Contingent consideration is the amount of consideration to be paid by an acquirer to the acquiree in a business combination which is dependent on some future event such as financial performance of the acquiree. It is recognized as either as an equity or a liability.
In a business combination, the acquiring company (the acquirer) either transfers cash to the target company or issues its own common stock or preferred stock to the shareholders of the target company. In most cases, the purchase consideration is fixed in terms of the sum of cash transferred or the number of shares allotted. In some cases, however, a portion of the total consideration is linked to a future event or future value of a benchmark. Such portion of consideration is called contingent consideration. The contingent consideration is uncertain both in whether it will be paid and in its total amount.
Negative contingent consideration is when some future event entitles the acquirer to receive back some of the consideration already transferred to the acquiree.
Accounting for contingent consideration
Contingent consideration must be recorded on the acquisition date at its fair value either as equity or a liability. It is recorded as an equity when it is expected to be settled in a fixed number of the acquirer’s shares. In all other cases, recognition as financial liability is better.
Contingent consideration recognized as a liability is periodically adjusted to its updated fair value and the associated gain or loss is recognized in income, but the contingent consideration recognized as equity is not adjusted for changes in fair value.
Company A acquired company B by issuing 1 million of its common shares and a promise to pay 0.1 million additional shares if Company B’s average revenue for the next 3 years exceeds $50 million. The current stock price of Company A and B is $55 and $25. There is 50% chance of Company B meeting the earning target.
The fixed portion of the consideration is $55 million (=1 million × $55). The contingent portion must be estimated based on the fair value of the option. Because there is a 50% chance of Company B meeting the earnings target and consequently Company A being required to transfer additional shares, the expected value of consideration to be paid in future is $2,750,000 (=0.1 million × $55 × 0.5). Since the consideration is payable at the end of 3rd year, it must be discounted back and recognized at its present value. If the cost of equity is 10% and there are no dividends, the present value works out to $2,066,116.
Because the number of shares issued is fixed which depends on occurrence or non-occurrence of a future event, it must be recognized as equity. You need to make the following journal entry to record the contingent consideration initially:
Since it is a contingent consideration recognized as equity, it needn’t be adjusted periodically if the expected value changes.