Accounting For Deferred Consideration
Deferred consideration is a portion of the purchase price that is to be paid at a later date after the transaction has been completed. This arrangement is typically negotiated between the buyer and the seller as a pre-agreed component of the purchase price. It is important to note that the actual amount of consideration and payment terms are determined in the negotiations. This can be done by both parties in order to ensure that the value of the deferred consideration is accurately reflected in the transaction.
The accounting for deferred consideration is important because it affects the financial statements of the buyer and the seller. The buyer must record the deferred consideration as an asset on its balance sheet, while the seller must record it as a liability. The deferred consideration must be recorded at its fair market value, which is determined in the negotiations. The buyer will then amortize the deferred consideration over the term of the agreement, while the seller will recognize the deferred consideration as income over the same period.
It is important for both parties to properly account for the deferred consideration in order to ensure that the financial statements accurately reflect the financial position of the company. Furthermore, it is important to ensure that the deferred consideration is paid in full and on time in order to avoid any issues with the financial statements or the tax authorities.
Types of Considerations
Payments of cash up front, consideration to be paid in the future, and consideration that is contingent on a certain event are the three types of considerations that may be included in a transaction:
- Upfront Payments in Cash: This type of consideration involves payment of money up front at the time of the transaction.
- Deferred Consideration: This type of consideration involves payment of money at a later date, either at a fixed date or when certain conditions are met.
- Contingent Consideration: This type of consideration involves payment of money when a certain event occurs, such as when a specific performance goal is achieved.
These considerations can have a significant effect on how the transaction is structured and accounted for. Different accounting treatments may be applied to each type of consideration, depending on the specifics of the transaction and the nature of the obligations.
It is important to ensure that the accounting records are accurate and up to date, and to follow applicable accounting principles for each type of consideration.
Accounting for Deferred Consideration
When a transaction involves obligations that are to be paid in the future, the present value of these obligations must be calculated and recorded in the accounting records. This process is known as accounting for deferred consideration.
Deferred consideration should have no conditions or contingencies attached to the payment and should always be discounted to present value. The discounted value of deferred consideration is the amount the parent company sets aside at acquisition date to be paid to the subsidiary on the due date. If no amounts are recorded by the parent company, deferred consideration is included in Goodwill and Liabilities at acquisition date.
Liabilities representing the present value of the consideration increase over time to cover the amount present (unwinding the discount). Finance costs are expensed and liabilities are increased each year as part of the unwinding of the discount. Goodwill is not impacted by the unwinding of the discount as it is calculated at acquisition date.
Accounting for deferred consideration is important to ensure that the present value of future obligations is accurately reflected in the accounting records. This helps to ensure that financial statements are accurate and up to date.
Example Of Deferred Consideration
The present value of future payments due to a subsidiary must be calculated and recorded in the accounting records to accurately reflect the obligations. In this example, Gems Inc. acquired 80% of Diamond Co. on 1st January 2021 and agreed to pay $10 million on 1st January 2022. The present value of $10 million in one year is $9.09 million and this amount is recorded as part of the goodwill calculation and as an equivalent liability within current liabilities.
At 31st December 2021, the amount is payable in one day and Gems Inc. contacts Diamond Co. to remind them of the payment. Pratt Co. shows a liability of $9.091 million, which is increased by 10% to adjust for the time value of money. The increase of $909k is added to the liability and recorded as a finance cost in the statement of profit or loss.
When accounting for deferred consideration, the following points must be taken into account:
- Calculate the present value of the future payments
- Record the present value as part of the goodwill calculation
- Record the present value as an equivalent liability
- Adjust for the time value of money and record the increase as a finance cost in the statement of profit or loss.
Contingent Consideration
Contingent consideration is an obligation imposed by the acquirer which may require additional assets or equity interests to be given to the former owners of the acquired entity based on the acquiree’s performance after the acquisition. The amount and payment terms of this consideration are outlined in the acquisition agreement and can be triggered by the occurrence of specific future events or the satisfaction of certain conditions.
The payment of the consideration is contingent upon the fulfilment of these conditions and events. The acquirer must recognize the contingent consideration in their financial statements and account for it as a liability. The liability will be measured at fair value and any changes in the fair value should be recorded in the acquirer’s income statement.
The acquirer must also ensure that the contingent consideration is properly disclosed in their financial statements. This helps to ensure that investors and other stakeholders are aware of the potential risks and rewards associated with the acquisition.
Benefits Of Deferred Considerations
Deferred considerations can offer both buyers and sellers a variety of advantages. It reduces the need for immediate cash payments, which is especially beneficial for companies with limited cash reserves. Furthermore, it is usually interest-free, providing an additional financial advantage.
From a commercial point of view, it can provide security in case of disputes between buyer and seller. In such cases, the buyer can recover costs through warranty claims, damages or partial refunds. Overall, deferred consideration offers a great degree of flexibility for both parties involved in a transaction.
It is an attractive option for those who are looking for an effective way to manage their cash flow and settle their debts. Additionally, it allows both parties to negotiate a reasonable agreement that fits their individual needs and circumstances.
Frequently Asked Questions
What are the tax implications of deferred consideration?
The tax implications of deferred consideration depend on the form and amount of the payment, the relevant tax jurisdiction, and the nature of the underlying transaction.
What happens if the conditions of the deferred consideration are not met?
If the conditions of the deferred consideration are not met, the party that is owed the payment may not receive the full amount, or any amount, as agreed upon.
How long does deferred consideration typically last?
Deferred consideration is typically a payment arrangement that lasts for a predetermined period of time. It may range from a few months to several years, depending on the specific conditions of the contract.
What is the difference between deferred consideration and upfront payment?
Deferred consideration is a payment method wherein payment is made at a later date, rather than upfront. This differs from upfront payment, which is a payment made immediately upon the completion of a transaction.
How do I determine the appropriate value of deferred consideration?
The appropriate value of deferred consideration is determined by considering the present value of future cash flows, the riskiness of the consideration, and the discount rate used to measure the value.
Conclusion
Deferred consideration is an important concept in accounting that requires careful consideration of the various types of consideration and the accounting for the same.
Understanding the example of deferred consideration and the contingent consideration can provide additional insight into the benefits of deferring consideration.
In conclusion, accounting for deferred consideration is an important part of financial management that requires a thorough understanding of the various types of consideration and their respective accounting methods.