The Financial Accounting Standards Board issued a revision of Statement of Financial Accounting Standards No. 141, Business Combinations, now codified within Accounting Standards Codification Topic 805, Business Combinations (ASC 805), in December 2007. After a relative drought in merger and acquisition activity in 2008 and 2009, business combinations are now on the rise. Acquisitive companies will need to be familiar with the new provisions in ASC 805, which contained significant changes in accounting for acquisitions. Likely, the most significant change is the new treatment of contingent consideration which is outlined below:

1.  What is “contingent consideration”?

Contingent consideration is an obligation of the acquirer to transfer additional assets or equity interest to the sellers of a target if specified events occur or conditions are met. Contingent consideration is commonly referred to as “earnouts.”

Business combination deals often contain “clawback” provisions that may reduce future payments to the sellers or call for a reimbursement from the sellers. These provisions are also covered by guidance in ASC 805.

2.  When is it recorded?

Under the new guidance, the fair value of the contingent consideration is recorded as a liability (when additional assets will be transferred) or within equity (when additional equity interest will be transferred) at the acquisition date. This is a major departure from previous guidance, under which any post-transaction earnout payments were accounted for if and when the related conditions were met. The fair value of the contingent consideration directly increases the purchase price to be allocated.

3.  How is the value determined?

The mechanics of determining the fair value of contingent consideration are as varied as the terms outlined in deals, and can be complex. In other words, the valuation model must be tailored to fit the specified conditions of the business combination. For example, the value of a linear earnout (the seller will be paid 3 times earnings of a future period) is calculated under a significantly different model than a non-linear earnout (the seller will be paid 3 times earnings of a future period only if the earnings exceed a specified milestone).

In general terms, two methods are used to value contingent consideration: discounted expected cash flow models and option pricing models.

In one commonly used form of the discounted cash flow method, management, often with the assistance of an outside valuation expert, assesses the cash flows associated with one or more potential outcomes (i.e., situations where the earnout is paid in full, situations where the earnout is not paid at all, and situations where a portion of the earnout is paid) along with the relative likelihood of each of those potential outcomes. The cash flows associated with the potential outcomes are discounted to the present, and the relative probabilities of the outcomes are applied to determine the value of the earnout.

The determination of the appropriate discount rate may include consideration of the risk-free rate, the deal’s internal rate of return, rates of return available on similar investments, the acquirer’s cost of borrowing, or other factors appropriate to the specific earnout analyzed.

Option pricing models may be used when the earnout structure is similar to an option instrument. These analyses can be quite complex.

4.  What happens next?

Contingent consideration recorded as a liability is remeasured at each reporting date, with any adjustments to fair value recorded within earnings, until the contingency is resolved.

Contingent consideration recorded in equity is not remeasured.

5.  What does this mean to me?

Earnouts have historically been used as a relatively low-cost way for buyers and sellers to reflect differing view of the risk of future performance, and we have been involved in a number of deals that may never have closed but for the existence of an earnout that bridged the gap between the negotiating positions of the parties. Under the new rules, it has become important to be aware of the potential financial statement impact of the earnout, both at the closing date and for the duration of the earnout agreement.

The fair value of the earnout will be included in the consideration paid to the seller, so it will have an impact on the initial purchase price allocation. In addition, as the expected cash flows associated with the earnout and the probability of realizing those cash flows change over time, the change in fair value of the earnout will affect earnings in each period.

At Decosimo Advisory Services (DAS), our experts can help you during the negotiation phase of the deal to structure an earnout that will facilitate fair value analysis, both at the closing date and over time. If you have already negotiated an earnout, we can help you comply with the new accounting requirements with purchase price allocation services, determination of the fair value of contingent consideration at closing, and remeasurement of the fair value of contingent consideration over time.

The Decosimo CPA firm and its valuation division, DAS, provides due diligence and valuation services to the merger and acquisition communities, specifically providing services to private equity groups. We have provided these services for 40 years, over a wide range of industries, and on total transactions exceeding $20 billion. DAS has a full staff of experienced professionals dedicated to providing valuation services and possessing the top valuation credentials. For a representative list of recent due diligence and valuation assignments, click here.

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