Overview
In this article, we will cover the contingent consideration. This include the different forms of consideration, how contingent consideration happen? In addition, we also cover the accounting for contingent consideration as well as the example. Before, we jump to the detail of the topic, let’s understand some back overview and influences as well as the control as result from the business combination.
As you may already aware of, the ordinary shares of a company are the rights to ownership of that company. When investors buy the shares of a company, they become owners of the company by the proportion of their number of shares held to the total number of issued shares of the company. These shares come with other rights as well such as voting rights in the meetings or matters of the company. The ordinary shares of a company can be bought by different entities such as individuals or other companies.
When one company buys the shares of another company, these shares must be disclosed in the financial statements of the acquirer company as investments. The accounting for these shares is no different than for normal investments up to a certain limit of ownership. This treatment will change depending on whether the acquirer company has a significant influence over the acquiree company or control of the acquiree company.
Significant influence
When one company buys the shares of another company and holds 20% or more shares in the company but below 51% shares, the company is said to have significant influence over the company it has bought the shares from. Significant influence may also exist if the company does not hold 20 % or more shares of the acquiree company but is permitted voting rights of 20% or more. This means that if the acquirer company holds only 19% shares in the acquiree company but those shares come with voting rights of more than 19%, the acquirer company is still said to have a significant influence of the acquiree company.
In case of the significant influence, the acquiree company is known as the associate company of the acquirer. The shares reported in the financial statements of the acquirer company must no longer be valued using the same method for other investments. Companies are required to value investments in associates using the equity method of accounting.
Control
If the acquirer company holds more than 50% of shares in the acquiree company, then the acquirer company is said to have control over the acquiree company. Similar to the significant influence, if the acquirer company does not own more than 50% of the shares of the acquiree company but has more than 50% voting rights in the acquiree company, it is still said to have control over the acquiree company.
When a company has control of another company, the controlee company is said to be the subsidiary of the controlling company. The controlling company is said to be the parent of the controlee company. When the subsidiary-parent relationship is established, the parent company has to prepare two sets of accounts, one set as a single company and the other set as a group of companies. In the group financial statements, the parent company must consolidate its financial statements with the financial statements of its subsidiary. This process is known as consolidation and the financial statements are known as consolidated financial statements.
Example
A company ABC Co. owns 30% shares of another company RST Co. with voting rights of 30%. ABC Co. also owns 59% shares of MNO Co. with voting rights of 59%. Finally, the company owns 23% shares of GHI Co. with voting rights of 19%. This means that ABC Co. must account for all 3 companies, in which it owns shares, differently.
First of all, ABC Co. must account for the shares in GHI Co. as a normal investment. This is because although ABC Co. owns 23% shares in GHI Co., it does not have sufficient voting rights (19%) to establish significant influence. For RST Co., ABC Co. owns sufficient shares and voting rights to establish significant influence, therefore, RST Co. is said to be the associate of ABC Co., and, therefore, the investment in RST Co. must be accounted for using the equity method of accounting in the financial statements of ABC Co.
At last, ABC Co. owns sufficient number of shares and voting rights in MNO Co. to establish control. This means ABC Co. is the parent of MNO Co. and MNO Co. is the subsidiary of ABC Co. Therefore, ABC Co. must prepare consolidated financial statements as a group with RST Co. ABC Co. will also prepare its own financial statements alongside the consolidated financial statements as a group.
Forms of Consideration
When a company acquires shares in a subsidiary company, it can pay a consideration to the shareholders of the subsidiary company in many forms. The simplest form of consideration paid to a subsidiary company is direct cash. However, the parent company may also pay the subsidiary using its own shares. For example, the parent company may pay 1 share in parent company for every 10 shares in the subsidiary company. Whenever an acquisition takes place, it is going to have either one or the other of the two above types of consideration. It may have both as well but one of the two above forms will always be there.
Consideration paid to subsidiary company can also be in deferred form. For example, the parent company may promise to pay the subsidiary company at some point in the future. In this case, the consideration is known as deferred consideration. Deferred considerations are discounted at the relevant cost of equity rate of the company for the total number of years these are deferred. Similarly, the parent company may also pay its subsidiary a deferred consideration but with a condition attached. This form of consideration is known as contingent consideration.
Practically, acquirers use a combination of different forms of considerations to acquire the shares of a company. While either cash or share considerations, or both, will always be a part of the acquisition, the two other forms of consideration, deferred and contingent considerations are also used some times. These two are used to allow the acquirer to spread the burden of payment over a period of time.
How Contingent Consideration Happen?
Contingent consideration, also known as “earnouts” or “clawbacks”, is conditional future considerations promised to the shareholders of the acquiree company, for the shares they hold in the subsidiary company. For example, the parent company may promise the shareholders of the subsidiary company a payment of $10 million in the future of for their shares if the subsidiary company exceeds $10 million sales in the next year. The parent company may also offer contingent considerations in the form of shares.
However, contingent considerations may also have a condition that favors the parent company instead of the shareholders of the subsidiary company. For example, the parent company may put a condition that if the profits of the subsidiary company do not exceed $2 million, the shareholders will have to return 20% of any consideration already paid to them. This is known as negative contingent consideration.
Contingent considerations may be paid in a single period or they may span over multiple periods. Similarly, the contingency, or the condition, may completely rely on financial metrics, such as profits, sales, etc. or it may depend on non-financial metrics. For example, some contingent considerations may come with a condition related to employee retention, etc.
Contingent considerations are used by the parent company to sweeten the deal for the shareholders of the subsidiary company. It can be used to bridge the gap between the acquirer and the acquiree. This consideration will be in line with the expectations of the parent company from the business. The parent company will put conditions, according to what it expects from the business, in the future. Not only does this allow the parent company to benefit in case the condition is not met but also allow them some time to pay the consideration.
Some contingent considerations may also come with a condition for the sellers to continue employment at the acquiree company after the acquirer obtains control of the company. This case happens when the acquiree is also employed at the subsidiary company. For example, when obtaining control over a subsidiary, the parent company may offer a contingent consideration if the CEO, who is also the shareholder of the subsidiary company, continues to work with the subsidiary company after the parent company takes over.
Contingent considerations may result in disputes between the acquirer and the shareholders of the subsidiary company. This may happen when the terms of the contingent consideration are not clear or the conditions are complex and subjectively determined. Therefore, it is crucial that the terms of the consideration must be clear and concise. This can be achieved through proper documentation. Furthermore, the conditions attached to these considerations must be based on objective targets.
Accounting for Contingent Consideration
Contingent considerations are recorded at their fair value on the acquisition date. Contingent considerations must be classified as either liability or equity when being initially recognized in the financial statements of the acquirer. The classification depends on whether the consideration that is promised is to be paid in a fixed number of shares in the future. In that case, the contingent consideration will be classified as equity.
In any other case, contingent considerations will be classified as a liability. When contingent considerations are classified as a liability, unlike when classified as equity, their fair value is adjusted periodically. The adjustment can be done either quarterly, semi-annually or annually. Any gains or losses on the fair value of the contingent considerations are taken to the profit or loss statement.
If the contingent consideration is offered to another company, that is a shareholder of the subsidiary, then the shareholder company must recognize the contingent liability as a financial asset in its financial statements. This case also applies in case of negative contingent considerations. The acquirer company must recognize negative contingent consideration as a financial asset in their financial statements.
Example
A company, ABC Co. acquired the shares of DEF Co. for a cash price of $50 million. In addition to the $50 million, ABC Co. offered DEF Co. a promise to pay 100,000 shares of ABC Co. if the profits of DEF Co. for the next year exceed $5 million. The fair value of the share of ABC Co. at the time of acquisition in the stock market is $40. It is estimated that DEF Co. has a 60% chance of achieving the target. The cost of equity of ABC Co. is 10%.
To recognize the contingent consideration in the accounts of ABC Co., the fair value of the contingent consideration must be established. This can be done by calculating the fair value of the consideration and then multiplying it with the chance of success for the condition. So, the fair value of the contingent consideration will be $2.4 million (100,000 shares x $40 x 60%). However, the amount will be payable after 1 year. Therefore, ABC Co. will have to discount the $2.4 million using their cost of equity. After discounting $2.4 million at a rate of 10% for 1 year, the amount will be $2.1816 million ($2,181,600).
Once the fair value of recognition is determined, it must be determined whether it should be recognized as equity or liability. In this case, the number of shares is fixed in the contingent consideration, i.e. 100,000 shares of ABC Co. after 1 year. Therefore, this contingent consideration will be recognized as equity in the financial statements of ABC Co.
The double entry to record this amount will be:
Dr Contingent Consideration $2,181,600
Cr Equity $2,181,600
If the number of shares were not fixed, then the contingent consideration would be recognized as a liability and the fair value of the shares would be evaluated periodically to check for any fluctuations in the fair value. Since that is not the case, the equity doesn’t need to be evaluated periodically.
Conclusion
There are many forms of considerations paid by an acquirer to acquiree during an acquisition. Contingent considerations are promises to pay the acquiree, by the acquirer, in a certain time in the future if a certain condition is met. It can be used during acquisitions to benefit both the parties. Contingent considerations are recognized at their fair value on the acquisition date and classified as either equity or liability based on whether the future consideration is in a fixed number of shares.
