Contingent consideration cash flow presentation investing
According to the FASB Master Glossary, contingent consideration is usually an obligation of the acquirer in a business combination to transfer additional assets or equity interest 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. Note that it can go the other way too, with contingent consideration giving the acquirer the right to the return of previously transferred consideration if specified conditions are met.
The obligation for contingent consideration will either be liability classified or equity classified. Scenario: Jackson Corp. It is considered probable that Solitary will meet its forecasted results for the current year and the following year. Question 1: What is the purchase price of this business combination of October 17?
Contingent consideration is included in the consideration paid purchase price. The amount to include is measured at the acquisition date fair value, and not the expected payout at settlement date. The probability of meeting the forecasted results does not impact whether or not an amount is recognized, however, the estimate of fair value would take into consideration the probabilities of payment as well as the time value of money.
The acquirer should classify an obligation to pay contingent consideration as a liability or equity in accordance other applicable GAAP. Since this example requires cash settlement, it would be liability classified. Question 2: How should the liability for the contingent consideration be subsequently accounted for? Answer 2: It depends on what caused the change. If the change is as a result of additional information about facts and circumstances that existed at the acquisition date, then they are measurement period adjustments, assuming the change is within the measurement period.
If the change results from events after the acquisition date, such as meeting an earnings target, this change should be accounted for as follows: Contingent consideration classified as equity should not be remeasured and its subsequent settlement should be accounted for within equity Contingent consideration classified as an asset or liability is remeasured to fair value at each reporting date until the contingency is resolved.
Changes in fair value are recognized in earnings. Question 3: Assume the targets are met and the contingent consideration liability is settled at the end of year two. Judgment needs to be applied to determine whether the payment arises from obtaining control an investing activity or whether it is a settlement of financing provided by the seller.
Factors that may be relevant include: 1 the time between initial recognition of the liability and settlement; 2 whether the settlement period reflects a normal credit period; and 3 whether the liability is discounted to reflect its deferred settlement which would suggest a financing element to the arrangement. Contingent consideration paid in excess of the fair value of consideration recognized on initial recognition either in operating activities, or consistent with the policy election for interest paid see Difference 3.
No specific guidance. Absent specific guidance in IAS 7, we believe that judgment is required, considering primarily the nature of the activity rather than the classification of the related items on the balance sheet. IAS 7 includes specific guidance related to purchase and sale of equipment held for rental to others. US GAAP includes similar principles, but when a transaction has characteristics of more than one class of cash flows — and each separately identifiable source or use of cash cannot reasonably be separated — then a company applies the predominance principle to determine the appropriate classification for the related cash flows.
Example: Company A routinely purchases equipment to be rented to others then sold. Under IFRS Standards, payments to purchase the equipment, as well as the proceeds from rentals and ultimate sale, are classified as operating activities. This classification is prescribed by the specific guidance in IAS 7 related to the purchase and sale of equipment held for rental to others.
However, the classification of the cash flows from the purchase and sale of equipment depends on which activity is predominant — rental or sale. If the rental is for a substantial period and the sales price modest, the rental activity is likely to be the predominant source of cash flows. In that case, the cash flows from the purchase and sale of equipment are classified as investing activities, consistent with other purchases and sales of productive assets.
CRYPTOCURRENCY SUPER RISKY IN THE LONG RUN BILL GATES
Daniel Peckham: There has been a lot of diversity in practice and debate in this area, with the lead accounting firms working together informally for months trying to develop best practices. The discussions among the firms came to a point where two leading views emerged. Those views are based on different interpretations of the accounting guidance.
View A, the liability view, is the view that the transaction premise is based on a transfer of a contingent consideration liability to a counterparty such as a bank or an insurance company, rather than based on the amount that the selling shareholders would be willing to receive in exchange for the earnout. So the conceptual basis for the measurement is to estimate the consideration required to entice a counterparty to step into an obligation to hold the liability to maturity and pay the earnout.
From an accounting perspective, those that were proponents of View A cited the language in paragraph 15 of ASC [Topic] [Fair Value Measurements and Disclosure] that indicates a fair value measurement assumes that the liability is transferred to a market participant at the measurement date, and that the liability to the counterparty continues without settlement so it is not sold, but transferred. View B, the asset view, is essentially based on the measurement of the corresponding asset.
View B notes that, in the absence of a real market, a hypothetical market is assumed, and furthermore that the market is efficient. Therefore, any arbitrage opportunity would be captured, forcing the fair value of the contingent consideration as a liability to approximate the fair value as an asset. The VRG members generally supported an approach similar to View B and recommended that the FASB amend ASC [Topic] to clarify that it is acceptable at all levels of the hierarchy, including Level 3 inputs, to use an asset valuation method when measuring fair value of a contingent consideration liability.
In a subsequent fair value measurement meeting with IASB and the FASB, the recommendation that a liability can be measured based on the exit price of the asset holder was adopted, putting to rest most of the differences in views on the conceptual basis for the measurement. Zyla: What are some of the outstanding issues that are involved in the valuation of contingent consideration?
Why are they so hard to value? The forecast is typically a risky forecast. The actual cash flows may turn out to be higher or lower. The relationship between cash flows and value is linear. An earnout, however, is often characterized by its nonlinearity. It is also a function of business performance, but in a nonlinear way. You have to think about multiple scenarios that address the full range of possible outcomes.
Zyla: Risk is an important component in valuing contingent consideration. What kinds of risks need to be considered? Amanda A. Miller: There are three kinds of risks that need to be considered when determining the discount rate for an earnout.
The first one is the risk associated with the underlying metric. In many cases, the earnout will be based on revenues or EBITDA or another metric that is related to the value of the business. In those cases, that underlying metric is typically viewed as being subject to the firm level of risk, so the IRR or the weighted average cost of capital WACC.
The second kind of risk is associated with the shape of the payoff. On the other hand, some other earnouts might have very low probability, very high risk, or have an option-like payout that pays a percentage of revenues or earnings above some high threshold. Those kinds of payouts are going to be much riskier than the WACC. How would you value that?
Travis Chamberlain: The earnout payment is fixed and contingent on revenue exceeding a fixed threshold. The payment is contingent on whether the revenue threshold is met. As David mentioned, due to the nonlinear payoff structure, and random nature of the underlying earnout metric, it is necessary to consider multiple scenarios and the expected future distribution of possible outcomes for revenue.
As such, an option-pricing model or a scenario-based model is needed to value this type of earnout. Since it can be difficult to estimate discount rates for nonlinear payoffs, some practitioners advocate the use of an option-pricing model instead of a scenario-based model or to estimate the discount rates for scenario-based models. Under an option-pricing model, the risk of the underlying metric in our example revenue is incorporated through a volatility estimate.
Then option-pricing theory is used to estimate the value of the earnout as an option, whereby the future payoffs are estimated in a risk-neutral probability framework and discounted back at the risk-free rate to the valuation date. In financial terms, the earnout formula in our example is analogous to a binary or digital option.
As such, a modified version of the Black-Scholes option-pricing model could be used to value the earnout. While there are some embedded assumptions in the option-pricing framework that inspire debate and some practical challenges in estimating volatility for metrics like revenue, option-pricing models remain a viable and appealing methodology for valuing contingent consideration. Zyla: One of the inputs to the option-pricing model is volatility.
It should also be noted that the amount of contingent consideration that is paid is supposed to be recorded at the fair value in the accounting records of the acquired entity. The main rationale behind contingent consideration being used in an acquisition setting mostly lies in the realms of ensuring that both the buyers and sellers can link the purchase consideration with the outcome that is mutually decided upon.
What are different settlement options involved in Contingent Consideration? Contingent Consideration might be settled in cash, shares, or any combination of two. Every particular settlement, as well as a combination of these settlements, comes with its fair share of advantages, as well as disadvantages.
For example, shares might not give liquidity to the receiver. On the other hand, dealing only in cash might not give a company a chance to possess any ownership in the company. Under the definition that has been mentioned above, it can be seen that contingent consideration is always due on cases when certain conditions are met. It is not applied irrespective of the conditions being met or not. Under the rules specified of the IFRS, the acquirer of the specified asset is supposed to recognize any contingent consideration as part and parcel of the acquirer.
The fair value approach is considered to be consistent in the manner in which other considerations are valued.
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