4.4 Contingent Consideration
ASC 323-10
25-2A If an equity method investment agreement involves a contingent consideration arrangement in which
the fair value of the investor’s share of the investee’s net assets exceeds the investor’s initial cost, a liability shall
be recognized.
30-2A Contingent consideration shall only be included in the initial measurement of an equity method
investment if it is required to be recognized by specific authoritative guidance other than Topic 805.
30-2B A liability recognized under paragraph 323-10-25-2A shall be measured initially at an amount equal to the lesser of the following:
- The maximum amount of contingent consideration not otherwise recognized
- The excess of the investor’s share of the investee’s net assets over the initial cost measurement (including contingent consideration otherwise recognized).
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).
Example 4-6
Entity A acquires a 25 percent interest in the voting stock of Investee X for cash consideration of $200. The arrangement also includes contingent consideration that meets the definition of a derivative and has a fair value of $20. Entity A has the ability to exercise significant influence over X and accounts for its investment under the equity method of accounting. Because the contingent consideration arrangement meets the definition of a derivative, A must recognize it in accordance with ASC 815 and would record a total initial cost of its investment of $220 ($200 cash consideration plus the $20 fair value of the derivative).
Example 4-7
Entity A acquires an equity method investment for $1,250. Entity A is obligated to pay an additional $100 in the future if certain earnings targets of the investee are reached. Entity A’s proportionate share of the investee’s net assets is $1,300, which exceeds A’s initial cost of $1,250. In accordance with ASC 323-10-30-2B, on the date of acquisition, A records a liability of $50, which is the lesser of (1) the maximum contingent consideration not already recognized ($100) or (2) the excess of A’s share of the investee’s net assets ($1,300) over the initial cost measurement ($1,250), with a corresponding increase in the cost of the equity method investment.
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:
5. Contingent consideration should only be included in the
initial measurement of the equity method investment if it is required to be
recognized by specific authoritative guidance other than Statement
141(R).
6. However, if an equity method investment
agreement involves a contingent consideration arrangement in which the fair
value of the investor’s share of the investee’s net assets exceeds the
investor’s initial cost, an amount equal to the lesser of the following shall be
recognized as a liability:
-
The maximum amount of contingent consideration not otherwise recognized
-
The excess of the investor’s share of the investee’s net assets over the initial cost measurement (including contingent consideration otherwise recognized).
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). This separation makes it 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 apply ASC 323-10-30-2B by using the fair value of the investee’s net assets 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
the guidance’s intent 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 rather than with
an investee as part of its 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.