Definition of Deferred Consideration
Deferred Consideration can be defined as a part of the purchase price that is payable by the buyer in the future, once the deal has been closed. The purchase price is mostly negotiated on the basis of the fair market value, and the mutual understanding between the purchaser, as well as the buyer of goods and services. In this regard, the actual amount of the consideration is determined, and the terms of payment are duly decided upon.
Explanation of Deferred Consideration
When an acquisition takes place, there are multiple factors that influence the overall actual negotiated price of the given deal. The payment that is made is usually in terms of cash, debt, or any other form of asset that is mutually decided upon.
Under most cases, there is a payment that is made upfront in the form of equity in the buying company in form of a promise to pay cash that is dependent and contingent on profit generation targets, or turnover-related targets. After the first payment is made, the remaining payments are decided after a mutual consensus on issues including interest, payment intervals, balloon payments, payment forms, collaterals, as well as restrictive or affirmative covenants.
In this regard, it can be seen that deferred consideration mostly allows the purchaser to defer the acquisition cost. This is mostly utilized by companies that struggle with liquidity. A deferred consideration agreement helps them to get through with the deal despite of the cash crunch that they face. However, it must be noted that in the case of deferred consideration, the seller faces an inherent default risk. Therefore, sellers mostly do not prefer a deferred consideration, and therefore, they agree on exchanging the related goods and services, even if it is at a reduced price. Furthermore, a seller also seeks a bank guarantee or collateral, where no assignation can move forward without the consent of the seller.
Types of Considerations
In order to fully understand the mechanics of deferred consideration, it is also important to understand the types of considerations that are present, and how acquisition deals are typically structured. When an acquisition takes place, consideration can be of the following types:
- Upfront Payments in Cash – Payments that are made in an upfront manner when a deal is signed.
- Deferred Consideration – Payments that are agreed to be paid at a later date depending on the mutual agreement between both the parties.
- Contingent Consideration – Payments that are contingent on certain outcomes. This implies that payment will only have to be made if those outcomes are kept and maintained.
Accounting for Deferred Consideration
For an acquisition to be recognized as a deferred consideration, there should be no conditions and contingencies pinned with the payment. Otherwise, it is classified as contingent consideration. In the same manner, for deferred consideration, the amount should also be incorporated for the time value of money. This means that the amount that is payable should be discounted to the present value.
The discounted value of the deferred consideration is basically the amount that the parent has to put aside at the acquisition date in order to be paid to the subsidiary on the due date.
In the case where no amounts are recorded by the parent company, the amount of deferred consideration is included within Goodwill and Liabilities at the acquisition date. The journal entry to record this is as follows:
Since liabilities are representative of the present value of the consideration, this needs to be increased with the due course of time till it covers the amount present. This process is referred to as unwinding the discount. With every passing year, liabilities are increased with the amount of interest that is used in the discounting calculation. The subsequent increase is further expensed to finance costs, and hence the double entry for this calculation is as follows:
This implies that the liability continues to increase as it approaches the actual payment date. It must also be noted that goodwill is not impacted by the unwinding of the discount, as goodwill is mostly calculated at the acquisition date itself.
Example of Deferred Consideration
Gems Inc. acquired 80% of Diamond Co. on 1st January 2021. As part of the consideration Gems Inc. agreed on paying Diamond Co. an amount equivalent to $10 Million on 1st January 2022. Gems Inc. had a cost of capital equivalent to 10%.
Since Gems Inc. gathered control of Diamond Co. on 1st January 2021, the goodwill was calculated at this particular date. This transaction is divided in 2 parts. The first part is the payment of the calculation, equivalent to $10 Million in one year. The present value of $10 Million in one year is equivalent to $9.09 Million ($10 Million x 1 / 1.10). This is also recorded as part of the goodwill calculation, which is an equivalent liability set up within current liabilities since that amount is payable in a period of 12 months.
However, by 31st December 2021, this amount was payable in 1 day. In that case, Gems Inc. would again contact Diamond Co. to remind them of the payment that needs to be made. Currently, Pratt Co. was showing a liability equivalent to $9.091 Million. This needed to be increased by 10% in order to adjust for the time value of money. The increase of $909k ($9091 x 10%) was further added to the liability, and then recorded as a finance cost in the statement of profit or loss.
Furthermore, it is also important to highlight the fact that Goodwill was calculated at the date of the acquisition, and therefore, all the subsequent changes to the consideration payable were not duly adjusted in the goodwill calculation.