Accounting for Business Combinations ASC 805: Contingent Consideration
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Accounting for Business Combinations ASC 805: Contingent Consideration

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.

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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.

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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.

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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!

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Comments (26)

  1. 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?

  2. 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?

  3. 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!!

  4. 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?

  5. 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!

  6. 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!

  7. 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.

  8. 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

  9. 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!

  10. 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?

  11. 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!

  12. 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.

  13. 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!

  14. 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.

  15. 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!!

  16. 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?

  17. 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?

  18. 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!

  19. 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!

  20. 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...

  21. 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!

  22. 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

  23. 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

  24. 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.

  25. 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.

  26. 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!


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