When an acquisition of a business is being made and the consideration for such business to include some portion of amount which is NOT certainly determinable and depending upon some future event/s to be met and accordingly an expectation is required to be built to calculate that uncertain portion called Contingent consideration.
Now, after having an idea about the contingent consideration in the context of business acquisition let’s refer current accounting (Current Indian GAAP which allows fair value & book value approach unlike Ind-As only allows FAIR VALUATION) for such contingent considerations-
As per AS -14 – “Accounting for amalgamation” para 15 states that “ Many amalgamations recognise that adjustments may have to be made to the consideration in the light of one or more future events. When the additional payment is probable and can reasonably be estimated at the date of amalgamation, it is included in the calculation of the consideration. In all other cases, the adjustment is recognised as soon as the amount is determinable [see Accounting Standard (AS) 4, Contingencies and Events Occurring After the Balance Sheet Date]”
Reader would appreciate to note that as per the para above the contingent consideration would be valued based on “reasonably” possible ways and any changes will be done based on an adjustments as per AS-4.
Let’s see what are the relevant extracts relating to contingent consideration arises during business purchase transaction (business has been defined under Ind-As 103) and its subsequent measurements –
As per Ind-As 103 – “Business combinations”
Definition of Contingent consideration
Usually, an obligation of the acquirer to transfer additional assets or equity interests to the former owners of an acquiree as part of the exchange for control of the acquiree if specified future events occur or conditions are met. However, contingent consideration also may give the acquirer the right to the return of previously transferred consideration if specified conditions are met.
Para -39– The consideration the acquirer transfers in exchange for the acquiree includes any asset or liability resulting from a contingent consideration arrangement (see paragraph 37). The
acquirer shall recognise the acquisition-date fair value of contingent consideration as part of the consideration transferred in exchange for the acquiree.
Para -40– The acquirer shall classify an obligation to pay contingent consideration that meets the
definition of a financial instrument as a financial liability or as equity on the basis of the definitions of an equity instrument and a financial liability in paragraph 11 of Ind AS 32,Financial Instruments: Presentation. The acquirer shall classify as an asset a right to the return of previously transferred consideration if specified conditions are met. Paragraph 58 provides guidance on the subsequent accounting for contingent consideration.
Para- 58– Some changes in the fair value of contingent consideration that the acquirer recognises after the acquisition date may be the result of additional information that the acquirer obtained after that date about facts and circumstances that existed at the acquisition date. Such changes are measurement period adjustments in accordance with paragraphs 45–49. However, changes resulting from events after the acquisition date, such as meeting an earnings target, reaching a specified share price or reaching a milestone on a research and development project, are not measurement period adjustments. The acquirer shall account for changes in the fair value of contingent consideration that are not measurement period adjustments as follows:
(a) Contingent consideration classified as equity shall not be remeasured and its subsequent settlement shall be accounted for within equity.
(b) Other contingent consideration that:
(i) is within the scope of Ind AS 109 shall be measured at fair value at each reporting date and changes in fair value shall be recognised in profit or loss in accordance with Ind AS 109.
(ii) is not within the scope of Ind AS 109 shall be measured at fair value at each reporting date and changes in fair value shall be recognised in profit or loss.
Let’s have a summary of what exactly we are trying to explain here which is different from current accounting and where one has to be careful while dealing with such contingent considerations-
1. There is a concept called “Indemnification” which essentially means that an amount of assurance/ compensation to be provided by business seller to the buyer subject to some future event to be happened e.g. there is a legal case pending at the time of acquisition and seller agrees to compensate full amount to the buyer, then buyer will recognize such liability towards legal case and equal amount of asset (i.e. indemnified asset) to make an overall effect of zero, Now one has to carefully distinct between indemnification and contingent consideration. THUMB rule – Indemnification will always be related to some EXISTING liability/ assets unlike contingent consideration which will be against fair value of business purchased (without having any specified assets/ liabilities against this contingent amount),
2. Contingent consideration could be e.g. “A further 50 equity shares will be issued if new business will reach to positive EBITA”. This is one of the example by which one can understand that these kind of uncertainties will arise and then the buyer & the seller will calculate such contingent considerations based on probabilistic approach (or other estimation techniques etc),
3. Such contingent consideration will be FAIR VALUED at the time of calculation of overall purchase consideration by using reasonable estimation techniques (expected outcomes, probabilities etc), One can visualize that under present accounting system there is NO specific requirement to make fair valuation of such contingent consideration (as per AS-14 mentioned above) however it is to be valued at its FAIR VALUE (fair value as defined under Ind-As 113) at the time of calculating overall purchase consideration,
4. Since contingent consideration will also be valued at its FAIR VALUE hence there is no effect on Goodwill calculation which is being done based on FAIR VALUE of all the assets acquired & liabilities assumed/ incurred + any contingent payments,
5. As per para 58 of Ind-As 103 (mentioned above) these contingent consideration will be fair valued at EACH SUBSEQUENT reporting date till its payments and any differences will then be transferred to profit and loss account in the post acquisition profits,
6. Now, Careful consideration to be given where such contingent consideration is valued initially either-
a.Fixed number of shares to be allotted in future then as per Ind-As-32 – “Financial Instruments- Presentation” this contingent consideration will be classified as “Equity” and hence after valuing at FAIR value at inception it will NOT revalued in any subsequent periods,
b. Fixed amount of cash equivalent shares then as per Ind-As-32 – “Financial Instruments- Presentation’ this will be classified as “financial liability” and hence will be fair-valued at the inception and each subsequent reporting periods till it is paid,
Reader will appreciate to note that the form of payment/ consideration will not affect the amount of Goodwill but the structure of the payment will have a significant effect on the post acquisition income because all contingent consideration that are not classified as equity will be remeasured at each accounting period and will have a effect on profit and loss account.
A reader will appreciate about the main objective of the standard and an approach which one can follow while keeping in mind the basis of origin of such requirements. There could possibly be some specific situations or circumstances where the interpretation of any standard will be different as we should always keep in mind that IND-AS is principle based standards and lot more areas need management judgment in line with the standards relevant interpretation and best practices.
One has to look into all related facts and patterns before concluding this type of assessment based on this concept. Readers are requested not to take this article as any kind of advice (it is not exhaustive in nature) and should evaluate all relevant factors of each individual cases separately.
(Author of this article is an experienced chartered accountant who has specialization on various GAAP conversions assignments covering different industries around different part of the world including acting as IFRS advisor & corporate trainer. He can be reached via email at firstname.lastname@example.org or whatsapp +91-9634706933)