IFRS 3 Fair value of contingent consideration – Contingent consideration often involves the buyer transferring additional consideration to the seller if certain performance targets are met in the future. This allows the buyer to share the risk associated with the future of the business with the seller by making some of the consideration contingent on future performance. What factors should be considered in determining the fair value of this type of arrangement? IFRS 3 Fair value of contingent consideration
Valuation methods for contingent consideration range from discounted cash flow analyses to more complex Monte Carlo simulations. The terms of the arrangement and the payout structure will influence the type of valuation model the acquirer uses. IFRS 3 Fair value of contingent consideration
Most valuation methods require an approach incorporating some form of option pricing techniques to incorporate the potential variability in outcomes.
Buyers may consider a best estimate discounted cash flow methodology for cashsettled arrangements. The key issue for a discounted cash flow is: what discount rate best represents the risks inherent in the arrangement? There is, in reality, more than one source of risk involved.
For example, both projection risk (the risk of achieving the projected performance level) and credit risk (the risk that the buyer may not have the financial ability to make the arrangement payment) need to be considered. Each of these risks may be quantifiable in isolation. Factors such as the potential correlation between the two risks and the relative impact of each risk upon the realisation of the arrangement need to be analysed when the two risks exist in tandem.
An alternative approach would be to develop a set of discrete potential scenarios for future performance. Each of these discrete payout scenarios could then be assigned a probability, and the probabilityweighted average payout could be discounted based on market participant assumptions. IFRS 3 Fair value of contingent consideration
Equitysettled arrangements have more complex valuation aspects than cashsettled arrangements. A bestestimate or probabilityweighted approach will rarely capture the potential variability in outcomes. The fair value of the contingent consideration may be based on the acquisition date share price of the buyer’s shares when the arrangement involves future delivery of a fixed number of shares and therefore the arrangement is classified as equity.
The valuation should incorporate the probability of achieving the performance target. The fair value of the acquisition date share price should be adjusted for any expected dividend cash flow the seller will not receive that is priced into in the acquisition date share price.
It may be necessary to calculate the expected future share price of the buyer (after consolidation of the acquiree) to calculate the fair value of more complex contingent consideration arrangements. The estimate of the future share price should consider various factors, including the relative size of the acquisition, impact on operational results, further market analysis of the acquisition strategy and others if this information is not public at the acquisition date.
There may well be a correlation between share price and the performance targets used to determine the contingent outcome. This could be factored into a probabilityweighted expected return model. It may also be necessary to consider dilution in the share price as a result of the new shares that will need to be issued.
Each arrangement has its own specific features that may lead to different modelling techniques and assumptions, as illustrated in the following examples. A valuation using an option pricing model may be appropriate for some arrangements because this type of model can incorporate additional complexities.
Additionally, for liabilityclassified arrangements, the model will need to be flexible enough to handle changing inputs and assumptions that need to be updated each reporting period. IFRS 3 Fair value of contingent consideration
Example 1 – Fair value using acquisitiondate share price of arrangement with fixed number of shares based on performance 

Entity A acquires Entity B in a business combination. The consideration transferred is 10 million Entity A shares at the acquisition date, and 2 million additional Entity A shares 2 years after the acquisition date if a performance target is met. The performance target is for Entity B’s revenues (as a wholly owned subsidiary of Entity A) to be greater than C500m in the second year after the acquisition. The market price of Entity A’s shares is C15 at the acquisition date. Entity A’s management assesses a 25% probability that the performance target will be met. Entity A’s cost of equity is 15%. A dividend of C0.25 per share is expected to be paid at the end of year 1 and 2, which the seller will not be entitled to receive. How should the fair value of the arrangement be determined? Simplifying assumption(s): The arrangement is not linked to providing services. The share price is the same in each revenue scenario. This is unlikely to be the case, as the future share price might be correlated to revenue and might change as revenue from the acquired business increases or decreases. Other potentially important issues such as dilution from issuance of new shares, statistical probability distribution of revenue scenarios, potential difference in distribution of share prices and the correlation of the different risks are also ignored. Solution The fair value is estimated at C7,296,786 (see calculation working sheet below). The fair value of the contingent consideration at the acquisition date in this example is based on the acquisitiondate fair value of the shares and incorporates the probability that Entity B will have revenues in 2 years greater than C500m. The value excludes the dividend cash flows in year 1 and 2 and incorporates the time value of money. The discount rate for the present value of dividends should be the acquirers cost of equity^{1} because returns are available to equity holders from capital appreciation and dividends paid. Those earnings are all sourced from net income of the acquirer. The following entry is recorded on the acquisition date for the fair value of the contingent consideration:
There are no remeasurements of the fair value in subsequent periods. CALCULATION WORKING SHEET

IFRS 3 Fair value of contingent consideration IFRS 3 Fair value of contingent consideration IFRS 3 Fair value of contingent consideration
Example 2 – fair value using the future price of arrangement with variable number of shares based on performance 

Entity A acquires Entity B in a business combination. The consideration is 1 million Entity A shares at the acquisition date and 100,000 additional shares if Entity B’s revenues (as a wholly owned subsidiary of Entity A) are greater than C2m during the oneyear period following the acquisition. If Entity’s B’s revenues exceed C2m, Entity A will issue an additional 10,000 shares for each C2m increase in revenues in excess of C2m, not to exceed 0.1 million additional shares (that is, 0.2 million total shares for revenues of C4m or more). Entity A’s cost of equity is 15%. A dividend of C0.25 per share is expected at the end of year 1, which the seller will not be entitled to receive. How should the fair value of the arrangement be determined? Simplifying assumption(s): The arrangement is not linked to providing services. The 40% probability of revenue between C2m and C4m is evenly spread within the range. The share price is the same in each revenue scenario. This is unlikely to be the case, as the future share price may be correlated to revenue and change as revenue from the acquired business increases or decreases. The share price will grow at the cost of equity less dividend yield. Other potentially important issues such as dilution from issuance of new shares, statistical probability distribution of revenue scenarios, potential difference in distribution of share prices and the correlation of the different risks are also ignored. Solution Since the number of Entity A’s shares that could be issued under the arrangement is variable and relates to the same risk exposure (that is, the number of shares to be delivered will vary depending on which performance target is achieved in the oneyear period following the acquisition), the contingent consideration arrangement would be considered one contractual arrangement under IAS 39.AG29; it should be classified as a liability in accordance with IAS 32.11. The fair value of the contingent consideration is C1,182,609 (see calculation working sheet below). This arrangement is slightly more complex than the previous example. A valuation method using the future price has been used − in contrast to the previous example, where acquisitiondate price was used. Entity A can estimate the fair value of the contingent consideration at the acquisition date based on the future estimated fair value of the shares, and incorporate the probability of the different number of shares to be transferred at different revenue levels. The model to estimate the future expected share price of Entity A should consider various factors, including the relative size of the acquisition, impact on operational results, further market analysis of the acquisition strategy, dilution from the share payout and others. The following entry is recorded on the acquisition date for the fair value of the contingent consideration:
Remeasurements of the fair value will be required each reporting period, with fair value change recognised in the income statement. CALCULATION WORKING SHEET

Complex situations – additional insights IFRS 3 Fair value of contingent consideration
The buyer may promise to issue the seller additional shares if the share price of the combined business falls below a specified level. This amount is agreed at the acquisition date in the event that the entity’s shares are trading below a set amount at a future date.
Valuations for this type of arrangement are highly complex. A bestestimate or a probabilityweighted approach will rarely be sufficient to estimate the fair value of this type of arrangement.
The following factors are some points to consider in developing a valuation approach. This may not be a complete list:
 What are the potential outcomes for the buyer’s financial results next year? IFRS 3 Fair value of contingent consideration
 What are the potential outcomes for the buyer’s share price changes over the coming year? IFRS 3 Fair value of contingent consideration
 How are the distributions of the financial results and share price returns correlated, and how can this correlation be quantified and modelled?
 What are the potential outcomes for other market events that could impact the overall stock market? IFRS 3 Fair value of contingent consideration
 What discount rate adequately reflects all of the risks (for example, projection risk, share price return estimation risk, the buyer’s credit risk) inherent in a valuation of this kind?
An optionpricing model may be appropriate in these situations, as it can incorporate the correlation between various factors such as the correlation of share price with different cash flow outcomes. IFRS 3 Fair value of contingent consideration
IFRS 3 Fair value of contingent consideration
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