Contingent Consideration: Your Balance Sheet and Income Statement Will Never Be the Same

June 2011


Brian Jones		Don Wenk

The implementation of Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 805[1] - Business Combinations (ASC 805), fundamentally changed the financial statements of acquiring companies. One of the most dramatic changes regards the treatment of contingent consideration. With M&A activity substantially reduced over the last few years due to the “Great Recession,” the earnings volatility this change in accounting treatment will bring to acquirers may not yet be fully realized. However, with the economy slowly improving and more acquisitions taking place, we expect the measurement of contingent consideration to become an area of concern for many CFOs and company auditors.

Contingent consideration is often a component of a transaction where a “value gap” exists between an acquirer and acquiree. Well-structured contingent consideration can alleviate common concerns and eliminate potential deal breakers that exist between acquirers and acquirees. Contingent consideration is often incorporated into the purchase agreement for the following reasons:

It allows the acquirer the ability to share the risk associated with the future performance of the business with the acquiree.
It allows the acquiree to participate in upside post-close.
It provides an incentive for the acquiree to remain productively involved in the business post-close.
It functions as a de facto non-compete agreement, since the acquiree would not compete against their future consideration.

Common components of contingency agreements include, but are not limited to, financial thresholds (e.g., sales, EBITDA), milestones (e.g., FDA approval, product launches, stage of development completion, customer retention) and market performance hurdles (e.g., stock price, IRR hurdles, caps, and tiers).

Definition and Classification

Contingent consideration[2] is defined as either an earn-out or a clawback and must be classified as either equity or an asset/liability.[3]

Earn-Out. An earn-out is an obligation if the acquirer is required to transfer additional assets or equity interests to the former owners as part of the exchange if specified future events occur or conditions are met. A contingency is deemed to be a liability if the number of shares is variable or has a cash settlement feature. A contingency is deemed to be equity if the number of shares is fixed.

Clawback. A clawback is the right of the acquirer to the return of previously transferred consideration, if specific conditions are met. A clawback contingency is deemed to be an asset. If the contingency is classified as equity, remeasurement to fair value at each reporting date is not required, and subsequent settlement would be accounted for in the equity account.[4] If the contingency is classified as either an asset or a liability, remeasurement to fair value at each reporting date is required until the contingency is resolved.[5] Any changes in fair value are recognized in earnings. The acquisition date fair value of the contingent obligation or asset will generally not equal the amount stated in the purchase agreement until immediately prior to the payment date, due to present value factors and the uncertainty of the payment.

Current Guidance - ASC 805

Under ASC 805, contingent consideration is to be recognized at the acquisition date as part of the consideration transferred.[6] Contingent consideration arrangements of the acquiree assumed by the acquirer will also be measured at fair value. These unresolved contingencies from prior acquiree transactions can also have a material impact on earnings volatility of the acquirer.

Reporting of contingent consideration under ASC 805 is in sharp contrast to the treatment under the prior standard, SFAS 141, where the consideration was recorded when the contingency was resolved and consideration was issued or became issuable (unless the contingency was determinable beyond a reasonable doubt). Fundamentally, FASB changed the way in which contingent consideration was accounted, since the former treatment did not adequately represent the economic consideration exchanged on the acquisition date.

Counterintuitive Accounting Treatment and Potential Risks

If the initial fair value measurement of the earn-out is less than the actual payment, a loss is recorded in the income statement upon the occurrence of the payment, even though the business performed better than originally expected. If the initial fair value measurement is greater than the actual payment, a gain is recorded in the income statement, even though the business is performing worse than originally expected.

The accounting treatment appears to provide an incentive for higher fair values assigned upon initial measurement for earn-outs, as the potential exists to record a gain if the earn-out is not paid due to underperformance of the acquired entity. The flip side to this strategy, however, is the potential adverse impact on debt covenants, as the earn-out may be considered a debt-like instrument if settled in cash or a variable number of shares. Additionally, any goodwill recorded as a result of the initial fair value measurement of an earn-out will remain on the acquirer’s balance sheet, even if no payment is made. This could lead to subsequent goodwill impairment issues, as the value of the goodwill may not be supported by the financial performance of the acquired company.

Valuation Methodologies

Due to the prospective nature of contingent consideration structures, the most frequent method employed to value them is the income approach. The asset/cost approach is not well suited for quantifying the inherent complexity, nor is the market approach, as there are few observable transactions for contingent asset or liabilities. Depending on the complexity of the earn-out structure, a single scenario cash flow analysis may be appropriate. More likely, a probability weighted scenario-based model utilizing multiple cash flow iterations should be employed. For very complex structures (caps, tiers, thresholds), a Monte Carlo simulation or lattice/binomial option pricing model may be required.

Whenever cash flow models are employed, a debate related to the discount rate can be expected. Acquiree-specific risks are captured in the expected cash flows, but industry-specific risks are not; the use of the acquirer’s weighted average cost of capital (WACC) may be appropriate. The discount rate decision is a question of volatility and must incorporate:

time value of money;
credit risk; and
projection risk.

Consistency with Purchase Price Allocation

The assumptions used in the valuation of the contingent consideration may differ from those incorporated in the valuation of the assets acquired. Per guidance from FASB, the cash flows used in the valuation of assets and liabilities of the acquired business normally do not include buyer-specific synergies. However, it may be appropriate to include buyer-specific synergies in the valuation of contingent consideration, if the synergies will drive the likelihood of achieving, or the amount of, the earn-out (or clawback).

Keep It Simple

Fundamentally, when dealing with contingent consideration structures, company management and their valuation specialists must keep three themes in mind:

The analysis should rigorously decompose the contingent structure to facilitate understanding for all stakeholders.
The analysis should be kept as simple as possible to provide transparency and aid in the audit review process.
The valuation specialist should apply a valuation methodology to the contingent structure that is an industry standard methodology, if possible. This will ultimately allow for easier remeasurement at future reporting periods as new information is acquired. ■

1 Formerly FASB Statement No. 141 (R), effective for business combinations with acquisition dates that occur in annual reporting periods beginning on or after December 15, 2008.

2 ASC 805-10-05-2 (FASB 141(R), para. 3f)

3 ASC 805-30-25-6 (FASB 141 (R) para. 42)

4 ASC 805-30-35-1 (FASB 141 (R) para. 65a)

5 ASC 805-30-35-1 (FASB 141 (R) para. 65b)

6 ASC 805-30-25-5 (FASB 141 (R) para. 41)