Last editedDec 20213 min read
Typically used in mergers and acquisitions, deferred and contingent consideration will impact your accounting processes. Here’s a closer look at what deferred consideration means for accounting as well as the contingent consideration meaning in business.
What does deferred consideration mean?
Deferred consideration in accounting refers to a portion of an agreed-upon purchase price that the buyer will pay at a future date. First, the purchase price is negotiated using a firm’s fair market value. It can then be broken down with a portion of payment due up front, and a portion deferred.
Payments might include cash, stocks, and future payouts as well as the payment of the target firm’s liabilities. Upfront payments usually either involve equity in the buying firm or the commitment to pay cash when targets are achieved.
When future or deferred payments are agreed, the terms should clearly outline factors including collateral, interest rates, and payment intervals. By using deferred consideration, the buyer has a chance to defer their acquisition cost for better management of the overall buyout.
There is, however, some risk involved for the seller when final payments are deferred. To mitigate this risk, they might ask for a higher upfront payment at a reduced overall rate. They might also use tools like bank guarantees or some form of collateral.
What is the difference between contingent consideration and deferred consideration?
The contingent consideration meaning in business is nearly identical to deferred consideration. Like deferred considerations, contingent considerations describe the amount that will be paid to a seller at a future date, typically as part of an acquisition or merger. However, a deferred contingent consideration is dependent on defined factors such as financial performance. The buyer will pay the seller, but this payment is contingent on the consideration in question.
For accounting purposes, contingent consideration could be recognized on the balance sheet as either an equity or liability. It’s also important to note that a contingent consideration doesn’t always refer to payments of cash or shares. While these considerations are often calculated based on financial metrics like revenue, taxes, or gross profit, some companies will use industry-specific metrics. For example, a pharmaceutical company might use metrics like the success of clinical trials as its metric.
How does contingent consideration accounting work?
Both deferred and contingent considerations involve an agreement to receive future payments, so how do you account for these in your financial records? Contingent considerations should be recorded on the date of acquisition. They’ll be listed at fair value either as a liability or equity. In most cases, you’ll recognize the consideration as a liability. However, if a fixed number of shares is involved, the consideration would qualify as equity.
Fair value changes over time, so it’s important to adjust the contingent consideration occasionally to reflect any changes in value. Resulting gains and losses should then be recognized on the income statement. This only applies to liabilities, however, as equity value won’t need to be adjusted.
So, how can you calculate value for contingent consideration accounting purposes? There are a number of methods to choose from, but typically a discounted cash flow method is a popular choice.
Contingent consideration accounting example
We can better illustrate how this works with a contingent consideration accounting example:
Imagine that Company Y acquires Company Z. It does this by issuing 2 million common shares as initial payment, with the agreement to pay out 0.5 million additional shares. However, this additional payment is contingent on Company Z’s future revenue. Company Z must earn an average of $30 million per year over the next three years. Current stock prices for Company Y are $50 and $20 for Company Z, with a 50% chance that Company Z will meet the target.
The fixed upfront payment of this consideration is (2 million x $50) = $100 million. However, there’s only a 50% chance that Company Z will meet its earnings targets, in which case Company Y would transfer the additional shares. To calculate the expected value of contingency consideration, you’d multiply (0.5 million x $50 x 0.5) to equal $12.5 million. Company Z would need to use a method like the discounted cash flow to find out what the value of these shares would be now, adjusting for factors like inflation. The transaction should be recorded as equity accordingly.
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