Current issues in accounting for business combinations: as the numbers of mergers and acquisitions contine to rise, so too, do the valuation and accounting challenges--particularly in light of changing rules.

• Author: Patel, P.J.
• Position: ACCOUNTING

In December 2007, SFAS 141R--now known as ASC 805--was issued to govern accounting and reporting standards, effective for all acquisitions taking place after Jan. 1, 2009. Because merger and acquisition activity was extremely low through the first half of 2009, there were very few opportunities to apply the new standard.

But as M&A activity has increased since mid-2009, so too, have the accounting challenges in completing these acquisitions. Coupled with an uncertain economic environment, the application of ASC 805 raises important questions and deal-structuring issues.

Valuing Contingent Consideration

Contingent consideration is generally defined as a potential future obligation of the acquirer to transfer additional assets or equity to the seller. There are several issues involved with accounting for the contingent consideration, which include:

* Whether the future payment is contingent consideration or employee compensation;

* The incorporation of ASC 820 (SFAS 157) fair value and market participant considerations; and

* Methods for determining fair value.

The first issue is determining whether the future payment qualifies as contingent consideration. ASC 805 provides guidance for determining whether it's a contingent consideration or future compensation. In short, if the seller is receiving consideration for the business, the future payment is deemed contingent consideration. In contrast, if the individual is being paid for his or her services to the acquiring company, the payment is deemed compensation and thus expensed post-transaction.

In a business combination, a contingent payment can be structured in a number of ways--a revenue or earnings threshold, a percent of revenue, earnings or milestones, among others. Based on the structure, most instances of contingent consideration are liabilities, though there are situations where it is classified as equity or even an asset.

In any case, ASC 820 provides valuation guidance. It defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Based on experience and observations, the most common approach to valuing contingent consideration is to use a probability-adjusted income approach. In this approach, a range of potential outcomes is determined and probabilities are assigned to each outcome. The probability of achieving different outcomes, along with the contingent payment that would occur for each, is used to determine a weighted average or expected contingent payment.

It is worth noting that the payouts are often non-linear...