This article is the second in a series on contingent consideration. The previous article discussed contingent consideration, or earn-outs in business combinations and their common use as a devise to bridge a gap between buyer and seller in the negotiation phase of a merger. This post will focus on the accounting requirements for the initial recognition of contingent consideration and on the subsequent remeasurement as required by FASB Topic 805, Business Combinations (formerly SFAS 141(R)). Because the subsequent remeasurement of earn-outs has the potential to impact future earnings, it is important for those structuring the merger to consider the accounting ramifications during the negotiation phase.
According to the FASB’s Master Glossary, contingent consideration is usually an obligation of the acquirer to transfer additional assets or equity interests to the former owner as part of an exchange of control of the acquired entity if specific future events occur or conditions are met. Contingent consideration is recognized as of the acquisition date and is classified either as a liability or as equity, depending on whether the obligation is certain. Certainty relates to the obligation’s existence, rather than the amount of the obligation. In other words, a certain obligation is an unconditional obligation.
If the obligation is certain (unconditional) at inception, it is classified as a liability. This type of earn-out is generally settled with cash or a variable number of the buyer’s shares (fixed dollar amount). If the obligation is not certain (conditional) at inception, it is classified as equity. The obligation is triggered if the acquired entity meets certain performance targets or if certain milestones are met. Settlement is generally a fixed number of the buyer’s shares (variable dollar amount). Regardless of whether the earn-out provision is classified as a liability or as equity, contingent consideration is measured at fair value.
Contingent consideration classified as a liability is subject to remeasurement at each reporting date until its ultimate settlement date. Any change in the fair value of the liability due to events that occur after the acquisition date would be recognized in earnings (except for hedging activities that flow through other comprehensive earnings.) However, contingent consideration classified as equity is not subject to remeasurement. Instead, any gain or loss at settlement is recorded as an adjustment to equity through other comprehensive income. Because companies generally try to avoid earnings volatility, there is an incentive to structure business combination transactions so that earn-outs will be conditional and therefore, not subject to remeasurement.
One interesting side effect of remeasurement is that it tends to buffer earnings. When an acquired entity has better than expected operating performance, there is a greater likelihood that earn-out performance targets will be met. Recognizing the increase in the fair value of the contingent obligation results in a remeasurement loss. The remeasurement loss tends to offset some of the improved operating performance. The converse is also true. Worse than expected operating performance leads to remeasurement gains, which offset poor operating results.
Because the remeasurement of contingent earn-out liabilities from business combinations has the potential to increase earnings volatility, accurate measurement of the obligation’s fair value at the acquisition date is critical. Future articles will discuss factors to consider and methods for measuring the fair value of contingent consideration.