The Treatment of contingent consideration under ASC 805.

1. June 2011
Kotzin Valuation Partners, LLC • 2800 N. Central Ave., Suite 1725 • Phoenix, AZ 85004 • www.kotzinvaluation.com
Contingent Consideration
Your balance sheet and income statement will never be the same
The implementation of Financial Accounting Standards Board former owners as part of the exchange if specified future events
(FASB) Accounting Standards Codification (ASC) Topic 8051 - occur or conditions are met.
Business Combinations (ASC 805), fundamentally changed the A contingency is deemed to be a liability if the number of
financial statements of acquiring shares is variable or has a cash settlement feature. A contin-
companies. One of the most dra- gency is deemed to be equity if the number of shares is fixed.
matic changes regards the treat- Clawback. A clawback is the right of the acquirer to the
ment of contingent considera- return of previously transferred consideration, if specific condi-
tion. With M&A activity substan- tions are met. A clawback contingency is deemed to be an asset.
tially reduced over the last few If the contingency is classified as equity, remeasurement to
years due to the “Great Reces- fair value at each reporting date is not required, and subsequent
Brian Jones Don Wenk sion,” the earnings volatility this settlement would be accounted for in the equity account.4 If the
602-544-3567 602-544-3557 change in accounting treatment contingency is classified as either an asset or a liability, remeas-
bjones@kotzinvaluation.com dwenk@kotzinvaluation.com
will bring to acquirers may not urement to fair value at each reporting date is required until the
yet be fully realized. However, with the economy slowly improv- contingency is resolved.5 Any changes in fair value are recog-
ing and more acquisitions taking place, we expect the measure- nized in earnings. The acquisition date fair value of the contin-
ment of contingent consideration to become an area of concern gent obligation or asset will generally not equal the amount
for many CFOs and company auditors. stated in the purchase agreement until immediately prior to the
Contingent consideration is often a component of a transac- payment date, due to present value factors and the uncertainty of
tion where a “value gap” exists between an acquirer and the payment.
acquiree. Well-structured contingent consideration can alleviate
Current Guidance - ASC 805
common concerns and eliminate potential deal breakers that
exist between acquirers and acquirees. Contingent consideration Under ASC 805, contingent consideration is to be recog-
is often incorporated into the purchase agreement for the follow- nized at the acquisition date as part of the consideration trans-
ing reasons: ferred.6 Contingent consideration arrangements of the acquiree
assumed by the acquirer will also be measured at fair value.
• It allows the acquirer the ability to share the risk associated
These unresolved contingencies from prior acquiree transactions
with the future performance of the business with the
can also have a material impact on earnings volatility of the
acquiree.
acquirer.
• It allows the acquiree to participate in upside post-close. Reporting of contingent consideration under ASC 805 is in
• It provides an incentive for the acquiree to remain produc- sharp contrast to the treatment under the prior standard, SFAS
tively involved in the business post-close. 141, where the consideration was recorded when the contin-
• It functions as a de facto non-compete agreement, since the gency was resolved and consideration was issued or became
acquiree would not compete against their future considera- issuable (unless the contingency was determinable beyond a
tion. reasonable doubt). Fundamentally, FASB changed the way in
which contingent consideration was accounted, since the former
Common components of contingency agreements include, treatment did not adequately represent the economic consid-
but are not limited to, financial thresholds (e.g., sales, EBITDA), eration exchanged on the acquisition date.
milestones (e.g., FDA approval, product launches, stage of devel-
opment completion, customer retention) and market performance Counterintuitive Accounting Treatment and Potential Risks
hurdles (e.g., stock price, IRR hurdles, caps, and tiers). If the initial fair value measurement of the earn-out is less
than the actual payment, a loss is recorded in the income state-
Definition and Classification ment upon the occurrence of the payment, even though the busi-
Contingent consideration2 is defined as either an earn-out or ness performed better than originally expected. If the initial fair
a clawback and must be classified as either equity or an asset/ value measurement is greater than the actual payment, a gain is
liability.3 recorded in the income statement, even though the business is
Earn-Out. An earn-out is an obligation if the acquirer is performing worse than originally expected.
required to transfer additional assets or equity interests to the The accounting treatment appears to provide an incentive for

2. higher fair values assigned upon initial measurement for earn- Consistency with Purchase Price Allocation
outs, as the potential exists to record a gain if the earn-out is not The assumptions used in the valuation of the contingent
paid due to underperformance of the acquired entity. The flip consideration may differ from those incorporated in the valuation
side to this strategy, however, is the potential adverse impact on
of the assets acquired. Per guidance from FASB, the cash flows
debt covenants, as the earn-out may be considered a debt-like
used in the valuation of assets and liabilities of the acquired
instrument if settled in cash or a variable number of shares. Addi-
business normally do not include buyer-specific synergies.
tionally, any goodwill recorded as a result of the initial fair value
However, it may be appropriate to include buyer-specific syner-
measurement of an earn-out will remain on the acquirer’s
gies in the valuation of contingent consideration, if the synergies
balance sheet, even if no payment is made. This could lead to
subsequent goodwill impairment issues, as the value of the good- will drive the likelihood of achieving, or the amount of, the earn-
will may not be supported by the financial performance of the out (or clawback).
acquired company. Keep It Simple
Valuation Methodologies Fundamentally, when dealing with contingent consideration
Due to the prospective nature of contingent consideration structures, company management and their valuation specialists
structures, the most frequent method employed to value them is must keep three themes in mind:
the income approach. The asset/cost approach is not well suited • The analysis should rigorously decompose the contingent
for quantifying the inherent complexity, nor is the market structure to facilitate understanding for all stakeholders.
approach, as there are few observable transactions for contin-
gent asset or liabilities. Depending on the complexity of the earn- • The analysis should be kept as simple as possible to
out structure, a single scenario cash flow analysis may be appro- provide transparency and aid in the audit review process.
priate. More likely, a probability weighted scenario-based model • The valuation specialist should apply a valuation methodol-
utilizing multiple cash flow iterations should be employed. For ogy to the contingent structure that is an industry standard
very complex structures (caps, tiers, thresholds), a Monte Carlo methodology, if possible. This will ultimately allow for easier
simulation or lattice/binomial option pricing model may be remeasurement at future reporting periods as new informa-
required.
tion is acquired. ■
Whenever cash flow models are employed, a debate related
to the discount rate can be expected. Acquiree-specific risks are Brian Jones and Don Wenk are partners in the Phoenix business valuation
captured in the expected cash flows, but industry-specific risks firm Kotzin Valuation Partners. Brian Jones is the firm’s financial reporting
are not; the use of the acquirer’s weighted average cost of practice leader, specializing in the valuation of businesses and assets in
capital (WACC) may be appropriate. The discount rate decision the technology, internet, e-commerce and life science industries. Don
is a question of volatility and must incorporate (a) time value of Wenk provides valuation opinions for financial reporting, tax planning
money, (b) credit risk, and (c) projection risk. and commercial litigation.
1
Formerly FASB Statement No. 141 (R), effective for business combinations with acquisition dates that occur in annual reporting periods beginning on or after December 15,
2008.
2
ASC 805-10-05-2 (FASB 141(R), para. 3f)
3
ASC 805-30-25-6 (FASB 141 (R) para. 42)
4
ASC 805-30-35-1 (FASB 141 (R) para. 65a)
5
ASC 805-30-35-1 (FASB 141 (R) para. 65b)
6
ASC 805-30-25-5 (FASB 141 (R) para. 41)
© 2011. Kotzin Valuation Partners, LLC.