Buyers and sellers of businesses in recent times are coming up with innovative deal structures that use contingent consideration and other instruments that allow the buyer and seller to share the economic risks for a period of time. When buyers and sellers cannot agree on the value of a business, contingent consideration arrangements are a common way to close the deal. In these arrangements, part of the purchase price is contingent on future events or conditions. Contingent consideration arrangements often depend on the acquiree meeting certain financial targets, such as revenues, Earnings Before Interest and Taxes (EBIT) or net income. It may also depend on other events, such as achieving a technical milestone (e.g., drug or patent approval).
Question
How does a seller of a business account for the contingent consideration?
Analysis
There is no direct guidance on accounting for contingent consideration under Indian GAAP from a seller’s perspective. Guidance is available under AS 14 Accounting for Amalgamations with respect to contingent consideration for the purposes of acquisition accounting. The provision relating to AS 14 Accounting for Amalgamations is set out below.
AS 14 Accounting for Amalgamations
15. Many amalgamations recognise that adjustments may have to be made to the consideration in the light of one or more future events. When the additional payment is probable and can reasonably be estimated at the date of amalgamation, it is included in the calculation of the consideration. In all other cases, the adjustment is recognised as soon as the amount is determinable.
It may also be worthwhile to consider guidance in AS 9 Revenue Recognition though AS 9 applies to goods and services and not to sale of a business.
AS 9 Revenue Recognition
9.1 Recognition of revenue requires that revenue is measurable and that at the time of sale or the rendering of the service it would not be unreasonable to expect ultimate collection.
9.4 An essential criterion for the recognition of revenue is that the consideration receivable for the sale of goods, the rendering of services or from the use by others of enterprise resources is reasonably determinable. When such consideration is not determinable within reasonable limits, the recognition of revenue is postponed.
11. In a transaction involving the sale of goods, performance should be regarded as being achieved when the following conditions have been fulfilled:
(i) the seller of goods has transferred to the buyer the property in the goods for a price or all significant risks and rewards of ownership have been transferred to the buyer and the seller retains no effective control of the goods transferred to a degree usually associated with ownership; and
(ii) no significant uncertainty exists regarding the amount of the consideration that will be derived from the sale of the goods.
The guidance in AS 29 Provisions, Contingent Liabilities and Contingent Assets can also be applied by analogy.
AS 29 Provisions, Contingent Liabilities and Contingent Assets
Definition of a contingent asset: A contingent asset is a possible asset that arises from past events the existence of which will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the enterprise.
32. Contingent assets are not recognised in financial statements since this may result in the recognition of income that may never be realised. However, when the realisation of income is virtually certain, then the related asset is not a contingent asset and its recognition is appropriate.
Author’s point of view
All the three standards viz., AS-9, AS-14 and AS-29 seem to uphold the concept of probability in recognition of revenue or gain. A careful analysis of AS-29 definition of contingent asset also indicates that if recovery is probable then it is an asset and not a contingent asset. Contingent asset is a possible asset and not a probable asset. Therefore recognition of contingent asset requires the use of virtual certainty principles.
Whether a seller of a business should recognise gain from contingent consideration will depend upon the nature of the contingent consideration itself. Where contingent consideration is based on normal revenue targets which are easily achievable, it may be highly probable that it would be received. In such circumstances contingent consideration should be recognised by the seller. If it appears that the set targets are unachievable, then it may not be appropriate to recognise contingent consideration. Rather they should be treated as contingent asset.
At other times, it may so happen that the contingent consideration is determined at each level of performance. As a result it is highly probable that a minimum amount of consideration is always received. Any excess of expected consideration over the minimum amount recognised is only possible and hence a contingent asset not to be recognised in the financial statements. For example, a seller will receive a contingent consideration of Rs. 1 million, if the following year performance is equal to previous year, and another half a million if the performance improves by 40%. In this case, the seller recognises one million consideration if it is probable that performance will be atleast as good as the previous year. However, the extra half a million will not be recognized if it is not probable (though possible) that it will be received. The said amount is a contingent asset and hence not to be recognised under AS 29. The standard also prohibits the disclosure of contingent assets.
