance.
Long story short, I would download the various Big 4 guides on business combinations. Here's the link to KPMG's:
https://frv.kpmg.us/reference-library/2016/01/accounting-for-business-combinations-and-noncontrolling-interests.html
Hope it helps!
Pam:
Jul 01, 2018 at 07:59 PM
Hi i want to ask how do we account for contingent consideration payable if the conditions were not met for example, the target sales was not met but during acquisition date of net assets it was expected that particular sales will be, so the contingent considerationpayable was recorded. How do we close it or reduce it since the payable shouldnolonger exist due to failure to reach targeted sales? Thanks.
Mike Walworth, CPA:
Jul 02, 2018 at 11:39 AM
Thanks for your question, Pam. You've uncovered a little known secret to accounting for contingent consideration (and one that I warn auditors about all the time)! If you've recorded the payable for contingent consideration against goodwill at acquisition and, assuming that the measurement period is done, the reversal of the payable would go through current period earnings!!
DAVID SNYDER:
Aug 17, 2018 at 08:45 AM
Does the guidance outlined above for scenario 1 apply for tax purposes? Or do you wait until its paid and amortize from that point forward or the original purchase date and adjust to make up the amortization for the year that has passed?
Matt:
Nov 10, 2018 at 07:48 AM
Hi I have accounted for a contingent consideration payable and based on expected sales over two years. When we prepared the financial statements the business combination was provisionally accounted for. During the period sales dropped and thus the contingent consideration payable decreased. Since it was provisionally accounted for can I just reassess the amount of contingent consideration against the goodwill?
Mike Walworth, CPA:
Nov 12, 2018 at 06:27 PM
Thanks for reading, Matt. ABSOLUTELY NOT! (emphasis added). Any change in contingent consideration, up or down, after the acquisition date must be recorded to the P&L. In your case, since your contingent consideration payable dropped, enjoy your P&L windfall!
Mike Walworth, CPA:
Nov 12, 2018 at 06:29 PM
Thanks for reading, David. The tax implications obviously depend on your tax jurisdiction and, unfortunately, I have not idea about tax (I was an auditor in a previous life that had a tax department that I relied upon). I'm sorry I am no hlelp!
Matt:
Nov 14, 2018 at 03:23 PM
Hi Mike, thanks for your answer... I have been looking at the standard but I really can t see where it says I cant do that.. IFRS 3 under provisional accounting does acctually day the opposite...
Mike Walworth, CPA:
Nov 16, 2018 at 11:24 AM
Matt,
Check out ASC 805-10-35-1. Some things MAY be considered measurement period adjustments (i.e. adjust goodwill). However, many items (including not meeting sales targets) would be recorded through P&L. Hope this helps!
Carey:
Dec 04, 2018 at 11:21 AM
Hi i need my help in my situation how about in this scenario we’re buying a project company are projection on the perfomance of the compant is usd13 million then we have a earnout scenario that if there is an increase in selling price we will pay additional amount in third year of operations. I’ve recorded this earnout as an additional capex and paid as an additional equity and added to depreciable cost. Is this correct to use this method
Macy:
Dec 16, 2018 at 05:02 PM
Hi Matt,
I find these blogs very, very helpful. Just a question, in the event that the conditions for the contingent consideration are not met, then what happens to the recorded Goodwill?
Thanks
Mike Walworth, CPA:
Mar 15, 2019 at 02:49 PM
Carey, thanks for reading and my apologies for the late reply. We had some issues with spam in the comments and, as a result, I wasn't receiving notifications that legitimate comments were posted. Sorry.
I am not sure I completely understand your question and, therefore, please do not take this response as Gospel. However, if you paid $13 million for a business and perhaps have to pay additional amounts in year 3, that sounds like contingent consideration (Contingent consideration includes obligations to transfer additional consideration to the former owners of an acquiree if future events occur or conditions are met).
If so, you would have to estimate the fair value of the contingent consideration AT THE ACQUISITION DATE (i.e. don't wait until year 3 to record anything). The FV of contingent consideration, in effect, increases the amount of goodwill (i.e. debit goodwill) and the corresponding credit would go to "Payable to former owners of acquiree." If you never have to pay it, you would reverse the payable (i.e. debit the payable) and credit P&L.
Mike Walworth, CPA:
Mar 15, 2019 at 02:49 PM
Carey, thanks for reading and my apologies for the late reply. We had some issues with spam in the comments and, as a result, I wasn't receiving notifications that legitimate comments were posted. Sorry.
I am not sure I completely understand your question and, therefore, please do not take this response as Gospel. However, if you paid $13 million for a business and perhaps have to pay additional amounts in year 3, that sounds like contingent consideration (Contingent consideration includes obligations to transfer additional consideration to the former owners of an acquiree if future events occur or conditions are met).
If so, you would have to estimate the fair value of the contingent consideration AT THE ACQUISITION DATE (i.e. don't wait until year 3 to record anything). The FV of contingent consideration, in effect, increases the amount of goodwill (i.e. debit goodwill) and the corresponding credit would go to "Payable to former owners of acquiree." If you never have to pay it, you would reverse the payable (i.e. debit the payable) and credit P&L.
Mike Walworth, CPA:
Mar 15, 2019 at 02:51 PM
Thanks for reading, Macy and my apologies for the late reply. We had some issues with spam in the comments and, as a result, I wasn't receiving notifications that legitimate comments were posted. Sorry.
See the end of my reply above for the answer to your question. In a nutshell, if you never have to pay the contingent consideration that you estimated at the acquisition, please enjoy your gain. That is why getting the fair value of contingent consideration RIGHT at the acquisition date is huge audit issue. Hope it helps!
Scott:
Jun 06, 2019 at 11:08 AM
Hi Mike, great blog post,
On an asset purchase agreement, where the contingent consideration is whether or not issued equity units vest, and the equity units are not mandatorily redeemable (which indicates equity), and have voting rights before they vest (which also indicates equity), should the fair value of the equity units be a liability or within equity? e.g. the seller was issued 100 shares valued at $30 per share, which vest over 5 years based on future company performance which is likely to occur. Should the $3,000 be an issuance of equity at the purchase date or a liability which is relieved into equity once the units actually vest?
Lisa:
Jun 12, 2019 at 01:15 PM
If you have contingent consideration that states you make a future payment of up to $1M depending on meeting certain revenue targets, does it impact the revenue recognition at all? Or is the only impact to operating income for the change in fair value of the contingent consideration until the payment date?
Joe Jones:
Aug 08, 2019 at 03:15 PM
Mike, you're mostly on the right track, but I'm not sure you're providing the whole story on contingent consideration re: asset acquisitions.
"Note that this is different from contingent consideration associated with an asset purchase (i.e. not classified as a business combinations) where the contingent consideration is only recorded if it is probable and reasonably estimable under ASC Topic 450."
First, contingent consideration in an asset acquisition (as you somewhat alluded to in one of your comments) meets the definition of a derivative and must be accounted for at fair value through earnings. Derivatives don't actually require a notional amount, it's a notional amount OR a payment provision (i.e., a contingent payment based on a future event). The only way to get out of derivative land is with the 815-59-15-59(d), which provides an exception for contracts not traded on an exchange for which settlement is based on "specified volumes of sales or service revenues of one of the parties to the contract". While this exception may apply to many contingent consideration arrangements, there are many other arrangements where this would not apply (think reaching certain development or construction milestones, etc.).
Also, if the fair value of assets acquired exceeds the initial consideration paid (i.e., bargain purchase), KPMG and Deloitte state that it would be appropriate to analogize to the guidance on equity method investments provided by ASC 323-10-25-2A and ASC 323-10-30-2B and recognize a liability equal to the lesser of:
• The maximum amount of contingent consideration.
• The excess of its share of the investee’s net assets over the initial cost measurement.
Once recognized, the contingent consideration liability is not derecognized (or adjusted) until the contingency is resolved and the consideration is issued or becomes issuable. Any difference between the amount initially recognized and the amount payable is reflected as an increase/decrease to the assets acquired (in accordance with their relative acquisition date fair values). KPMG views application of this model to be an accounting policy election, why Deloitte appears to view this approach as preferable.
Joe Jones:
Aug 08, 2019 at 05:21 PM
"First, contingent consideration in an asset acquisition (as you somewhat alluded to in one of your comments) meets the definition of a derivative and must be accounted for at fair value through earnings. Derivatives don't actually require a notional amount, it's a notional amount OR a payment provision (i.e., a contingent payment based on a future event). The only way to get out of derivative land is with the 815-59-15-59(d), which provides an exception for contracts not traded on an exchange for which settlement is based on "specified volumes of sales or service revenues of one of the parties to the contract". While this exception may apply to many contingent consideration arrangements, there are many other arrangements where this would not apply (think reaching certain development or construction milestones, etc.)."
Hmm...I guess please disregard the above paragraph? Based on the below link it seems like the SEC may disagree. Couldn't for the life of me tell you why. Any insight into why the SEC would have determined that the payment based on FDA approval shouldn't be accounted for as a derivative? Based on the whole exchange, I'm guessing they hung their hat on the scope exception in 815-10-15-59(b) and argued that the underlying was based on the value of a non-financial asset (the drug) that is unique and that the party owning the drug (Questcor) was not the one benefitting under the contract from the increase in the fair value of the drug. Seems awful flimsy to me. I agree with Questcor, the implementation guidance they cited seems to expressly contradict this interpretation and it also seems inconsistent with the FASB comment that many contingent consideration arrangements are derivatives.
https://www.sec.gov/Archives/edgar/data/891288/000119312514237772/filename1.htm
Andrew:
Jul 26, 2020 at 09:06 PM
What if a former seller of the acquired company, who is not staying on as an employee, receives a restricted stock grant of the acquirer as part of the total consideration, which has certain vesting requirements? Time vesting would lead me to believe it's contingent consideration as there is no requirement to stay on as an employee, thus no service element, however what if there is another vesting provision such as a non compete agreement as part of the vesting requirements? What if the shares are forfeitable during the vesting period if the non compete provision has been violated?
To me that seems like a non-employee service element which would require the grants to be treated under ASC 718 not 805, and expensed over the vesting period as opposed to being a component of goodwill. I'm just not 100% there is not argument for these grants being treated as contingent consideration.
Jessica:
Sep 23, 2020 at 03:20 AM
What if a contingent payment of 100,000 cash on January 1,20x7, if the average income of during the 2 year period exceeds 250,000 per year. It was estimated that there is a 30 percent chance or probability that the 100,000 payment will be required. How should I account for this? Is this like the 1st scenario?
matt:
Feb 27, 2021 at 11:27 PM
Hi everyone,
I have a little situation on one of my entity. 3 years ago company A acquired a company (company B). We did recognized goodwill and other intangibles as part of the purchase price allocation. Note that company B had only employees that were hired directly in company A at acquisition date. In 2019 all the operations were transferred to Company A and B has been de registered.. The operations of Company B represent 40% to total revenue in A. I am now. I am now preparing the standalone accounts of A, should I recognize the goodwill or intangibles or not? For sure the investment has to be impaired but not sure about the treatment of the intangibles thanks
Vinay Katariya:
Dec 03, 2021 at 06:45 AM
Hi, In case where the fair value of contingent consideration changed due to the change in terms of the agreement, what would be the accounting treatment. For example, at the acquisition date, Company agreed to pay USD 100 on meeting certain criteria at the end of year 2. In the year 2 the terms of the agreement were modified and it was agreed that USD 200 will be paid on meeting those criteria. In this case can you please explain the accounting for the difference of USD 100 (ignoring time value of money)
Mike Walworth, CPA:
Jan 10, 2022 at 12:44 PM
Vinay,
See my response to Matt above. Subsequent to the business combination, ANY change in the contingent consideration is recognized in the P&L.
Bunty:
Aug 24, 2023 at 01:05 PM
What if at time of closing of transaction under asc 805, the buyer terminate the seller insurance policy at closing but seller has prepaid left on the books? does the buyer account it as an opening balance sheet asset acquired? In my opinion, it should not since it does not mean asset definition but don't see any where in guidance it talks about it such kind of arrangement.
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