Last update 04/08/2019
Usually, an obligation of the acquirer to transfer additional assets or equity interests 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. However, contingent consideration also may give the acquirer the right to the return of previously transferred consideration if specified conditions are met.
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.” See the definition above.
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, judgement is required.
Contingent consideration
Contingent consideration
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