4.4 Contingent Consideration

A contingent consideration arrangement should be recognized as a liability and included in the cost of an equity method investment in only two circumstances:

• Authoritative literature other than ASC 805 (e.g., ASC 480, ASC 450, or ASC 815) requires the arrangement to be recognized. For example, if the contingent consideration meets the definition of a derivative under ASC 815, it would be initially recognized at fair value and included in the basis of the equity method investment. Subsequent changes in fair value of the derivative would not be included in the cost of the equity investment, as further discussed in Section 5.1.8.
• The fair value of an investor’s share of an investee’s net assets exceeds the initial cost of the investment. In such an instance, a liability should be recognized in a manner consistent with ASC 323-10-30-2B (which is consistent with the requirement to recognize an asset acquisition at its cost or the fair value of the asset received, whichever is more reliably measurable). In accordance with ASC 323-10-30-2B, on the date of acquisition, the investor should recognize a liability (with a corresponding increase in the cost of the equity method investment) at the lesser of (1) “[t]he maximum amount of contingent consideration not otherwise recognized” or (2) “[t]he excess of the investor’s share of the investee’s net assets over the initial cost measurement.” The share of the investee’s net assets should be calculated on the basis of fair value and should exclude any calculated equity method goodwill (see Section 4.5).

ASC 323-10-30-2B(b) does not provide specific guidance about whether the investee’s net assets are based on book value or fair value. The guidance in ASC 323-10-25-2A and ASC 323-10-30-2A and 30-2B was codified from EITF Issue 08-6, which states, in part:

In the Codification, which is organized by topics, paragraph 6 from EITF Issue 08-6 is broken out into two separate paragraphs under ASC 323-10: one within the Recognition section (ASC 323-10-25-2A), and the other within the Initial Measurement section (ASC 323-10-30-2B). Accordingly, it is unclear whether the reference to fair value in ASC 323-10-25-2A also applies in ASC 323-10-30-2B, which has no such reference. Since paragraph 6 of EITF Issue 08-6 does refer to fair value and the Codification was not intended to change existing U.S. GAAP, we believe that investors should use the fair value of the investee’s net assets in applying ASC 323-10-30-2B even though the fair value reference is absent.

Another question that may arise is whether equity method goodwill (see Section 4.5.1) should be included in the calculation of the investee’s net assets if the liability has to be recognized in accordance with ASC 323-10-25-2A. ASC 323-10-30-2B specifies that the liability should be recognized at the lesser of (1) “[t]he maximum amount of contingent consideration not otherwise recognized” or (2) “[t]he excess of the investor’s share of the investee’s net assets over the initial cost measurement (including contingent consideration otherwise recognized).” If equity method goodwill is included in the calculation of the investee’s net assets, the amount calculated in (1) will always equal the amount calculated in (2), thereby rendering the distinction of recognition at the “lesser of” amount irrelevant. Inclusion of equity method goodwill in the calculation of the investee’s net assets would be circular and would ignore that the guidance is intended to include the distinction of recognizing the liability at the “lesser of” amount. In addition, equity method goodwill for the investment is associated more with an investor than with an investee’s net assets. Therefore, we believe that equity method goodwill should not be included in the calculation of the investee’s net assets when an entity is evaluating ASC 323-10-30-2B.