Acquired deferred consideration

What Is Acquired Deferred Consideration?

Acquired deferred consideration refers to a portion of the purchase price in a business combination that an acquirer agrees to pay to the former owners of an acquired company at a future date, contingent upon the achievement of specific future events or performance targets. This concept falls under the broader umbrella of financial reporting and mergers and acquisitions (M&A) accounting. Unlike a simple delayed payment, acquired deferred consideration is inherently tied to uncertainty, meaning the amount ultimately paid may vary or even be zero. It is recognized by the acquirer on its balance sheet as a liability or, in rare cases, an asset, and is measured at its fair value at the acquisition date.

History and Origin

The accounting treatment for business combinations, including acquired deferred consideration, has evolved significantly over time, primarily driven by changes in accounting standards designed to enhance transparency and comparability. Historically, the treatment of contingent consideration was less standardized, sometimes resulting in delayed recognition until the contingency was resolved. However, the introduction of FASB ASC 805, Business Combinations, significantly reformed this approach in the United States. This standard, effective for business combinations initiated after December 15, 2008, mandated that acquirers recognize the acquisition-date fair value of contingent consideration as part of the consideration transferred for the acquiree.¹⁴ This shift aimed to provide a more comprehensive and immediate picture of the full acquisition cost, aligning with the "acquisition method" of accounting.¹³ The updated guidance clarifies that if a new entity is formed to effect a business combination, one of the combining entities that existed before the business combination must be identified as the acquirer.¹²

Key Takeaways

• Acquired deferred consideration represents future payments in an M&A deal that depend on specific post-acquisition conditions.
• It is recognized at its acquisition-date fair value by the acquirer as a liability or, less commonly, an asset.
• The subsequent accounting for acquired deferred consideration depends on its classification: liabilities and assets are remeasured to fair value at each reporting date, with changes recognized in earnings, while equity-classified amounts are not remeasured.
• This mechanism is often used to bridge valuation gaps between buyers and sellers, particularly in deals involving private companies or high-growth sectors.
• It impacts the calculation of goodwill in a business combination.

Interpreting Acquired Deferred Consideration

When assessing acquired deferred consideration, its presence indicates that a portion of the acquisition's ultimate cost is variable and tied to the performance or achievement of specific milestones by the acquired entity. For financial statement users, understanding the nature and magnitude of this deferred payment is crucial. A large acquired deferred consideration component suggests that the initial purchase price was lower, with significant upside potential for the seller if the acquired business performs well. Conversely, it also implies a lower initial risk for the acquirer, as they avoid overpaying for anticipated performance that may not materialize.

Analysts interpret changes in the fair value of acquired deferred consideration liabilities on the income statement. An increase in the fair value of the liability (due to improved prospects for the targets to be met) typically results in a loss recognized in earnings, while a decrease (due to reduced probability of targets being met) results in a gain. This dynamic can impact reported profitability and should be considered when evaluating the financial performance of the combined entity. The classification of the contingent consideration (as a liability, equity, or asset) also determines its subsequent accounting treatment and how it impacts financial metrics.¹¹

Hypothetical Example

Consider Tech Innovations Inc. acquiring Creative Solutions Ltd. for a total consideration package. The agreed terms include an upfront cash payment of $50 million and acquired deferred consideration of up to $20 million. This $20 million is contingent on Creative Solutions Ltd. achieving certain revenue targets over the next two years post-acquisition.

At the acquisition date, Tech Innovations Inc. engages a valuation specialist to determine the fair value of this acquired deferred consideration. Based on projections and probabilities of meeting the revenue targets, the fair value is estimated at $12 million.

Journal Entry at Acquisition Date (Simplified):

Six months later, Creative Solutions Ltd. is performing better than initially expected, making it more probable that the higher revenue targets will be met. The fair value of the acquired deferred consideration is re-estimated at $15 million. Tech Innovations Inc. would record a $3 million loss on its income statement to reflect this increase in the liability. This change would also be reflected in the cash flow statement as a non-cash adjustment.

Practical Applications

Acquired deferred consideration, frequently structured as an earn-out, is a common feature in M&A deals for several reasons:

• Bridging Valuation Gaps: It allows buyers and sellers to agree on a purchase price when there's a significant disagreement on the future performance or value of the target company. The earn-out ties part of the payment to actual post-acquisition performance.¹⁰
• Risk Mitigation for Acquirers: Buyers can mitigate the risk of overpaying by making a portion of the purchase price contingent on the acquired business achieving predefined goals. This is particularly relevant in industries with uncertain future revenues, such as technology or biotechnology.
• Incentivizing Sellers: Sellers, who often remain with the acquired entity for a period, are incentivized to ensure the business performs well to maximize their earn-out payments.
• Startup and Private Company Acquisitions: Earn-outs are very common in the acquisition of private companies and startups where future profitability and growth can be difficult to predict.⁹ A Practice Note from Thomson Reuters provides a general discussion of earn-out provisions in private M&A transactions.⁸
• Accounting Treatment under ASC 805: Under U.S. Generally Accepted Accounting Principles (GAAP), specifically ASC 805, Business Combinations, acquired deferred consideration is measured at fair value on the acquisition date and subsequently remeasured if classified as a liability or asset.⁷ The Securities and Exchange Commission (SEC) provides guidance and interpretations on these accounting standards.⁶

Limitations and Criticisms

While acquired deferred consideration offers flexibility in M&A transactions, it also presents complexities and potential drawbacks. One significant limitation is the subjective nature of determining the initial fair value and subsequent remeasurements. This often requires the use of valuation specialists and can introduce judgment, making it a challenging aspect for both preparers and auditors of financial statements.⁵

Another area of concern revolves around potential disputes between the buyer and seller. The specific performance metrics, the length of the earn-out period, and operational control of the acquired business post-acquisition can lead to disagreements. For instance, the buyer's decisions regarding resource allocation or strategic direction might impact the seller's ability to achieve the earn-out targets. These complexities necessitate carefully drafted legal agreements to define performance metrics, reporting mechanisms, and dispute resolution processes.⁴ If not managed well, it can lead to litigation, eroding the potential benefits of the arrangement. Furthermore, the constant remeasurement of these liabilities can introduce volatility into the acquirer's earnings, which may obscure underlying operating performance.

Acquired Deferred Consideration vs. Contingent Consideration

The terms "acquired deferred consideration" and "contingent consideration" are often used interchangeably in the context of business combinations, but "acquired deferred consideration" specifically refers to the accounting recognition of contingent consideration from the acquirer's perspective after an acquisition.

• Contingent Consideration: This is the broader term describing any portion of the purchase price in a business combination that is dependent on future events or conditions. It's a contractual agreement.
• Acquired Deferred Consideration: This term emphasizes that the acquirer has recognized this contingent payment on its financial statements as a liability (or rarely, an asset) at the fair value as of the acquisition date. It signifies the accounting and reporting aspect of such a contingent payment from the buyer's perspective.

In essence, all acquired deferred consideration is a form of contingent consideration, but not all contingent consideration necessarily falls under the specific accounting context implied by "acquired deferred consideration" if it's not yet recognized or is handled differently in non-acquisition scenarios. The accounting standards, particularly ASC 805, mandate that contingent consideration be treated as acquired deferred consideration by the acquirer.³

FAQs

What is the primary purpose of acquired deferred consideration in an M&A deal?

The primary purpose is to bridge valuation gaps between the buyer and seller. It allows the buyer to pay less upfront while providing the seller with the potential for a higher overall purchase price if the acquired business performs well post-acquisition. It also helps manage the buyer's risk.

How is acquired deferred consideration accounted for on the balance sheet?

Acquired deferred consideration is typically recognized as a liability on the acquirer's balance sheet at its fair value on the acquisition date. This is mandated by accounting standards like ASC 805, which governs business combinations.

Does acquired deferred consideration impact goodwill?

Yes, it does. The fair value of acquired deferred consideration included in the total consideration transferred directly impacts the calculation of goodwill. An increase in acquired deferred consideration, all else being equal, will result in higher goodwill.

Can acquired deferred consideration be an asset?

While less common, acquired deferred consideration can be classified as an asset if it represents a right to receive consideration from the seller based on certain conditions being met, rather than an obligation to pay.² This might occur, for example, if the acquirer has a right to the return of previously transferred consideration under specific circumstances.

How does the fair value of acquired deferred consideration change over time?

If classified as a liability or asset, the fair value of acquired deferred consideration is remeasured at each subsequent reporting date. Changes in its fair value are generally recognized in the acquirer's earnings (income statement), reflecting the updated assessment of the probability and amount of the future payment or receipt.¹