Contingent consideration

Contingent consideration
See also
Asset sales Noncovered security Swap Ratio Issued share capital Zero cost collar Equity instrument Equity Participation Trading capital Incremental borrowing rate

Contingent consideration it is a payment with use of additional cash or additional shares which company pay or issue in the future. This situation is used when the company is the acquirer which merger another company. After that the acquirer promising to pay particular sum of money or issue shares from the equity capital. Every amount of additional money or assets, which are the part of business acquisition are established (at acquisition date) to fair value. The acquirer and the company which is merged, may negotiated the contingent consideration.

Change in fair value

Sometimes the value may changed because of additional informations. If the change in value appears over “measurement period” (which is necessary to established fair value) than this change is regarded as variation in “provisional amount” and settled by the correction of goodwill. But when the change in value appears after the measurement period, and it is an asset, then this change is reported in “earnings of the period”.

Classification of contingent consideration

Contingent consideration is classified as:

• Asset
• Liability
• Equity

Forms of non-cash consideration

Apart from standard classification, sometimes when transaction is non-cash, acquirer may use three types of “non-cash consideration":

• Non-cash assets
• Liabilities incurred or assumed
• Equity interest issue

Then the measurement is lean on acquirer cost and “the fair value of the assets acquired”.

Measurement of asset and liability

Contingent liability is measured “in the best valuation of the amount of the loss”, or in initially recognized amount of money, which is the higher. In opposite to contingent liability, a contingent asset is measured not in amount of loss but in “settlement amount”, which is also the best valuation. Apart from that contingent asset is lower than fair value (for the date of acquisition).

Contingent consideration payments after the business acquisition

Contingent consideration depending on date of payment by the acquirer may be classified as:

• Cash outflows for financing activities and operating activities (if “payment is not made after the acquisition date”)
• Financing activities (if “payment is at the acquisition date”)
• Cash outflows for investing activities (if “payment is made after acquisition date”)

Examples of Contingent consideration

• In some cases, the acquirer may promise to make a contingent payment to the target company if certain milestones or objectives are achieved. For example, an acquirer may agree to pay the target company an additional amount of money if the target company achieves a certain level of sales or profits within a specified time period.
• Companies may also use contingent consideration when structuring an acquisition to reduce the initial purchase price. For example, a company may agree to pay the target company a reduced purchase price with the understanding that additional payments will be made later if certain performance criteria are met.
• In some cases, the acquirer may also agree to issue additional shares of its own stock as part of the contingent consideration. For example, an acquirer may agree to issue additional shares of its own stock to the target company if the target company achieves certain levels of earnings or revenue in a specified time period.

Advantages of Contingent consideration

Contingent consideration is advantageous for companies because it provides a way to acquire the target firm without using up all the available capital. The main advantages of contingent consideration are:

• It allows the acquirer to pay for a business without depleting its cash reserves. This can be beneficial for companies that lack the financial resources to make an all-cash purchase.
• It allows the target company to receive payment in the future when it has achieved certain milestones. This can be beneficial for small businesses that need to maintain their cash flow in order to grow.
• It allows the acquirer to spread out the payment over time and potentially reduce the overall cost of the acquisition.
• It can also incentivize the target company to achieve certain goals, making it more likely that the acquisition will be successful.

Limitations of Contingent consideration

Contingent consideration has several limitations that should be taken into account. They include:

• Lack of certainty of payment – There is no guarantee that payment will be made, as it is based on the fulfilment of certain conditions.
• Financial risks – Contingent consideration may be subject to financial risks associated with the performance of the acquired company or other external factors.
• Accounting complexity – Accounting for contingent consideration is complex due to the need to address the uncertainty of payments and estimates of fair value.
• Tax implications – Depending on the specifics of the transaction, there may be tax implications associated with the use of contingent consideration.

Other approaches related to Contingent consideration

One approach related to Contingent consideration is to provide future payments or shares at predetermined targets. This approach is used to incentivize the seller to achieve particular goals related to the merger transaction. Other approaches include:

• Earn-outs: This approach involves the acquirer paying the seller a predetermined amount of money or issuing shares upon the achievement of certain financial targets.
• Contingent Value Rights (CVRs): This approach allows the seller to receive additional payments or shares that are based on the performance of the combined company.
• Put and Call Options: This approach involves the seller having the right to sell their shares to the acquirer at a predetermined price or the acquirer having the right to buy the seller’s shares at a predetermined price.

In conclusion, contingent consideration is an important part of merger transactions that can be structured in various ways, such as earn-outs, CVRs, and put/call options. These approaches allow the acquirer to incentivize the seller to achieve certain goals and can provide benefits for both parties.

Footnotes

• CFA Institute, (2016), CFA Program Curriculum 2017 Level II, Volumes 1-6, John Wiley & Sons
• Delaney P. R., Whittington O. R., Wile, (2009), Wiley CPA Examination Review, Outlines and Study Guides, John Wiley & Sons
• Delaney P. R., Whittington O. R., Wiley (2010), CPA Exam Review 2010, Financial Accounting and Reporting, John Wiley & Sons
• Flood J. M., (2014), Wiley GAAP 2015: Interpretation and Application of Generally Accepted Accounting Principles, John Wiley & Sons
• Hahne R. L., Aliff G. E., (2018), Accounting for Public Utilities, LexisNexis
• Robinson T. R., Henry E., Pirie W. L., Broihahn M.A., Cope A. T., (2015), International Financial Statement Analysis, Third Edition (CFA Institute Investment Series), John Wiley & Sons

Author: Kinga Dudek