Contingent Payments, Research Paper Example

There has been a continued change in the way that businesses acquire companies. One of the most dynamic changes is the contingent consideration. In business, there are transactions that take place that usually contain variables that are based on events in the future. These events are known as contingent payment sales because they are usually contingent on payments that occur in the future and the selling price of such transactions are usually not able to be determined as of the end of the year. There are a lot of uncertainties that surround such transactions and therefore there is usually a difficulty in computing the liability of taxes for such transactions. Contingent payments can also be defined as the type of installment sales in which either the price or payment period for what has been sold is not fixed. Such transactions usually have a special set of rules that vary depending on whether the fixed amount is the price or the schedule.

Contingent considerations are often a component of transaction where there exists between the person acquirer and the acquiree. There are usually various concerns with acquisitions and therefore the contingent consideration plan should be well structured so as to do away with such uncertainties and also help in eliminating the potential deal breakers that exist between the acquirers and the acquires. The contingent considerations are usually incorporated in the purchase agreement because they usually give the acquirer the ability to share the risk that is associated with the future performance of the business with the person who is acquiring the business. It also allows the person acquiring the business to participate in upside post closure of the business before the business is officially handed over to him or her. The agreement of purchase also provides an incentive for the person acquiring the business to remain involved in the business in a productive way before the business is closed or handed over to them. The components of contingency payments usually include financial thresholds such as sales but they are not limited to them.

Contingent considerations can be defined as earn outs or claw backs and they are usually classified as equity or asset liabilities. An earn out is an obligation of the acquirer if he or she is required to transfer the additional assets or equity interests to the previous owners as part of the exchange process but only if the events that have been specified to occur in the future actually occur or the conditions set forth to such events are met. A contingency can however be considered as a liability if the number of shares is variable or has a feature of cash settlement. It is however considered as equity if the number of shares is fixed. A claw back is the right of the person making an acquisition to the return of considerations that had been previously transferred if the specific conditions set towards it are met. The claw back contingency is considered as an asset.

The re-measurement of the fair value of the contingency after each reporting date is not required and there would be account of subsequent settlement of the amount if the contingency is classified as equity. If the contingency is classified as either an asset or a liability then the re-measurement of the fair value of the assets and liabilities from the reporting date is necessary until the contingency is resolved. The contingent consideration is supposed to be recognized at the acquisition date as part of the transferred acquisition. The arrangements made between the acquiree and the acquirer under the contingent consideration will be measured at fair value. Such contingencies if left unresolved from the previous acquiree transactions can have a very big impact on earnings volatility of the acquirer. The reporting of contingency payments is usually different especially under the accounting standards that were there before and that are there now after various reforms. Due to the nature of the contingent consideration structures, the most appropriate and commonly used to value such contingencies is the income approach. The asset or coast approach is not suitable for quantifying the inherent complexity of the acquisition or that of the contingency consideration. If the earn out structure is very complex then a single scenario cash flow analysis will be the most appropriate method to be used.

Accounting for contingent considerations under mergers and acquisitions are very complicated. When the buyer and seller cannot agree on the total price of the purchase made then the two parties will agree to an additional payment or contingent consideration which will be based on the outcomes of the events of the future. Such payments are usually referred to as earn outs and they are they are based on the targets of revenue and earnings that the company that is acquired should achieve after the acquisition date. In the past, the earn outs were generally accounted for as part of the cost of the acquisition when settled which means that there was no accounting done at the acquisition date.

However, when the buyer paid the seller pursuant to the earn-out arrangement, the buyer would record that amount as additional purchase price. It did not matter that there was no agreement between the buyer and the seller on the amount. Under the new standards, buyers must recognize earn-outs on the acquisition date therefore even though the buyer and the seller do not agree on the total purchase price then the buyer is now required to determine the fair value of the earn-out and recognize that amount in the purchase price. Basically when dealing with contingent consideration structures, then the management of the company and their valuation specialists must keep in mind that the analysis should rigorously decompose the contingent structure to facilitate understanding for all stakeholders that are involved in the process. The management should also ensure that the analysis should be kept as simple as possible to provide the transparency and help in the process of audit review. The valuation specialist should also apply a valuation methodology to the contingent structure that is an industry standard methodology if there is such a possibility.