The examples consider various contingent consideration arrangements and provide analysis for determining the classification of contingent consideration arrangements as a liability or as equity. The examples assume Company A is a public company and would issue the same class of shares as its publicly traded shares if the contingent performance measures are achieved. The analyses below for nonpublic entities would generally be the same, except that most nonpublic companies would not have a means to net cash settle the arrangement outside the contract since their shares are not readily convertible to cash. However, our experience is that most contingent consideration arrangements involving nonpublic companies include net settlement provisions within the contract. Without net settlement, the arrangement would not be considered a derivative within the scope of
ASC 815. If an arrangement was not considered a derivative due to physical settlement terms or for any other reason, it would still need to meet the conditions of
ASC 815-40 to be classified as equity. If the contingent consideration is not classified in equity, it is required to be reported at fair value with changes in fair value reflected in earnings in accordance with
ASC 805-30-35-1(b).
The examples provided in this section assume common shares are non-redeemable.
- Example BCG 2-22 illustrates a contingent consideration arrangement when a fixed number of shares is issued based on an entity’s performance.
- Example BCG 2-23 illustrates a contingent consideration arrangement when a variable number of shares is issued based on an entity’s performance and there is only one discrete performance period.
- Example BCG 2-24 illustrates a contingent consideration arrangement that is linked to the acquisition-date fair value.
- Example BCG 2-25 provides an example of a contingent consideration arrangement when a fixed number of shares is issued based on another entity’s operations.
- Example BCG 2-26 illustrates a contingent consideration arrangement when a variable number of shares is issued based on an entity’s performance and there are multiple performance periods.
EXAMPLE BCG 2-22
Issuance of a fixed number of shares based on entity’s performance
Company A, a publicly traded company, acquires Company B in a business combination by issuing 1 million of Company A’s common shares to Company B’s shareholders. Company A also agrees to issue 100,000 additional common shares to the former shareholders of Company B if Company B’s revenues (as a wholly owned subsidiary of Company A) exceed $200 million during the one-year period following the acquisition.
Company A has sufficient authorized and unissued shares available to settle the arrangement after considering all other commitments. The contingent consideration arrangement permits settlement in unregistered shares and meets all of the other criteria required by
ASC 815-40 for equity classification. The company has concluded that there is one unit of account since there is only one performance target.
How should the issuance of a fixed number of shares based on Company B's performance be recognized?
Analysis
The common shares of Company A that have been issued at the acquisition date are recorded at fair value within equity. The contingent consideration arrangement is not within the scope of
ASC 480. That is, at inception, the arrangement will not result in the issuance of a variable number of shares and the arrangement does not obligate Company A to transfer cash or other assets to settle the arrangement.
The contingent consideration arrangement meets the characteristics of a derivative because it (1) has one or more underlyings (Company B’s revenues and Company A’s share price) and notional amount (100,000 common shares), (2) has an initial investment that is “less by more than a nominal amount” than the initial net investment that would be required to acquire the asset, and (3) can be settled net by means outside the contract because the underlying shares are publicly traded with sufficient float so that the shares are readily convertible to cash.
In determining whether the derivative instrument is in the scope of
ASC 815, the instrument must be evaluated to determine if it is subject to the exception in
ASC 815-10-15-74(a) (i.e., the arrangement is indexed to an entity’s own stock and classified in shareholders’ equity). In determining whether the arrangement is considered indexed to Company A’s own shares, the first step is to determine whether there are exercise contingencies and, if so, if they are based on an observable market, other than the market for the issuer’s shares, or an observable index, other than an index calculated solely by reference to the issuer’s operations. The exercise contingency (i.e., meeting the revenue target) is based on an index calculated solely by reference to the “operations” of the issuer’s consolidated subsidiary, so step one of
ASC 815-40-15 does not preclude the arrangement from being considered indexed to Company A’s own shares. In performing step two of
ASC 815-40-15, it has been determined that the settlement of the arrangement is considered fixed-for-fixed, since the exercise price is fixed and the number of shares is fixed (i.e., the settlement amount equals the difference between the fair value of a fixed number of the entity’s equity shares and a fixed monetary amount).
Based on the analysis performed, the contingent consideration arrangement would be classified as equity if all of the other criteria in
ASC 815-40 for equity classification have been satisfied and classification as mezzanine equity is not required under
ASC 480-10-S99.
EXAMPLE BCG 2-23
Issuance of a variable number of shares based on entity’s performance: single performance period
Company A, a publicly traded company, purchases Company B in a business combination by issuing 1 million of Company A’s common shares to Company B’s shareholders. Company A also agrees to issue 100,000 additional common shares to the former shareholders of Company B if Company B’s revenues (as a wholly owned subsidiary of Company A) equal or exceed $200 million during the one-year period following the acquisition. In addition, if Company’s B’s revenues exceed $200 million, Company A will issue an additional 1,000 shares for each $2 million increase in revenues in excess of $200 million, not to exceed 100,000 additional shares (i.e., 200,000 total shares for revenues of $400 million or more).
Company A has sufficient authorized and unissued shares available to settle the arrangement after considering all other commitments. The contingent consideration arrangement permits settlement in unregistered shares and meets all of the other criteria required by
ASC 815-40 for equity classification.
How should the issuance of a variable number of shares based on Company B's performance be recognized?
Analysis
The common shares of Company A that have been issued at the acquisition date are recorded at fair value within equity. The contingent consideration arrangement must first be assessed to determine whether each of the performance targets represents a separate contract. Since the number of Company A shares that could be issued under the arrangement is variable and relates to the same risk exposure (i.e., the number of shares to be delivered will vary depending on which performance target is achieved in the one-year period following the acquisition), the contingent consideration arrangement would be considered one contractual arrangement. The arrangement may be within the scope of
ASC 480 since it is an obligation to issue a variable number of shares and it varies based on something other than the fair value of the issuer’s equity shares (in this case, based on Company B’s revenues). A determination would need to be made as to whether the arrangement’s monetary value at inception is based solely or predominantly on Company B’s revenues (versus Company A’s share price), which, if so, would require liability classification. This determination would be based on facts and circumstances, but generally the more substantive (i.e., difficult to achieve) the revenue target, the more likely the arrangement is based predominantly on the revenue target. If the arrangement is determined to be predominantly based on revenues, it would be considered a liability under
ASC 480.
For the purpose of this example, assume that Company A determines the arrangement is not based solely or predominantly on Company B’s revenues. Although the contingent consideration arrangement is not required to be classified as a liability under
ASC 480, liability classification would still be required because the arrangement would also not meet the second step of
ASC 815-40-15 for equity classification. The settlement amount of the contingent consideration arrangement incorporates variables other than those used to determine the fair value of a fixed-for-fixed forward or option on equity shares (i.e., one of the key variables to determine fair value for this contingent consideration arrangement is Company B’s revenues). In other words, the amount of revenues not only determines whether the exercise contingency is achieved, but also adjusts the settlement amount after the exercise contingency is met. Therefore, the contingent consideration arrangement would not be considered indexed to Company A’s shares because the settlement provisions are affected by the amount of revenues which is not an input in valuing a fixed-for-fixed equity award. Therefore, the contingent consideration arrangement would be recorded as a liability at its fair value following the guidance in
ASC 805-30-25-6. Further, changes in the liability will be recognized in Company A’s earnings until the arrangement is resolved in accordance with
ASC 805-30-35-1(b).
EXAMPLE BCG 2-24
Contingent consideration arrangement linked to the acquisition-date fair value
Company A, a publicly traded company, acquires Company B in a business combination by issuing 1 million of Company A’s common shares to Company B’s shareholders. At the acquisition date, Company A’s share price is $40 per share. Company A also provides Company B’s former shareholders contingent consideration whereby if the common shares of Company A are trading below $40 per share one year after the acquisition date, Company A will issue additional common shares to the former shareholders of Company B sufficient to make the current value of the acquisition date consideration equal to $40 million (i.e., the acquisition-date fair value of the consideration transferred). However, the number of shares that can be issued under the arrangement cannot exceed 2 million shares.
Company A has sufficient authorized and unissued shares available to settle the arrangement after considering all other commitments. The contingent consideration arrangement permits settlement in unregistered shares and meets all of the other criteria required by
ASC 815-40 for equity classification.
How should the contingent consideration agreement linked to the acquisition-date fair value be recognized?
Analysis
The common shares of Company A that have been issued at the acquisition date are recorded at fair value within equity. The security price guarantee feature of the contingent consideration arrangement should be assessed to determine whether it is a freestanding feature or whether it is embedded within the shares issued in the business combination. In this instance, the guarantee is a freestanding financial instrument that was entered into in conjunction with the purchase agreement and is legally detachable and separately exercisable. The guarantee arrangement is within the scope of
ASC 480 (
ASC 480-10-25-14(c)) since, at inception, the guarantee arrangement creates an obligation that Company A would be required to settle with a variable number of Company A’s equity shares, the amount of which varies inversely to changes in the fair value of Company A’s equity shares. For example, if Company A’s share price decreases from $40 per share to $35 per share one year after the acquisition date, the amount of the obligation would be $5 million. Therefore, the freestanding guarantee would be recorded as a liability at its fair value following the guidance in
ASC 805-30-25-6. Further, changes in the liability will be recognized in Company A’s earnings until the arrangement is resolved in accordance with
ASC 805-30-35-1(b).
EXAMPLE BCG 2-25
Issuance of a fixed number of shares based on another entity’s operations
Company A, a publicly traded company, acquires Company B in a business combination by issuing 1 million of Company A’s common shares to Company B’s shareholders. Company A also agrees to issue 100,000 additional common shares to the former shareholders of Company B if Company B’s operating revenues (as a wholly-owned subsidiary of Company A) exceed Company X’s (its largest third-party competitor) operating revenues by $1 million at the end of the one-year period following the acquisition.
Company A has sufficient authorized and unissued shares available to settle the arrangement after considering all other commitments. The contingent consideration arrangement permits settlement in unregistered shares and meets all of the other criteria required by
ASC 815-40 for equity classification. Company A has concluded that there is one unit of account since there is only one performance target.
How should the issuance of a fixed number of shares based on another entity’s operations be recognized?
Analysis
The common shares of Company A that have been issued at the acquisition date are recorded at fair value within equity. The contingent consideration arrangement is not within the scope of
ASC 480. That is, at inception the arrangement will not result in the issuance of a variable number of shares and the arrangement does not obligate the Company to transfer cash or other assets to settle the arrangement.
The contingent consideration arrangement meets the characteristics of a derivative because it (1) has one or more underlyings (Company B’s operating revenues, Company X’s operating revenues, and Company A’s share price) and notional amount (100,000 common shares), (2) has an initial investment that is “less by more than a nominal amount” than the initial net investment that would be required to acquire the asset, and (3) can be settled net by means outside the contract because the underlying shares are publicly traded with sufficient float so that the shares are readily convertible to cash.
In determining whether the derivative instrument is in the scope of
ASC 815, the instrument must be evaluated to determine if it is subject to the exception in
ASC 815-10-15-74(a) (i.e., the arrangement is indexed to an entity’s own stock and classified in shareholders’ equity). In making the determination of whether the arrangement is considered indexed to Company A’s own stock, the first step would be to determine whether there are exercise contingencies and, if so, if they are based on an observable market, other than the market for the issuer’s shares, or an observable index, other than an index calculated solely by reference to the issuer’s operations. The exercise contingency requires Company B’s operating revenues to exceed Company X’s (largest third-party competitor) operating revenues by $1 million at the end of the one-year period following the acquisition and, therefore, is based on an index that is not calculated solely by reference to the issuer’s operations (i.e., the index is a comparison to Company X’s revenues). This precludes the arrangement from being considered indexed to Company A’s own stock. Therefore, it is not necessary to perform the second step of
ASC 815-40-15.
Since the arrangement is not considered indexed to Company A’s own stock under
ASC 815-40-15, the arrangement is a liability and should be subsequently measured at fair value with changes in fair value recorded in earnings in accordance with
ASC 805-30-35-1(b).
EXAMPLE BCG 2-26
Issuance of a variable number of shares based on entity’s performance: multiple performance periods
Company A, a publicly traded company, acquires Company B in a business combination by issuing 1 million of Company A’s common shares to Company B’s shareholders. Company A also agrees to issue 100,000 common shares to the former shareholders of Company B if Company B’s revenues (as a wholly-owned subsidiary of Company A) equal or exceed $200 million during the one-year period following the acquisition. Furthermore, Company A agrees to issue an additional 50,000 common shares to the former shareholders of Company B if Company B’s revenues (as a wholly-owned subsidiary of Company A) equal or exceed $300 million during the second one-year period following the acquisition. The achievement of the earnouts is independent of each other (i.e., outcomes could be zero, 50,000, 100,000 or 150,000 additional shares issued).
Company A has sufficient authorized and unissued shares available to settle the arrangement after considering all other commitments. The contingent consideration arrangement permits settlement in unregistered shares and meets all of the other criteria required by
ASC 815-40 for equity classification.
How should the issuance of a variable number of shares based on Company B's performance be recognized?
Analysis
The common shares of Company A that have been issued at the acquisition date are recorded at fair value within equity. The contingent consideration arrangement must first be assessed to determine whether each of the performance targets represents a separate contract. Since this is a contingent consideration arrangement subject to
ASC 805, and the year one and year two outcomes are independent and do not relate to the same risk exposures (i.e., the number of shares to be delivered will vary depending on performance targets achieved in independent one-year periods following the acquisition), the arrangement would be treated as two separate contracts that would each result in the delivery of a fixed number of shares, and not as a single contract that would result in the delivery of a variable number of shares. As a result, the arrangement is not within the scope of
ASC 480. That is, at inception, the separate arrangements will not result in the issuance of a variable number of shares and do not obligate Company A to transfer cash or other assets to settle the arrangement.
The contingent consideration arrangement meets the characteristics of a derivative because it (1) has one or more underlyings (Company B’s revenues and Company A’s share price) and a notional amount (common shares of Company A), (2) has an initial investment that is “less by more than a nominal amount” than the initial net investment that would be required to acquire the asset, and (3) can be settled net by means outside the contract because the underlying shares are publicly traded with sufficient float so that the shares are readily convertible to cash.
In determining whether the derivative instruments are in the scope of
ASC 815, the instruments must be evaluated to determine if they are subject to the exception in
ASC 815-10-15-74(a) (i.e., the arrangements are indexed to an entity’s own stock and classified in shareholders’ equity). In making the determination of whether the independent arrangements are considered indexed to Company A’s own stock, the first step would be to determine whether each separate, independent contract has an exercise contingency that is based on an observable market, other than the market for the issuer’s shares, or an observable index, other than an index calculated solely by reference to the issuer’s operations. The exercise contingency (i.e., meeting the revenue target) is based on an index calculated solely by reference to the “operations” of the issuer’s consolidated subsidiary, so step one of
ASC 815-40-15 does not preclude the independent arrangements from being considered indexed to Company A’s own shares. In performing the second step of
ASC 815-40-15, it has been determined that the settlements for each separate, independent contract would be considered fixed-for-fixed since the exercise price is fixed and the number of shares is fixed (i.e., the settlement amounts are equal to the price of a fixed number of equity shares). The arrangement is for the issuance of the common shares of Company A, which are classified as shareholders’ equity.
Based on the analysis performed, assuming the other requirements in
ASC 815-40 are met and classification as mezzanine equity is not required under
ASC 480-10-S99, each independent contract within the contingent consideration arrangement would be classified as equity.
For contingent consideration arrangements in a business combination, judgment is required to determine whether the unit of account should be the overall contract or separate contracts within the overall arrangement. For instance, an arrangement to issue 100,000 shares if revenues equal or exceed $200 million in the one-year period following the acquisition or 110,000 shares if revenues equal or exceed $220 million in the one-year and one-month period following the acquisition would likely be considered a single overall contract with multiple performance targets. That is, the performance targets for both the one-year and the one-year and one-month periods are largely dependent on achieving the revenue targets in the first year given the short duration of time (i.e., one month) that elapses between the end of the first period and the end of the second period. If the arrangement (or multiple performance targets) relates to the same risk exposure, the unit of account would be the overall contract rather than two separate, independent contracts.