What is Contingent Consideration?

Contingent Consideration can be defined as an obligation of the acquiring entity to transfer additional assets or equity interests towards former owners of the acquired entity. The amount of consideration can be declared as significant, depending on the subsequent performance of the acquired entity.

The teams under the supervision of which considerations are mostly calculated and paid are considered to be part of the acquisition agreement. However, the consideration is only supposed to be paid if certain events occur, or certain conditions that have already been communicated earlier are duly met. 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?

 

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.

Explanation of Contingent Consideration

In accordance with the International Financial Reporting Standards (IFRS 3), contingent consideration is defined as follows:

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.

 

Suppose there is a change to the fair value of the contingent consideration due to any additional information obtained after the acquisition date that impacts the facts or circumstances from how they were at the date of the acquisition. In that case, it is then adjusted by using measuring period adjustment. Subsequently, contingent liability and goodwill are re-measured.

In the case where there are changes in the consideration arising from the events after the acquisition date, the treatment differs as follows:

  • Contingent Consideration that was previously classified as equity is not supposed to be remeasured. Similarly, its subsequent settlement is supposed to be accounted for within equity.
  • Contingent Consideration that is classified as an asset, or a liability that is a financial instrument is measured at fair value, with subsequent gains and losses reported in the Statement of Profit and Loss, or other Comprehensive Income. In the same manner, if it is not a financial instrument (i.e. outside the scope of IFRS 9), it is then accounted for in accordance with IFRS 37 – Provisions, Contingent Liabilities, and Contingent Assets.

Journal Entries to Record Contingent Considerations

Particular Debit Credit
Contingent Consideration xxx
  Equity xxx

The journal entry above shows that contingent consideration is recorded in order to ensure that companies account for the payment that might be received as a result of certain conditions being met.

Example of Contingent Consideration

The concept of Contingent Consideration is illustrated in the following example:

Windies Co. has acquired Sparko by issuing 1 million common shares. Furthermore, they have also promised to pay an amount equivalent to 100,000 shares if Sparko’s average revenue is higher than $30 Million for the next three years. The stock price of Windies Co. is $50, whereas the stock price of Sparko is currently $20.

It can be seen that the fixed portion of purchase consideration can be calculated as follows:

Fixed Consideration = Share price * Number of Shares = 50 * 1,000,000 = $50,000,000

The contingent portion, however, is supposed to be calculated based on the fair value of the option. Since there is a 50% even chance of Sparko meeting the contingency of average revenues being higher than $30 Million, upon which Windies Co. is required to pay an amount equivalent to 100,000 shares, the contingent consideration can be calculated as follows:

Contingent Consideration = Share price * Number of shares set up as contingency * 0.5

Contingent Consideration = 50 * 100,000 *0.5 = $ 2,500,000

However, it must also be realized that this particular contingent consideration is supposed to be paid at the end of the 3rd year. Hence, it must be discounted back to its present value. This discount rate would then reflect the actual amount of money that Sparko is likely to receive in case the contingency is duly met.

Assuming a discount rate of 10% for the three years, the Present Value of the Contingent Consideration amounts to be $1,878,287.

The journal entry to record the creation and subsequent treatment of Contingent Consideration is as follows:

Particular Debit Credit
Contingent Consideration $1,878,287
  Equity $1,878,287

Given that contingent consideration is tied up with some other event taking place (in this case, average inventory being closer to $30 Million), it is not adjusted periodically if the expected value changes.

Advantages of Contingent Consideration

Contingent Consideration proves to be advantageous from the perspective of both the buyer and the seller. Mostly, it acts to the advantage of the buyers in the following ways:

  • Helps buyers to avoid overpaying: Buyers that are doubtful regarding the seller projections of targets are not considered to be comfortable in paying the complete price upfront. Therefore, they prefer to break it into parts, with the second payment being conditional that other respective tasks are duly met.
  • Reduction in the need for cash: Since the payment does not need to be upfront, the buyers can save up on considerable amount of cash that needs to be paid up front. Hence, it makes the overall transaction easier for the buyers.
  • Provision of incentive for sellers to stay on: Since contingent consideration provides additional gains for sellers, the sellers are motivated to stay with the business even after the acquisition has been made.

On the other hand, from the perspective of the seller, Contingent Consideration has the following advantages:

  • Fair purchase consideration: Since Contingent Consideration is only paid if conditions are met, sellers feel that they have been treated fairly, and they are getting a fair price of the asset that is being sold.
  • Opportunities for growth: After the initial purchase price is made, sellers then get the chance to earn any additional proceeds from the sale of the company, if the agreed-upon targets are met.