A simple example to understand what is a contingent consideration in a business combination

Contingent consideration in a business combination is an obligation assumed by the acquiring entity to transfer additional assets or equity share to the acquired entity on the condition that this entity achieves specific objectives, such as an increase in sales or productivity.

Let’s look at the following example to better understand the concept of contingent consideration in a business combination

In 2005, the Cardiff group, a multinational company dedicated to selling sugary drinks, acquired 70% of the equity interest of a company located in Southeast Asia.

This is with the objective of expanding its operation and entering this market.

This group paid a sum of 553,000 million dollars for the shares of this Asian company.

This operation is known as a business combination, and the sum paid, equivalent to 553,000 million dollars for the shares of this company, is known as the consideration paid.

¿ Then, what is contingent consideration in a business combination ?

Using the same example that we have been analyzing, if Cardiff group decides that in addition to the 553,000 million, it will pay an additional sum of 50,000 dollars if, in the next four years, the entity located in Asia increases its net profit by a certain percentage, or the sales are increase by a certain level, this is known as contingent consideration in a business combination.

That is a conditional consideration on the acquired entity achieving some specific objectives.

Let’s see a practical example:

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Example of contingent consideration in a business combination paid in cash

In year 1, company A acquires 100% of the equity interest of entity B for 10,000.

Entity B’s identifiable assets are 19,000 and liabilities 7,000.

Furthermore, company A is willing to pay an additional 5,000 if, at the end of year 2, entity B’s sales increase by 10%.

The fair value of the consideration in the business combination at the beginning of year 1 equals 4,500, and the fair value at the end of this same year amounts to 4,700.

At the end of year 2, entity B’s sales increased by 15%.

Exercise solution:

The accounting record is as follows:

Example of contingent consideration paid in cash

To determine the value of goodwill, we must compare the total consideration versus the acquiree’s net identifiable assets and liabilities.

The total consideration is made up of the consideration paid plus the fair value of the contingent consideration.

Total consideration: 10,000 + 4,500 = 14,500

 Goodwill = Total consideration – Identifiable net assets and liabilities

Goodwill = 14,500 – (19,000 – 7,000) = 2,500

 As you can see in the example above, the acquiring entity must recognize goodwill resulting from paying a higher value for the identifiable assets and liabilities of entity B.

Thus, in the example that we have just analyzed, the contingent consideration payment meets the financial instrument definition; therefore, the entity will recognize changes in its fair value in profit and loss under paragraph 58 of IFRS. 3 numeral B.

Example of contingent consideration in a business combination with equity instruments

In year 1, company A acquires all the shares of entity B for 15,000.

Entity B’s identifiable assets and liabilities amount to 30,000 and 7,000, respectively.

In addition, company A is willing to pay a fixed number of shares if, at the end of year 2, entity B’s sales increase by 10%.

The fair value of the contingent consideration at the beginning of year 1 is equal to 12,000.

On the other hand, the fair value of the contingent consideration at the end of year 1 equals 12,800, and the fair value at the end of year 2 amounts to 13,500.

At the end of year 2, entity B’s sales increased by 20%

Exercise solution

The accounting record is as follows:

Example of contingent consideration paid in cash

As we can see, in subsequent years, until maturity, no changes are recognized in the fair value of the contingent consideration in a business combination under paragraph 58 of IFRS 3 numeral A.

In this way, when the contingent consideration in a business combination is calculated and its subsequent adjustment is with financial instruments such as cash or equity instruments, the goodwill are calculated in the same way by the two methods.

The only difference presented is that when the contingent consideration is calculated and paid with cash, the change in its fair value in profit and loss must be shown.

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