adjustments after initial accounting

When the buyer determines it is necessary to make an adjustment to contingent consideration recognized in the accounting for a business combination, the accounting for that adjustment depends on a number of factors.

Depending on those factors, the buyer could be required to account for the adjustment as a measurement period adjustment. For example, the buyer may have recognized a provisional amount for contingent consideration in its initial accounting for the business combination because it was waiting for the report from a valuation specialist that includes the final fair value estimate of the contingent consideration as of the acquisition date.

In that situation, the buyer would make an adjustment to the provisional amount of contingent consideration recorded in the initial accounting for the business combination, which would affect the amount of contingent consideration recognized as well as the amount of goodwill (or gain from a bargain purchase) recognized in the accounting for the business combination. The guidance in Section 12.7 would be used to determine if an adjustment to contingent consideration should be accounted for as a measurement period adjustment. In other situations, the buyer could be required to account for the adjustment using the subsequent accounting guidance applicable to contingent consideration, which would likely result in the recognition of income or expense instead of an adjustment to the accounting for the business combination.

A few points to highlight when determining whether an adjustment to contingent consideration should be accounted for as a measurement period adjustment include the following:

y A contingent consideration adjustment identified within one year of the acquisition date is not

automatically considered a measurement period adjustment. If the adjustment does not relate to the facts and circumstances that existed as of the acquisition date, it is not a measurement period adjustment.

y A contingent consideration adjustment identified more than one year after the acquisition date is not automatically accounted for using the subsequent accounting guidance applicable to contingent consideration. If the contingent consideration adjustment should have been identified within one year of the acquisition date and it would have otherwise met the definition of a measurement period adjustment, the buyer would need to apply the guidance in Topic 250 to properly account for the contingent

consideration adjustment as a measurement period adjustment.

y To account for an adjustment to contingent consideration as a measurement period adjustment, the contingent consideration should have been identified in the buyer’s disclosures as a provisional amount in the initial accounting for the business combination (see Section 12.7.1).

y Events occurring after the acquisition date should not be confused with measurement period adjustments because events occurring after the acquisition date may or may not constitute additional information about the facts and circumstances in existence at the acquisition date (a prerequisite for a measurement period adjustment). Examples of such events in the context of contingent consideration that would not give rise to a measurement period adjustment include achieving an earnings target, a specified share price, or a pre-determined milestone.

To the extent an adjustment to contingent consideration does not meet the definition of a measurement period adjustment or an error, the subsequent accounting guidance applicable to contingent consideration would be used to account for that adjustment. The subsequent accounting guidance applied to contingent consideration depends on whether the contingent consideration is classified as an asset/liability or equity:

y If the contingent consideration is classified as an asset/liability, it is remeasured to its fair value at the end of each reporting period and the change in fair value is reflected in income or expense unless the contingent consideration qualifies as a designated hedging instrument for which FASB ASC 815-20-35 requires the change in fair value to be recognized in OCI.

– Contingent consideration is not generally used as a hedging instrument. As such, it would be extremely unlikely to see a situation in which contingent consideration qualifies as a designated hedging instrument.

– Whether the contingent consideration is a derivative only affects the subsequent accounting for the contingent consideration to the extent it qualifies as a designated hedging instrument for which FASB ASC 815-20-35 requires the change in fair value to be recognized in OCI. Otherwise, the accounting for contingent consideration that is a derivative or is not a derivative is essentially the same in that both are remeasured to their fair value at the end of each reporting period with the change in fair value reflected in income or expense. To the extent the contingent consideration is a derivative, the presentation and disclosure requirements generally applicable to a derivative are also applicable to the contingent consideration.

– If a contingency remains unresolved at the end of a reporting period, there generally will be a change in the fair value of the contingent consideration asset or liability that is recognized in the income statement even when there is not a change in expectations about meeting the contingency.

This is due to the fair value of the contingent consideration changing over reporting periods because of the time value of money. In other words, the fair value of a contingent consideration asset or liability should change between reporting periods, at a minimum, due to the time value of money.

– We believe the change in the fair value of contingent consideration that is not a derivative should be reflected on the income statement in a line item that is included within operating expense or operating income. This position is based on an analogy to the guidance in FASB ASC 410-20-35-5, which addresses changes in an ARO due to the passage of time. Such changes are not considered part of interest costs. The line item in which the change in the fair value of contingent consideration that is a derivative is reflected in the income statement depends on the facts and circumstances.

y If the contingent consideration is classified as equity, it is not remeasured to its fair value at the end of each reporting period. If shares are issued upon resolution of the contingency, then a reclassification within equity may be necessary. For example, the par value of the stock issued may need to be reclassified from additional paid-in capital to common stock.

Removal of a contingent consideration liability from the buyer’s books

A liability recognized for contingent consideration in the accounting for a business combination should only be removed from the buyer’s books upon settlement or expiration of the contingency. Removing a contingent consideration liability from the books is different from determining that the fair value of a contingent

consideration liability at the end of a reporting period is zero. A contingency exists until it has expired or been settled. Until that time, the buyer may need to make disclosures about the contingent consideration even if its fair value at the end of the reporting period is zero.

Equity that was recognized when accounting for the contingent consideration involved in a business combination is not removed from the buyer’s books even if the shares or other equity consideration are not subsequently issued.

12.4.5 Income tax effects

The income tax effects of contingent consideration are discussed in Section 11.4.4.

12.4.6 Classification of cash payment for contingent consideration on the cash flow statement

The classification of a cash payment for a contingent consideration obligation on the cash flow statement depends on how the recognition of the liability was treated from an accounting perspective. In other words, did recognizing some or all of the liability affect the accounting for the business combination or did recognizing some or all of the liability affect the income statement?

Consider a situation in which the buyer in a business combination recognizes a contingent consideration liability in the amount of $1,000,000 in its initial accounting for the business combination. The contingent consideration is identified as a provisional amount as the buyer is still waiting for the final valuation of the obligation from an external valuation specialist it hired. The final valuation indicates that a contingent consideration liability in the amount of $1,250,000 should have been recognized in the accounting for the business combination. As such, the buyer increases the contingent consideration liability through a measurement period adjustment (which effectively increases the amount of goodwill recorded in the business combination) (see Section 12.4.4).

In a subsequent accounting period, there is a change in the facts and circumstances and the buyer determines that the fair value of the contingent consideration liability at the end of that subsequent accounting period is

$1,750,000. As such, the buyer increases the contingent consideration liability through a subsequent accounting adjustment, which results in the buyer recognizing $500,000 of operating expenses in the income statement.

When the buyer subsequently makes a cash payment of $1,750,000 to settle the contingent consideration liability, we believe that payment should be classified as follows in the cash flow statement:

Classification of the portion of the payment reflected in the accounting for the business combination as a cash outflow from financing activities is consistent with the guidance in FASB ASC 230-10-45-13(c), which indicates the following:

Payments at the time of purchase or soon before or after purchase to acquire property, plant, and equipment and other productive assets, including interest capitalized as part of the cost of those assets [are cash flows for investing activities]. Generally, only advance payments, the down payment, or other amounts paid at the time of purchase or soon before or after purchase of property, plant, and equipment and other productive assets are investing cash outflows. However, incurring directly related debt to the seller is a financing transaction (see paragraphs 230-10-45-14 through 45-15, and subsequent payments of principal on that debt thus are financing cash outflows. [Clarifying phrase added]

Because contingent consideration reflected in the accounting for the business combination is more akin to the buyer incurring debt to acquire the business than it is to an amount that the buyer will pay soon after the acquisition date to acquire the business, the cash payment for the contingent consideration reflected in the accounting for the business combination should be reflected as a cash outflow from financing activities instead of a cash outflow from investing activities.

Consider another situation in which the buyer in a business combination recognizes a contingent consideration liability in the amount of $1,000,000 in its initial accounting for the business combination. The contingent consideration is identified as a provisional amount as the buyer is still waiting for the final valuation of the obligation from an external valuation specialist it hired. The final valuation indicates that a contingent consideration liability in the amount of $1,250,000 should have been recognized in the accounting for the business combination. As such, the buyer increases the contingent consideration liability through a measurement period adjustment (which effectively increases the amount of goodwill recorded in the business combination). In a subsequent accounting period, there is a change in the facts and circumstances and the buyer determines that the fair value of the contingent consideration liability at the end of that subsequent accounting period is $750,000. As such, the buyer decreases the contingent consideration liability through a subsequent accounting adjustment, which results in the buyer recognizing $500,000 of operating income in the income statement. When the buyer subsequently makes a cash payment of $750,000 to settle the contingent consideration liability, we believe it should classify that payment as a cash outflow from financing activities in the cash flow statement.

12.4.7 Disclosures

The disclosure requirements applicable to contingent consideration are discussed in Section 14.2.4 and Section 14.4.3.

Portion of payment reflected in the consideration transferred (i.e., the accounting for the business combination)

Portion of payment reflected in the income statement

Amount ($1,250,000)

($500,000)

Classification Cash outflow from financing activities Cash outflow from operating activities

Example 12-2: Adjustments to contingent consideration

Buyer enters into a business combination in which it acquires Target. The acquisition date is November 1, 20X1.

Buyer is a private company and has a calendar year end. Buyer must provide its audited comparative financial statements to one of its lenders annually on February 28th. Buyer agrees to pay Sellers an additional $600,000 in cash if Target’s revenue growth is 10% or more for the nine-month period following the acquisition date (i.e., November 1, 20X1 to July 31, 20X2). Buyer has hired a valuation expert to determine the fair value of this contingent consideration. The valuation expert does not expect to have the fair value estimate completed until March 15, 20X2. Buyer’s best estimate of the fair value of the contingent consideration as of the acquisition date is $450,000, which Buyer uses as a provisional amount in its December 31, 20X1 financial statements. The amount of goodwill reflected in Buyer’s December 31, 20X1 financial statements related to its acquisition of Target is

$900,000. The fair value estimate received from the valuation expert on March 31, 20X2 indicates the fair value of the contingent consideration as of the acquisition date is $400,000. On August 15, 20X2, Buyer determines Target’s revenue growth for the nine-month period ending July 31, 20X2 was 10.5%. As such, Buyer is obligated to pay Sellers $600,000 of additional consideration.

Because the contingent consideration must be settled in cash and it is not otherwise tied to Buyer’s (or one of its consolidated subsidiaries’) equity, it should be classified as a liability.

The analysis of this fact pattern based on the discussion in Section 12.7.2 about measurement period adjustments is as follows:

¾ Has Buyer completed its identification and measurement of the contingent consideration when it issues its December 31, 20X1 financial statements?

¾ No. While the identification activities related to the contingent consideration are completed prior to Buyer issuing its December 31, 20X1 financial statements, its measurement activities are not as it is waiting for the valuation expert to finish the fair value estimate of the contingent consideration. As such, Buyer records a provisional amount for the contingent consideration in its December 31, 20X1 financial statements in the amount of $450,000 and makes the appropriate disclosures about the incomplete accounting for this item.

Analysis of adjustment necessary upon receipt of fair value estimate from valuation expert:

Buyer receives the fair value estimate from the valuation expert within the measurement period. As such, Buyer determines whether it is necessary to treat the adjustment to the provisional amount as a measurement period adjustment. The two critical questions that must be answered “Yes” for the adjustment to be considered a measurement period adjustment are:

1. Does the valuation expert’s fair value estimate pertain to the facts and circumstances that existed as of the acquisition date?

2. If the buyer had the valuation expert’s fair value estimate at the acquisition date, would that information have affected: (a) whether the buyer recognized an asset or liability as of that date or (b) the buyer’s measurement of an asset, liability, or other amount involved in the accounting for the business combination?

¾ Yes to both. The valuation expert estimated the fair value of the contingent consideration as of the acquisition date. In addition, if Buyer had access to the completed fair value estimate prior to issuing its December 31, 20X1 financial statements, Buyer would have included its results in the accounting for the business combination. As such, Buyer would record the following measurement period adjustment as of the acquisition date:

Buyer would also disclose the nature and amount of the measurement period adjustment in its December 31, 20X2 financial statements.

Analysis of adjustment necessary upon determining Target’s revenue growth:

During the measurement period, Buyer determines that Target’s revenues grew by 10.5% for the nine-month period ending July 31, 20X2. As such, Buyer determines whether it is necessary to treat the adjustment to the liability for contingent consideration as a measurement period adjustment. The two critical questions that must be answered “Yes” for the adjustment to be considered a measurement period adjustment are:

1. Does the 10.5% revenue growth-rate pertain to the facts and circumstances that existed as of the acquisition date?

2. If the buyer had the information at the acquisition date, would that information have affected: (a) whether the buyer recognized an asset or liability as of that date or (b) the buyer’s measurement of an asset, liability, or other amount involved in the accounting for the business combination?

¾ No to (1). Target’s achievement of 10.5% in revenue growth for the nine-month period ending July 31, 20X2 does not pertain to the facts and circumstances that existed as of the acquisition date (November 1, 20X1). In other words, the facts and circumstances that gave rise to

the 10.5% revenue growth all occurred after the acquisition date. As such, Buyer does not treat the adjustment to the liability for contingent consideration as a measurement period adjustment. Instead, Buyer would record the adjustment on August 15, 20X2 as follows:

Other expense (Note 1)

Liability for contingent consideration (Note 2)

Debit

$200,000

Credit

$200,000

Note 1: While Topic 805 does not address the classification of this amount in the income statement, we believe that this expense should enter into the determination of operating income as the payment resulted from Target’s operating performance after being acquired.

Note 2: The adjustment to the liability for contingent consideration is equal to the difference between the carrying amount of the liability ($400,000, after recording the measurement period adjustment to reflect the valuation expert’s fair value estimate of the liability) and the amount Buyer is obligated to pay Sellers upon it determining that Target achieved the necessary revenue growth ($600,000).

Liability for contingent consideration Goodwill

Debit

$50,000

Credit

$50,000

Note: The adjustment to the liability for contingent consideration and goodwill is equal to the difference between the provisional amount recorded for the liability ($450,000) and the fair value determined by the valuation expert ($400,000).

12.4.8 Counterintuitive nature of subsequent accounting guidance applicable to contingent