Consideration transferred

What Is Consideration Transferred?

Consideration transferred refers to the aggregate of the fair value of the assets transferred by the acquirer, the liabilities incurred by the acquirer to former owners of the acquiree, and the equity interests issued by the acquirer in a business combination. This concept is a fundamental component of financial accounting, specifically under the acquisition method for mergers and acquisitions (M&A) as outlined in accounting standards like FASB ASC 805, Business Combinations. It represents the total payment made by one entity to gain control over another business. The measurement of consideration transferred is crucial for accurately determining the purchase price and, subsequently, the amount of goodwill or gain from a bargain purchase recognized in the transaction.

History and Origin

The concept of consideration transferred in business combinations gained prominence with the evolution of accounting standards for mergers and acquisitions. Historically, various methods were used to account for such transactions, including the "pooling-of-interests" method. However, with the issuance of Statement of Financial Accounting Standards No. 141 (FAS 141) by the Financial Accounting Standards Board (FASB), later revised as FAS 141(R) and codified into ASC 805, the acquisition method became the sole method for accounting for business combinations in the United States. This shift emphasized a fair value approach for all identifiable assets acquired and liabilities assumed, as well as for the consideration transferred. The U.S. Securities and Exchange Commission (SEC) has also provided interpretive guidance through Staff Accounting Bulletins (SABs) to ensure consistency with these accounting standards¹⁷, ¹⁸. The updated standards aimed to provide a more transparent and economically relevant representation of M&A transactions on financial statements¹⁶.

Key Takeaways

• Consideration transferred is the total payment made by an acquirer in a business combination.
• It is measured at the fair value of assets transferred, liabilities incurred, and equity interests issued on the acquisition date.
• The accurate measurement of consideration transferred is essential for calculating goodwill or gain on a bargain purchase.
• Common forms of consideration include cash, stock, or a combination thereof.
• The accounting for consideration transferred is governed by specific financial accounting standards, such as FASB ASC 805.

Formula and Calculation

The calculation of consideration transferred in a business combination, according to accounting standards, is the sum of the acquisition-date fair values of various components.

The formula for consideration transferred is:

Where:

• Fair Value of Assets Transferred: This includes any cash paid, other non-cash assets given up by the acquirer, or a business or subsidiary of the acquirer.
• Fair Value of Liabilities Incurred: These are obligations assumed by the acquirer on behalf of the former owners of the acquiree.
• Fair Value of Equity Interests Issued: This refers to the value of the acquirer's own equity interests (e.g., common stock, preferred stock, options, warrants) issued to the former owners of the acquiree.

Additionally, contingent consideration (e.g., earn-outs) is also recognized at its acquisition-date fair value as part of the total consideration transferred¹⁴, ¹⁵.

Interpreting the Consideration Transferred

Interpreting the consideration transferred involves understanding not just the total amount, but also its composition and how it impacts the acquirer's balance sheet and future financial performance. A high amount of consideration transferred, particularly relative to the net identifiable assets acquired, generally results in a larger amount of goodwill being recognized. Goodwill represents intangible assets not separately identifiable, such as reputation, customer relationships, or synergistic benefits.

The form of consideration—whether primarily cash, stock, or a mix—also provides insights. An all-cash deal may indicate the acquirer has strong cash reserves or access to financing, while an all-stock deal suggests a desire to preserve cash or leverage a high stock valuation. The choice impacts the acquirer's capital structure and potential dilution of existing shareholders' ownership.

#¹², ¹³# Hypothetical Example

Suppose Alpha Corp. acquires Beta Solutions.

Alpha Corp. agrees to pay Beta Solutions' former owners:

• $50 million in cash.
• $20 million in newly issued common stock of Alpha Corp. (measured at its fair value on the acquisition date).
• An additional $5 million contingent consideration (earn-out) if Beta Solutions achieves certain revenue targets over the next two years, with the fair value of this earn-out estimated at $3 million on the acquisition date.

To calculate the total consideration transferred:

• Cash transferred: $50,000,000
• Fair value of stock issued: $20,000,000
• Fair value of contingent consideration: $3,000,000

The total consideration transferred by Alpha Corp. for the acquisition of Beta Solutions is $73,000,000. This amount would then be compared to the fair value of the identifiable assets acquired and liabilities assumed to determine the amount of goodwill to be recognized.

Practical Applications

Consideration transferred is a critical element in various aspects of finance and accounting:

• Mergers and Acquisitions (M&A): It forms the core of the purchase price allocation in a business combination. Accurate measurement is vital for financial reporting and for valuing the acquired entity. Th¹¹e form of consideration chosen, whether cash, stock, or a mix, significantly impacts deal structuring, financing, and the acquirer's capital structure. Fo¹⁰r example, Microsoft's acquisition of LinkedIn in 2016 was an all-cash deal, demonstrating the acquirer's confidence and immediate liquidity provided to sellers.
• ⁹ Financial Reporting: Companies are required to disclose the details of the consideration transferred in their financial statements following a business combination. This transparency allows investors and analysts to understand how an acquisition was funded and its impact on the company's financial position.
• ⁸ Valuation: Understanding the components of consideration transferred is crucial for financial analysts in performing due diligence and assessing the true cost of an acquisition. It directly influences the calculation of goodwill, which is the residual amount after allocating the consideration to identifiable assets and liabilities.
• Regulatory Compliance: Regulatory bodies, such as the SEC, closely scrutinize how consideration transferred is accounted for in business combinations, ensuring compliance with U.S. GAAP and other relevant pronouncements. Th⁶, ⁷e SEC provides detailed guidance through its Staff Accounting Bulletins to ensure consistency in practice across reporting entities.

#⁵# Limitations and Criticisms

While the concept of consideration transferred is fundamental to business combinations, its application can present challenges and has faced some criticisms:

• Fair Value Measurement Complexity: A significant limitation lies in the subjective nature of measuring the fair value of certain forms of consideration, especially complex equity interests or contingent consideration. Estimating these values can require significant judgment and assumptions, which may introduce volatility or potential for manipulation.
• ⁴ Impact on Post-Acquisition Profitability: Accounting rules for business combinations, including how consideration transferred is allocated, can significantly impact an acquirer's reported post-acquisition profitability. For instance, writing acquired assets up to fair value can lead to higher depreciation and amortization expenses, potentially lowering reported earnings. Re³search indicates that investors and analysts may not always fully incorporate these accounting effects when assessing post-acquisition performance.
• ² Distortion of Economic Reality: Critics argue that the accounting treatment, particularly the recognition of goodwill as a residual, might not always perfectly reflect the economic substance of an acquisition. The emphasis on recognizing all identifiable assets and liabilities at fair value can sometimes obscure the underlying business rationale or the true value drivers of a deal.
• ¹ Acquisition-Related Costs: Costs incurred directly related to the acquisition, such as advisory fees or legal expenses, are generally expensed as incurred rather than being included in the consideration transferred. This approach, while simplifying the measurement of consideration, means these direct costs of the transaction do not enhance the cost basis of the acquired assets.

Consideration Transferred vs. Contingent Consideration

Consideration transferred represents the total value given by an acquirer in a business combination. It is the overarching measure of what the acquirer provides to gain control of the acquiree. This total can comprise various elements, including cash, the acquirer's own equity interests, assumed liabilities, and even non-cash assets transferred.

Contingent consideration, on the other hand, is a specific component of the total consideration transferred. It refers to an obligation of the acquirer to transfer additional assets or equity interests to the former owners of the acquiree if specified future events occur or conditions are met, such as achieving certain financial targets or milestones. While contingent consideration is measured at its fair value at the acquisition date and included in the overall consideration transferred, it is distinct in that its payment is dependent on future events. The value of the contingent consideration can change over time based on actual performance or revised expectations, impacting subsequent financial reporting, whereas the initial measurement of other components of consideration transferred is generally fixed at the acquisition date.

FAQs

Q: What forms can consideration transferred take?
A: Consideration transferred can take many forms, including cash, the acquirer's equity instruments (such as stock or options), other assets transferred, and liabilities incurred on behalf of the former owners of the acquiree. Contingent consideration, like earn-out clauses, is also included at its fair value.

Q: Why is it important to measure consideration transferred accurately?
A: Accurate measurement of consideration transferred is crucial for determining the correct amount of goodwill (or gain from a bargain purchase) that results from a business combination. This directly impacts the acquirer's balance sheet and future financial reporting.

Q: Does consideration transferred include acquisition-related costs?
A: No, acquisition-related costs such as legal, accounting, valuation, and advisory fees are generally not included in the consideration transferred. These costs are typically expensed as incurred by the acquirer, separate from the measurement of the consideration given for the acquiree itself.