Contingent consideration – Merger and acquisition strategies may be driven by the desire to enhance market position, expand into new markets, reduce costs and gain talented management or a workforce.
Merger and acquisition strategies may be driven by the desire to enhance market position, expand into new markets, reduce costs and gain talented management or a workforce.
These strategic drivers may lead to purchase agreement terms that are more complex than a cash payment of asking price on the acquisition date. Buyers and sellers may want to tailor payment terms to align the value of what is paid with the strategic business purpose of the transaction. Buyers may not want to pay the entire price upfront if there are significant uncertainties associated with the acquired business or the value of the acquired business is dependent on key management personnel. Upfront payment of cash may transfer too much risk to the buyer or, if adjusted downward for risk, force the seller to seek better terms elsewhere.
For example, an energy company might not want to pay the full asking price for a development-stage oil and gas property because of uncertainty around the actual reserve amounts and future energy prices. A pharmaceutical company may prefer to pay the sellers of a biotech company for compounds after the compounds have passed the development phase and once the final drugs have reached sales milestones.
Contingent consideration can be a useful way of sharing risks between the buyer and seller and of aligning the expectations of both parties. A suitable contingent consideration arrangement can allow the buyer to promise more consideration if the business proves to be more valuable. However, management should be careful when agreeing to contingent arrangements, as there can be unexpected cash flow and/or accounting consequences. A company that does not anticipate the accounting consequences when negotiating a contingent term may feel the financial reporting effects for years to come.
What is contingent consideration?
It is the obligation of the buyer to transfer additional assets or equity interests to the seller of the business (usually cash or shares) if future events occur or conditions are met. Contingent consideration can also take the form of a right of the buyer to the return of previously transferred assets or equity interests from the sellers of the acquired business. Contingent consideration that is paid to sellers that remain employed and linked to future services is generally considered remuneration and is expensed as incurred. Management should evaluate any payments made or shares transferred to the sellers of the acquired business.
Contingent consideration is classified as a liability or equity and is measured at fair value on the acquisition date. Contingent consideration that is classified as a liability is remeasured to fair value at each reporting date, with changes included in the income statement in the post-combination period. Contingent consideration that is classified as equity is not remeasured in the post-combination period.
The most desirable accounting outcome for the buyer is a contingent arrangement that is fully recognised at the acquisition date and classified as equity. This results in the least post-acquisition income statement volatility. Buyers are keen to reach this outcome, but there are numerous hurdles to overcome to get there.
Assessing the appropriate contingent arrangement requires the buyer to look at a series of complex questions such as classification, linkage to future service and estimated fair value measurements. The remeasurement requirements have brought sharper focus to these arrangements, and buyers are interested in the accounting consequences of ‘traditional’ transaction structures. Many of the questions arise in the following areas:
- Arrangements settled in a variable number of shares;
- Fair value measurement;
- What is consideration versus remuneration?;
- Escrow arrangements;
- Options to acquire additional interests upon contingent events;
- Royalty arrangements; and Accounting from the seller’s perspective.
IFRS References: IFRS 3 39 – 40, IFRS 3 58
Introductonary exampleScenario 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. |
Initial classification
Determine initial classification when the contingent consideration is based on the buyer’s shares
Classification is one of the most important issues in accounting for contingent consideration. The initial classification may significantly impact post-acquisition profit or loss. Fair value changes from period to period of liability-classified arrangements will introduce an element of post-acquisition income statement volatility.
The liability-classified arrangement is recorded at fair value at initial recognition; measurement is updated at each reporting date, with changes recognised in the income statement each reporting period until the arrangement is settled or derecognised.
Remeasurement can effectively offset the underlying business performance effect on the income statement; if the acquired business performs well, the amount due to the sellers increases, and the increase is an expense in current-period income statement.
Equity-classified arrangements are not remeasured, even if the fair value of the arrangement on the settlement date is different. Equity classification is achieved if the arrangement ‘will or may be settled in the issuer’s own equity instrument and it is a non-derivative that includes no contractual obligation for the issuer to deliver a variable number of its own equity instruments’ [IAS 32.16].
In simple terms, this is a fixed number of shares for achieving a specific outcome. Arrangements settled in a variable number of the buyer’s shares are likely to be classified as liabilities.
An arrangement could involve a number of performance targets, each with its own potential share award. This arrangement may still be classified as equity but only if the arrangement is deemed to be a series of separate contracts for each performance target within that overall contract rather than one overall contract.
To be assessed as separate contracts, the performance targets must be readily separable and independent of each other and must relate to different risk exposures [IAS39 AG29]. Management should determine whether the arrangement is separable without regard to how the legal agreements document the arrangement (that is, separate legal agreements entered into at the same time as the acquisition would not necessarily be accounted for as separate contracts). If separable, the contracts for each performance target may individually result in the delivery of a fixed number of shares and, as a result, be classified as equity (if all other applicable criteria have been met). Otherwise, the arrangement must be viewed as one contract that results in the delivery of a variable number of shares because the number of shares that will be delivered depends on which performance target is met. Management needs to exercise judgement to determine whether the unit of account should be the overall contract or separate contracts within the overall arrangement.
Classification framework
The following flowchart illustrates the framework to determine the initial classification of contingent arrangements in the buyer’s accounts.
¹Judgment is required to determine whether the unit of account should be the overall contract or separate contracts within the overall arrangement. Refer to example 3 and 4.
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Example 1 – initial classification of arrangement settled in a fixed number of shares with a single measurement period Entity A acquires Entity B in a business combination by issuing 1 million of Entity A’s shares to Entity B’s shareholders. Entity A also agrees to issue 100,000 shares to the former shareholders of Entity B if Entity B’s revenues (as a wholly owned subsidiary of Entity A) equal or exceed C200m during the one-year period following the acquisition. How should the arrangement to issue 100,000 shares be classified? Simplifying assumption(s): Assume the arrangement is not linked to providing services. Solution |
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Example 2 – initial classification of arrangement settled in variable shares with a single measurement period Entity A acquires Entity B in a business combination by issuing 1 million of Entity A’s shares to Entity B’s shareholders. Entity A also agrees to issue 100,000 shares to the former shareholders of Entity B if B’s revenues (as a wholly owned subsidiary of Entity A) equal or exceed C200m during the one-year period following the acquisition. If Entity B’s revenues exceed C200m, Entity A will issue an additional 1,000 shares for each C2m increase in revenues in excess of C200m, not to exceed 100,000 additional shares (that is, 200,000 total shares for revenues of C400m or more). How should the arrangement to issue additional shares be classified? Simplifying assumption(s): Assume the arrangement is not linked to providing services. Solution |
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Example 3 – initial classification of arrangement settled in a variable number of shares with multiple contracts Entity A acquires Entity B in a business combination by issuing 1 million of Entity A’s shares to Entity B’s shareholders. Entity A also agrees to issue 100,000 shares to the former shareholders of Entity B if B’s revenues (as a wholly owned subsidiary of Entity A) equal or exceed C200m during the one-year period following the acquisition. Entity A agrees to issue an additional 50,000 shares to the former shareholders of Entity B if B’s revenues (as a wholly-owned subsidiary of Entity A) equal or exceed C300m during the second one-year period following the acquisition. Each contingent promise is independent − that is, outcomes could be zero (target not met), 50,000 (year 2 target only met), 100,000 (year 1 only target met) or 150,000 additional shares issued (year 1 and year 2 target met). How should the arrangement to issue additional shares be classified? Simplifying assumption(s): Assume the arrangement is not linked to providing services. Solution |
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Example 4 – initial classification of arrangement settled in a variable number of shares with a single contract Entity A purchases Entity B in a business combination by issuing 1 million of Entity A’s common shares to Entity B’s shareholders. Entity A also agrees to issue additional common shares to the former shareholders of Entity B as follows: 100,000 shares if revenues equal or exceed C100m in the 12 months following the acquisition; 100,000 shares if revenues equal or exceed C150m in months 13 to 24 following the acquisition; and 100,000 shares if revenues equal or exceed C300m in the cumulative two-year period year following the acquisition. How should the arrangement to issue additional shares be classified? Simplifying assumption(s): Assume the arrangement is not linked to providing services. Solution The performance target for the cumulative two-year period largely depends on achieving the revenue targets in the first year and second year, given the overlap between the periods. The unit of account is therefore the overall contract rather than the individual performance targets because the arrangement (or multiple performance targets) relates to the same risk exposure. The arrangement will result in the issuance of a variable number of shares; it is therefore classified as a liability in accordance with IAS 32.11. |
Complex situations − additional insights
Share profits between the buyer and the seller without creating volatility
Contingent consideration paid in cash can create volatility in the income statement.
A buyer and a seller may seek to structure an arrangement so that any future cash payments become dividends or distributions rather than taking the form of a financial liability. The seller, in these arrangements, must assume more risk before the arrangement can be classified as an equity instrument. An unconditional promise to pay cash on events outside the control of the buyer will result in liability classification. A promise to pay cash on conditions that are within the control of the buyer may be an equity instrument, but the seller takes on the risk that the buyer may choose not to pay or be unable to pay.
A perpetual preferred share, for example, accumulates dividends from one period to the next. Perpetual preferred shares pay dividends only when dividends are paid on common shares. These will often be classified as an equity instrument. A seller who accepts perpetual preferred shares is accepting the risk that the holder of the common shares will never declare dividends.
There may be a structuring opportunity if a buyer intends to resell the acquired business within an identified time frame. The seller could accept a form of non-controlling interest in the vehicle that owns the acquired business. The vehicle itself would be liquidated and all proceeds distributed if the acquired business is sold.
Payments that take the form of dividends or distributions result in the seller assuming more risk but may allow the buyer to avoid recording a financial liability. These structures are complex.
Contingent consideration
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