Taxmann’s Analysis | Accounting for Contingent Consideration in Mergers and Acquisitions

Accounting For Contingent Consideration In Merger And Acquisition

Accounting For Contingent Consideration In Merger And Acquisition

Contents

1.0

Introduction

5

2.0

Accounting for Contingent Consideration in Books of Buyer

5

2.1 Under Indian Accounting Standards (Ind AS)

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2.2 Accounting of Contingent consideration under Accounting Standards (AS)

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Contingent Consideration in Standalone Books of Seller

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3.1 Under Indian Accounting Standards (Ind AS)

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3.2 Under Accounting Standards (AS)

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Conclusion

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3.0

4.0

1.0 Introduction Contingent consideration is frequently incorporated in the price structures of merger and acquisition transactions. As its name suggests, it is consideration which depends upon some future uncertain events. It arises upon happening or non-happening of those future events which may or may not happen.

For example, an entrepreneur puts a lot of efforts, money, and time into the business he owns to make it profitable. However, sometimes, it did not turn profitable, So, when a buyer approaches him for buying his business, he/she asks for additional consideration on the basis that it will generate profits after sometimes, let say after 2 more years. The buyer agrees to pay 20% of profits business will generate for the 3rd year as additional consideration in cash.

As the consideration is depended upon making profits during 3rd year, it will be considered as Contingent consideration. The seller/entrepreneur will get nothing if the business would not earn profits during 3rd year.

The accounting treatment of contingent consideration for entities complying with Indian Accounting Standards (Ind AS) by Ind AS 103 Business Combinations.

There is no specific accounting treatment is available for entities complying with Accounting Standards (AS) except for AS 14 which is applicable in case of Amalgamations.

2.0 Accounting for Contingent Consideration in Books of Buyer 2.1 Under Indian Accounting Standards (Ind AS) 2.1-1. Classification Initial classification is one of the most important exercise in accounting for the Contingent Consideration. Based on how buyer will have to settle the consideration under the acquisition agreement with seller, it will be classified as Liability or Equity.

Under Ind AS, an entity shall classify contingent consideration as liability only if its meets the definition of financial liability as provided in para 11 of Ind AS 32, Financial Instruments: Presentation. Accordingly, the conditions for classifying as liability under Ind AS are as follows:A)

The contingent consideration is expected to be settled in cash or any other financial asset; or by way of exchanging any financial asset or financial liability with the seller under conditions that are potentially unfavourable to the buyer: or

B)

The contingent consideration is expected to be settled by way of issuing additional variable number of buyer’s own equity shares, for example, say if in the above example the buyer agrees to issue additional 1,000

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equity shares at the end of 3rd year, if the business will make only profits in 3rd year, and 500 equity shares at the end 4th year, if the profits will increase by minimum 20% in 4th year.

In any other case, the contingent consideration is classified as Equity.

In the above example, as the buyer has agreed to pay 20% of profits generated by the business during 3rd year in cash, it may be classified as Liability in the buyer’s books if other conditions are also satisfied.

2.1-2. Recognition According to Ind AS 103, a buyer shall recognise a contingent consideration as financial liability in its books when all the conditions as mentioned above for classifying the consideration as financial liability are fulfilled. Similarly, whenever the consideration qualifies to classify as equity, it should be recognised as other equity in the books of buyer.

2.1-3. Initial measurement The acquirer shall recognise the acquisition-date fair value of contingent consideration whether it is classified as financial liability or equity. The fair value is measured/determined using the guidance provided in Ind AS 113, Fair Value Measurement.

2.1-4. Subsequent measurement (a)

Contingent consideration classified as equity shall not be remeasured and its value remains same as valued or recorded initially. Further 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.

2.1-5. Derecognition A contingent consideration classified and recognised as equity is derecognised and transferred to the Equity Share Capital at the time when the buyer issues its additional equity shares to the seller.

A financial liability is derecognised from the buyer’s books when the buyer discharges it by paying requisite amount to the seller.

2.1-6. Special Point Sometimes, contingent consideration also may give the buyer the right to the return of previously transferred consideration if specified conditions are met.

In such case, the contingent consideration is recorded as financial asset at fair value when it meets the definition of financial asset as provided in para 11 of Ind AS 32.

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2.2 Accounting of Contingent consideration under Accounting Standards (AS) No specific guidance is given there in the Accounting Standards Framework for accounting treatment of contingent consideration in the financial statement of the buyer. One of the accounting practices, based on guidance provided in Para 15 of AS 14 - Amalgamation, is explained herewith.

2.2-1. Classification An entity complying with AS may classify a contingent consideration as liability if it meets the definition of liability as provided in AS 29, Provisions, Contingent Liabilities and Contingent Assets. Accordingly, if the settlement of the consideration is expected to result in outflow of money or any other asset from the buyer, then it shall be classified as Liability. In any other case, the consideration would be classified as Equity.

In the first example of the introduction part, as the buyer has agreed to pay 20% of profits generated by the business during 3rd year in cash, it may be classified as Liability in the buyer’s books.

2.2-2. Recognition AS 14 provides that contingent consideration, being a liability, should be recognised only if the following 2 conditions are met: (i)

payment of consideration is probable, i.e. chances of outflow of money or other asset are more than 50%, and

(ii)

the amount of consideration can reasonably be estimated

So, if in the above example (introduction part) there is 70% chance that the business will make profits at the end of 3rd year and the profit is estimated at Rs. 50 lacs, then a liability for Rs. 10 lacs (20% of Rs. 50 lacs) may be recorded with corresponding increase to the cost of investments in the buyer’s standalone books.

As far as, contingent consideration classified as equity is concerned, the buyer may wait till the event on which the consideration is based takes place.

After happening of the event, equity share capital and cost of investment shall be increased by face value of additional shares after adjusting premium or discount, if any.

2.2-3. Initial measurement A buyer complying with AS, may value a contingent consideration, being liability, if recognised, on estimation basis which is explained above.

In case of equity, there is no need of initial valuation as the buyer is suggested to wait till actual happening of the event.

2.2-4. Subsequent measurement Once valued & recognised, there is no requirement of subsequent valuation of contingent consideration for entities complying with AS. The value remains same till it’s derecognition.

2.2-5. Derecognition A contingent consideration classified and recognised as liability is derecognised from the books when the buyer discharges it.

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2.2-6. Special Point Sometimes, contingent consideration also may give the buyer the right to the return of previously transferred consideration if specified conditions are met. In such case, the buyer complying with AS, may record an asset if return of previously transferred consideration becomes certain as per principles of AS 29.

3.0 Contingent Consideration in Standalone Books of Seller 3.1 Under Indian Accounting Standards (Ind AS) In Ind AS, the right to receive additional consideration in the form of money or any other financial asset or buyer’s equity shares can be recorded as financial asset in the seller’s book if meets the definition of a financial asset as provided in para 11 of Ind AS 32. Such financial asset is recorded at fair value and may be classified as financial asset subsequently measured amortised cost, or at fair value through profit or loss, or at fair value through other comprehensive income as per principles of Ind AS 109.

3.2 Under Accounting Standards (AS) There is no specific guidance is available for accounting of contingent consideration in the books of a seller of business under AS. However, the right to receive additional consideration in the form of money or any other asset can be recorded as receivable/asset in the books if its inflow to the seller is certain in accordance with AS 29. Such receivable shall be derecognised from the books upon receipt of the consideration. There is no general guidance over accounting of right to receive additional shares of buyer under AS.

4.0 Conclusion It is evident from the above guidance and explanations that the amount of contingent consideration can make big changes to financial statements of an entity, from goodwill to profit or loss of buyer. Therefore, accounting professionals must exercise proper care while making accounting treatment of it.

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Our Associations INCOME TAX DEPARTMENT

INDIAN INSTITUTE OF BANKING & FINANCE

INCOME-TAX APPELLATE TRIBUNAL

NATIONAL INSTITUTE OF SECURITIES MARKETS An Education Initiative of SEBI

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