Chapter 5 — Measurement of Goodwill or Gain From a Bargain Purchase, and Consideration Transferred in a Business Combination

5.7 Contingent Consideration

The ASC master glossary defines contingent consideration as:

Usually an obligation of the acquirer to transfer additional assets or equity interests to the former owners of an acquiree as part of the exchange for control of the acquiree if specified future events occur or conditions are met. However, contingent consideration also may give the acquirer the right to the return of previously transferred consideration if specified conditions are met.

Contingent consideration arrangements in which the acquirer may be required to make a future payment are commonly referred to as “earn-out” provisions. The acquirer and acquiree may specify future events or conditions such as (1) the acquiree’s postcombination performance measured on the basis of certain financial targets (e.g., revenue, EBITDA, or operating profit) over a specified period after the acquisition, (2) the market price of the acquirer’s shares after the acquisition, or (3) the occurrence of a discrete event, such as the FDA’s approval of a drug candidate of the acquiree that is under development as of the acquisition date.

5.7.1 Initial Measurement of Contingent Consideration

ASC 805-30

25-5 The consideration the acquirer transfers in exchange for the acquiree includes any asset or liability resulting from a contingent consideration arrangement. The acquirer shall recognize the acquisition-date fair value of contingent consideration as part of the consideration transferred in exchange for the acquiree.

Contingent consideration is part of the consideration transferred for the acquiree and therefore must be measured and recognized at fair value as of the acquisition date, which can be challenging. Acquirers need to identify the key inputs of the arrangement and use market participant assumptions when determining the fair value of contingent consideration. Key inputs may include estimated timing and the probability that the conditions or milestones in the arrangement will be met. Acquirers also need to apply judgment when assessing the probability that each potential outcome will be achieved.

Not all payments to be made to the seller in the future should be classified as contingent consideration. For example:

Consideration held in escrow, or payments related to working capital adjustments, are not contingent consideration because they are not contingent on a future event; such amounts are payable on the basis of facts and circumstances that existed as of the acquisition date (see Sections 5.3.1 and 5.3.2).
A conditional future payment linked to continuing employment should be accounted for as compensation in the acquirer’s postcombination financial statements (see Section 6.2.3.3.1).
Obligations to deliver consideration in the future that are not contingent on the occurrence of a future event (e.g., a seller note or a payment for the use of property) should be accounted for by using other applicable GAAP, depending on the nature of the obligation. Like contingent consideration, noncontingent obligations would generally be initially measured at fair value; however, the subsequent accounting may differ.

Example 5-2

Noncontingent Arrangement to Transfer Consideration in the Future

Company A acquires Company B for $2 million in cash in a transaction accounted for as a business combination. The acquisition agreement also obligates A to pay additional cash consideration of $1 million to the seller on the fifth anniversary of its acquisition of B. Because the obligation to transfer additional cash of $1 million is not contingent on a future event and the payment is based solely on the passage of time, the obligation is not contingent consideration but rather seller financing. Company A measures the obligation at fair value as of the acquisition date, taking into account the financing component, and includes the fair value as an element of the consideration transferred. After the acquisition, A accounts for the obligation under ASC 835-30.

5.7.2 Initial Classification of Contingent Consideration

ASC 805-30

25-6 The acquirer shall classify an obligation to pay contingent consideration as a liability or as equity in accordance with Subtopics 480-10 and 815-40 or other applicable generally accepted accounting principles (GAAP). For example, Subtopic 480-10 provides guidance on whether to classify as a liability a contingent consideration arrangement that is, in substance, a put option written by the acquirer on the market price of the acquirer’s shares issued in the business combination.

25-7 The acquirer shall classify as an asset a right to the return of previously transferred consideration if specified conditions are met.

While ASC 805 specifies that contingent consideration must be recognized at its acquisition-date fair value, it refers to other GAAP for determining the classification of such consideration as of the acquisition date as a liability, as equity, or (less frequently) as an asset. How an acquirer classifies a contingent consideration arrangement determines the subsequent accounting for the arrangement.

The classification of many contingent consideration arrangements will be evident. For example, arrangements are classified as liabilities if they obligate the acquirer to deliver to the seller cash, other assets, or equity securities of a third party. Similarly, contingent consideration arrangements are classified as assets (or as equity if appropriate under ASC 815-40) if they require the seller to return previously transferred consideration to the acquirer if the contingency is met in the future.

Example 5-3

Arrangement to Transfer Cash Consideration in the Future on the Basis of Security Prices

Company A acquires Company B for 1 million shares of A’s common stock and an agreement to pay cash if the quoted market price of A’s common stock is below $25 on the one-year anniversary of the acquisition date. The total cash, if any, paid by A on the one-year anniversary date will be the amount necessary to guarantee the $25 per share price. Because the value of the arrangement is contingent on a future event (i.e., the market price of A’s common stock), the arrangement is contingent consideration and is measured at fair value on the acquisition date. Company A concludes that this arrangement is a liability because A is obligated to deliver cash to B if the price of its common stock is below $25 on the one-year anniversary of the acquisition date.

Often, contingent consideration arrangements obligate the acquirer to deliver its own equity instruments (or the equity instruments of one of the acquirer’s substantive subsidiaries) to the seller. Determining the classification of a contingent consideration arrangement that is settleable in the acquirer’s own equity can be challenging. ASC 805 does not provide guidance on classifying such contingent consideration arrangements, but it refers to other accounting standards for guidance (generally ASC 480-10 and ASC 815). To determine the classification of a contingent consideration arrangement that is settleable in the acquirer’s own equity, an acquirer should consider the following guidance:

ASC 480-10 on distinguishing liabilities from equity.
ASC 815-10-15 on determining whether an arrangement meets the definition of a derivative instrument and is within the scope of ASC 815-10.
ASC 815-40-15-5 through 15-8 on determining whether an arrangement is indexed to the acquirer’s own shares.
ASC 815-40-25 on determining whether an arrangement is classified in equity in the acquirer’s statement of financial position.

Most contingent consideration arrangements will be classified as liabilities under the above guidance. However, entities should base their determination on their specific facts and circumstances. Depending on the complexity of the arrangement, they may decide to consult with a financial instruments specialist. The discussion below highlights some common contingent consideration scenarios but does not provide comprehensive guidance.

Changing Lanes

In August 2020, the FASB issued ASU 2020-06, which simplifies the accounting for certain financial instruments with characteristics of liabilities and equity, including convertible instruments and contracts on an entity’s own equity. ASU 2020-06 amends ASC 815-20-45 to remove some of the conditions for equity classification related to an entity’s ability to settle a contract on its own equity by delivering shares. For more information about ASU 2020-06, see Deloitte’s August 5, 2020, Heads Up.

5.7.2.1 Unit of Account for Contingent Consideration Arrangements

Before classifying a contingent consideration arrangement, an acquirer must determine the arrangement’s unit of account. Contingent consideration arrangements often specify that the issuance of shares under the arrangement depends on whether successive or cumulative performance targets (e.g., earnings or revenues) for the acquired entity are met. For example, an arrangement may require the entity to deliver (1) 100,000 of its equity shares if the subsidiary’s revenue exceeds $100 million in the first year after the acquisition and (2) an additional 50,000 of its equity shares if the subsidiary’s revenue exceeds $125 million in the second year after the acquisition. If so, the entity should evaluate whether the contingent consideration arrangement contains one or multiple units of account.

The entity’s determination of whether the contingent arrangement contains one or multiple units of account may affect whether the arrangement qualifies as equity in whole or in part. If an entity determines that an arrangement includes multiple payment conditions, triggers, or targets that are independent of one another and that would, if met, result in the issuance of specified consideration regardless of whether any other targets were met, each target-based payment is treated as a separate unit of account (contract) that must be assessed for classification. If the payment conditions or targets are cumulative or not independent of one another, the arrangement is considered one contract that requires delivery of a variable number of shares.

The following are examples that illustrate this approach to identifying the appropriate units of account for contingent consideration arrangements:

Contingent Consideration Arrangement — Acquirer Must Deliver 10,000 of Its Equity Shares to the Seller if the Acquiree:	Analysis
Has earnings of at least $100 million in the year after the acquisition (otherwise, no shares will be delivered).	One unit of account. There is only one payment condition and target.
Has earnings of at least $100 million in the first year after the acquisition (otherwise, no shares will be delivered at the end of the first year). In addition, the acquirer must deliver 10,000 of its equity shares if the acquiree has earnings of at least $100 million in the second year after the acquisition (otherwise, no shares will be delivered at the end of the second year).	Two units of account. There are two independent payment conditions and targets.
Has earnings of at least $100 million in the year after the acquisition. The acquirer will deliver an additional 5,000 shares if earnings in that year exceed $125 million. Otherwise, no shares will be delivered.	One unit of account. There are two targets, but they cover the same period, and that period has multiple outcomes.
Has earnings of at least $100 million in the first year after the acquisition (otherwise, no shares will be delivered at the end of the first year). In addition, the acquirer is required to deliver 10,000 of its equity shares if the acquiree has cumulative earnings of at least $200 million in the first two years after the acquisition (otherwise, no shares will be delivered at the end of the second year).	Two units of account. There are two targets that cover different periods.

For more information about determining the unit of account for contingent consideration arrangements, see Deloitte’s Roadmap Contracts on an Entity’s Own Equity.

5.7.2.2 Distinguishing Liabilities From Equity Under ASC 480-10

ASC 480-10 establishes standards for an issuer’s classification of certain financial instruments with characteristics of both liabilities and equity. Contingent consideration arrangements that obligate an acquirer to deliver its own equity instruments meet the definition of a financial instrument. We believe that a contingent consideration arrangement must be analyzed as if it is a separate freestanding instrument. ASC 480-10 requires a freestanding financial instrument to be classified as a liability (or, in some circumstances, an asset) if the instrument has any of the following characteristics:

It is a share in legal form and is mandatorily redeemable (e.g., the instrument unconditionally requires the issuer to redeem it by transferring its assets on a specified or determinable date (or dates) or upon an event that is certain to occur other than liquidation or termination of the reporting entity).
It is not an outstanding share and, at inception, embodies an obligation to repurchase the issuer’s equity shares (e.g., forward purchase contracts or written put options that are to be physically settled) or is indexed to such an obligation (e.g., a warrant on puttable shares or a written put option that is cash settled) and requires or may require the issuer to settle the obligation by transferring assets.
It will or may be settled by the issuance of a variable number of the issuer’s shares, and at inception the monetary value of the instrument is solely or predominantly based on any one of the following:
1. A fixed amount (e.g., a payable for a fixed amount that is settleable with a variable number of the issuer’s equity shares).
2. Being derived from something other than the fair value of the issuer’s equity shares (e.g., an obligation to deliver shares indexed to the S&P 500 and settleable with a variable number of the issuer’s equity shares).
3. Movement in a direction opposite to the value of the issuer’s equity shares (e.g., a written put option that can be net share settled).

Contingent consideration arrangements are often evaluated under the third item above because they involve instruments that require delivery of the acquirer’s shares, and the value of the obligation is solely or predominantly based on whether certain contingencies or target thresholds are met. If an arrangement varies on the basis of the extent to which contingencies or metrics are met (e.g., the number of shares delivered depends on how much EBITDA exceeds a target), we believe that a determination of whether it is within the scope of ASC 480 depends on whether its monetary value, at inception, is based solely or predominantly on the exercise contingency (e.g., EBITDA or revenue target) or share price. If the monetary value is based solely or predominately on the exercise contingency, the arrangement is likely to be classified as a liability under ASC 480. If, however, the monetary value is based solely or predominately on the share price, the arrangement is likely to be outside the scope of ASC 480, but entities would need to consider the guidance in ASC 815. Further, we believe that the determination of whether an arrangement’s monetary value, at inception, is based solely or predominately on the exercise contingency or share price depends on the entity’s particular facts and circumstances.

ASC 480 discusses the underlying in a contingent consideration arrangement and notes that instruments that “solely or predominantly” vary on the basis of something other than the entity’s shares do not qualify for equity treatment.

Since ASC 805 specifically addresses the subsequent measurement of contingent consideration, the subsequent measurement guidance in ASC 480 does not apply. See Section 5.7.3 for more information about subsequent measurement of the contingent consideration.

Example 5-4

Determining the Classification of Contingent Consideration Under ASC 480-10 — Issuance of a Fixed Number of the Acquirer’s Shares if an Earnings Target Is Met

Company A acquires Company B for 1 million shares of A’s common stock and an agreement to issue an additional 250,000 shares if B’s earnings exceed a specified target for the 12-month period after the acquisition.

The terms of the contingent consideration arrangement obligate A to issue a fixed number of its shares if the earnings target is met. The arrangement is not within the scope of ASC 480-10 because it (1) is not mandatorily redeemable, (2) does not embody an obligation to repurchase the issuer’s equity shares, and (3) does not obligate A to deliver a variable number of its shares. While the obligation does require A to deliver its own shares, the number of shares delivered is fixed at 250,000. However, A still must consider whether it has to classify the arrangement as a liability in accordance with ASC 815-40 (see Example 5-8).

Example 5-5

Determining the Classification of Contingent Consideration Under ASC 480-10 — Issuance of a Fixed Number of the Acquirer’s Shares for Each Year That Earnings Exceed a Specified Amount

Company A acquires Company B for 1 million shares of A’s common stock and an agreement to issue, for five years, an additional 25,000 shares for each 12-month postacquisition period in which B’s earnings exceed $2 million. The shares must be issued within a reasonable period after the end of each year in which the earnings target is achieved.

Because each yearly delivery of the 25,000 shares is independent of the others, the arrangement is considered five separate units of account. The arrangements are not within the scope of ASC 480-10 because each arrangement (1) is not mandatorily redeemable, (2) does not embody an obligation to repurchase the issuer’s equity shares, and (3) does not obligate A to deliver a variable number of its shares. However, A still must consider whether it has to classify the arrangements as liabilities in accordance with ASC 815-40 (see Example 5-9).

Example 5-6

Determining the Classification of Contingent Consideration Under ASC 480-10 — Issuance of a Variable Number of the Acquirer’s Shares as a Security Price Guarantee

Company A acquires Company B for 1 million shares of A’s common stock and an agreement to issue additional shares if the quoted market price of A’s common stock is below $25 on the one-year anniversary of the acquisition date. The number of shares, if any, that A will issue will be the amount necessary to guarantee the price of $25 per share.

In accordance with ASC 480-10-25-14(c), A concludes that this arrangement should be classified as a liability because it requires A to settle the obligation by issuing a variable number of its own equity shares, the monetary value of which move in the direction opposite to the value of its shares.

Example 5-7

Determining the Classification of Contingent Consideration Under ASC 480-10 — Issuance of a Fixed Number of the Acquirer’s Shares for Each Increment of Earnings That Exceeds a Specified Amount

Company A acquires Company B for 1 million shares of A’s common stock and an agreement to issue an additional 25,000 shares for each $500,000 increment of B’s earnings that exceeds $2 million, not to exceed $5 million for the 12-month period after the acquisition.

Because each delivery of 25,000 increment of shares is not independent of the others, the arrangement is one unit of account. In accordance with ASC 480-10-25-14(b), A concludes that the arrangement should be classified as a liability because it requires A to issue a variable number of its shares, the value of which is predominantly derived from something other than the fair value of A’s equity shares (derived from B’s earnings over a 12-month period).

5.7.2.3 Definition of a Derivative in ASC 815-10-15

To determine whether a contingent consideration arrangement that is settleable in an acquirer’s own equity is a derivative instrument, the acquirer must consider the guidance in ASC 815-10-15-83, which states that a derivative is a financial instrument or other contract with all of the following characteristics:

It has one or more underlyings and notional amounts or payment provisions or both.
It has “no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.”
It can be net settled.

A contingent consideration arrangement that is a derivative is classified as a liability unless the arrangement meets a scope exception that allows equity classification. ASC 815-10-15-74(a) provides a scope exception for an entity’s contracts that are both (1) indexed to the entity’s own shares and (2) classified in equity in the entity’s statement of financial position.

5.7.2.4 Indexed to the Acquirer’s Own Shares Under ASC 815-40-15

ASC 815-40-15-5 through 15-8 discuss how to determine whether a contingent consideration arrangement that is settleable in an acquirer’s own equity is indexed to the acquirer’s own shares. Under that guidance, an acquirer performs the two-step evaluation discussed below.

5.7.2.4.1 Step 1 — Evaluate Contingent Exercise Provisions

Contingent consideration, by its nature, has an exercise contingency, which the ASC master glossary defines as “a provision that entitles the entity (or the counterparty) to exercise an equity-linked financial instrument (or embedded feature) based on changes in an underlying, including the occurrence (or nonoccurrence) of a specified event.” For example, exercise contingencies include provisions that:

Affect whether an instrument becomes exercisable or settleable.
Accelerate the timing of (1) an entity’s ability to exercise an instrument or (2) the settlement of an instrument.
Extend or defer the timing of (1) an entity’s ability to exercise an instrument or (2) the settlement of an instrument.
Result in the cancellation of an instrument.

An arrangement with an exercise contingency is not necessarily classified as a liability. According to ASC 815-40-15-7A, the only contingent exercise provisions that would preclude an arrangement from being considered indexed to the entity’s own shares are those that are based on either of the following (emphasis added):

“An observable market, other than the market for the issuer’s stock (if applicable).”
“An observable index, other than an index calculated or measured solely by reference to the issuer’s own operations (for example, sales revenue of the issuer; earnings before interest, taxes, depreciation, and amortization of the issuer; net income of the issuer; or total equity of the issuer).”

If the exercise contingency does not preclude an arrangement from being considered indexed to the acquirer’s own shares, the next step is to evaluate the settlement provisions.

ASC 815-40-15-5C indicates that an instrument is not precluded from being considered indexed to the entity’s own shares under ASC 815-40-15-5 through 15-8 if the payoff is based, in whole or in part, on the shares of a consolidated subsidiary as long as the subsidiary is a substantive entity. If the subsidiary is not a substantive entity, the instrument is not considered to be indexed to the entity’s own shares. If an acquiree meets the definition of a business in ASC 805 and is therefore substantive, we believe that the guidance in ASC 815-40-15-5C applies and that a contingent consideration arrangement based on the performance of the acquired business can be considered indexed to the entity’s shares. ASC 815-40-15-5C clarifies that the guidance applies regardless of whether the parent or consolidated subsidiary entered into the arrangement.

For additional discussion of the effect of exercise contingencies on the classification of a contract, see Deloitte’s Roadmap Contracts on an Entity’s Own Equity.

5.7.2.4.2 Step 2 — Evaluate Settlement Provisions

ASC 815-40-15-7C states, in part, that an arrangement is considered indexed to an entity’s own shares if its settlement amount will equal the difference between:

“The fair value of a fixed number of the entity’s equity shares.”
“A fixed monetary amount or a fixed amount of a debt instrument issued by the entity.”

In addition, ASC 815-40-15-7D states:

An instrument's strike price or the number of shares used to calculate the settlement amount are not fixed if its terms provide for any potential adjustment, regardless of the probability of such adjustment(s) or whether such adjustments are in the entity's control. If the instrument's strike price or the number of shares used to calculate the settlement amount are not fixed, the instrument (or embedded feature) shall still be considered indexed to an entity's own stock if the only variables that could affect the settlement amount would be inputs to the fair value of a fixed-for-fixed forward or option on equity shares (provided that paragraph 815-40-15-7A does not preclude such a conclusion).

The fair value inputs of a fixed-for-fixed forward or option on equity shares may include (1) the entity’s share price, (2) the strike price of the instrument, (3) the term of the instrument, (4) expected dividends or other dilutive activities, (5) share borrow cost, (6) interest rates, (7) share price volatility, (8) the entity’s credit spread, and (9) the ability to maintain a standard hedge position in the underlying shares.

An instrument cannot be considered indexed to the entity’s own shares if (1) the instrument’s settlement calculation incorporates variables other than those used to determine the fair value of a fixed-for-fixed forward or an option on equity shares or (2) the instrument contains a feature (such as a leverage factor) that increases exposure to the additional variables listed in the preceding paragraph in a manner that is inconsistent with a fixed-for-fixed forward or an option on equity shares.

For additional discussion of the effect of settlement provisions on the classification of a contract, see Deloitte’s Roadmap Contracts on an Entity’s Own Equity.

Example 5-8

Determining the Classification of Contingent Consideration Under ASC 815-40-15 — Issuance of a Fixed Number of the Acquirer’s Shares on the Basis of an Earnings Target

Company A acquires Company B for 1 million shares of A’s common stock and an agreement to issue an additional 250,000 shares if the earnings of B exceed a specified target for the 12-month period after the acquisition. Company A determined that this arrangement is not within the scope of ASC 480-10 (see Example 5-4) and concluded as follows as a result of performing the two-step assessment in ASC 815-40-15-5 through 15-8:

Step 1 — The exercise contingency (i.e., exceeding the earnings target) is based on an observable index, but it can only be measured by reference to B’s operations. Therefore, step 1 does not preclude A from considering the contingent consideration arrangement to be indexed to its own shares.
Step 2 — The settlement amount is considered fixed-for-fixed because it equals the difference between the fair value of a fixed number of A’s shares (i.e., the fair value of 250,000 of A’s own shares) and a fixed exercise price (i.e., zero).

The contingent consideration arrangement is therefore considered indexed to A’s own shares. However, A still must determine whether the arrangement qualifies for equity classification or must be classified as a liability in accordance with ASC 815-40-25.

Example 5-9

Determining the Classification of Contingent Consideration Under ASC 815-40-15 — Issuance of a Fixed Number of the Acquirer’s Shares for Each Year That Earnings Exceed a Specified Amount

Company A acquires Company B for 1 million shares of A’s common stock and an agreement to issue an additional 25,000 shares for each 12-month postacquisition period in which B’s earnings exceed $2 million for five years. In each year in which the earnings target is achieved, the shares must be issued within a reasonable period after the end of the year.

Because each yearly delivery of the 25,000 shares is independent of the others, the arrangement is considered to contain five units of account. Company A determined that this arrangement is not within the scope of ASC 480-10 and concluded the following as a result of performing the two-step assessment in ASC 815-40-15-5 through 15-8 (see Example 5-5):

Step 1 — The exercise contingency (i.e., exceeding the earnings target) is based on an observable index, but it can be measured only by reference to B’s operations. Therefore, step 1 does not preclude each arrangement from being considered indexed to A’s own shares.
Step 2 — The settlement amount is considered fixed-for-fixed because it equals the difference between the fair value of a fixed number of A’s shares (i.e., the fair value of 25,000 of A’s own shares) and a fixed exercise price (i.e., zero).

The five separate contingent consideration arrangements are therefore considered indexed to A’s own shares. However, A still must consider whether the arrangement qualifies for equity classification or must be classified as a liability in accordance with ASC 815-40-25.

Example 5-10

Determining the Classification of Contingent Consideration Under ASC 815-40-15 — Issuance of a Fixed Number of the Acquirer’s Shares as a Security Price Guarantee

Company A acquires Company B for 1 million shares of A’s common stock and an agreement to issue an additional 25,000 shares if the quoted market price of A’s common stock is below $25 on the one-year anniversary of the acquisition date. Company A determined that this arrangement is not within the scope of ASC 480-10 and concluded the following as a result of performing the two-step assessment in ASC 815-40-15-5 through 15-8:

Step 1 — The exercise contingency (i.e., the quoted market price of A’s common stock is below $25 on the one-year anniversary) is based on an observable market, but it is the market for A’s shares. Therefore, step 1 does not preclude the arrangement from being considered indexed to A’s own shares.
Step 2 — The settlement amount is considered fixed-for-fixed because it equals the difference between the fair value of a fixed number of A’s shares (i.e., the fair value of 25,000 of A’s own shares) and a fixed exercise price (i.e., zero).

The contingent consideration arrangement is therefore considered indexed to A’s own shares. However, A still must consider whether the arrangement qualifies for equity classification or must be classified as a liability in accordance with ASC 815-40-25.

Example 5-11

Determining the Classification of Contingent Consideration Under ASC 815-40-15 — Issuance of a Fixed Number of the Acquirer’s Shares on the Basis of an Observable Market Increase

Company A acquires Company B for 1 million shares of A’s common stock and an agreement to issue an additional 25,000 shares in three years if the S&P 500 Index increases 1,000 points within any given calendar year during that three-year period. The arrangement meets the definition of a derivative instrument in ASC 815-10-15. Company A determined that this arrangement is not within the scope of ASC 480-10 and concluded the following as a result of performing the two-step assessment in ASC 815-40-15-5 through 15-8:

Step 1 — The exercise contingency (i.e., a 1,000-point increase in the S&P 500 Index) is based on an observable index that is not measured solely by reference to A’s (or B’s) own operations. Therefore, the arrangement is not considered indexed to A’s own shares.
Step 2 — Not necessary.

The contingent consideration arrangement is not indexed to A’s shares. Since the arrangement does not qualify for equity classification in accordance with ASC 815-40-25, it must be classified as a liability.

Example 5-12

Determining the Classification of Contingent Consideration Under ASC 815-40-15 — Issuance of a Fixed Number of the Acquirer’s Shares on the Basis of Regulatory Approval

Company A acquires Company B for 1 million shares of A’s common stock and an agreement to issue an additional 250,000 shares if B obtains regulatory approval for a drug within three years of the acquisition date. Company A determined that this arrangement is not within the scope of ASC 480-10 and concluded the following as a result of performing the two-step assessment in ASC 815-40-15-5 through 15-8:

Step 1 — The exercise contingency (i.e., obtaining regulatory approval) is not based on an observable market or index. Therefore, step 1 does not preclude the arrangement from being considered indexed to A’s own shares.
Step 2 — The settlement amount is considered fixed-for-fixed because it equals the difference between the fair value of a fixed number of A’s shares (i.e., the fair value of 250,000 of A’s own shares) and a fixed exercise price (i.e., zero).

5.7.2.5 Determining Whether Contingent Consideration Is Classified as Equity Under ASC 815-40-25

If the acquirer determines that a contingent consideration arrangement (1) is not required to be classified as a liability under ASC 480-10 and (2) is indexed to the entity’s own shares under ASC 815-40-15-5 through 15-8, the acquirer must consider whether the arrangement meets the criteria in ASC 815-40-25 to be classified in equity. If an entity determines that a contingent consideration arrangement is indexed to the entity’s own shares, it applies the guidance in ASC 815-40-25, which generally permits equity classification for instruments that require settlement in their own shares (physical settlement or net share settlement) or gives the issuer a choice of net cash settlement or physical settlement as long as certain conditions are met.

A contingent consideration arrangement that is not precluded from equity classification under ASC 480-10 and ASC 815-40-15 may be classified in equity only if it meets all of the following conditions in ASC 815-40-25:

It is required to be physically settled in shares or net share settled or the acquirer has a choice of net cash settlement or settlement in shares (either net share settlement or physical settlement).
If an event could trigger net cash settlement that is outside the issuer’s control, the arrangement requires net cash settlement only in specific circumstances in which holders of shares underlying the contract also would receive cash in exchange for their shares.
It permits the acquirer to settle in unregistered shares (however, see Changing Lanes discussion below).
The acquirer has sufficient authorized and unissued shares to settle the contract. In making that determination, the acquirer must consider all other commitments or potentially dilutive instruments (e.g., options, warrants, convertible arrangements) that may require the issuance of shares during the maximum period the arrangement could remain outstanding.
The arrangement contains an explicit limit on the number of shares to be delivered in a share settlement.
There are no required cash payments to the seller in the event the acquirer fails to make timely filings with the SEC.
There are no cash-settled top-off or make-whole provisions.
There are no provisions in the arrangement that indicate that the seller has rights that rank higher than those of a holder of the shares underlying the contract (however, see Changing Lanes discussion below).
There is no requirement in the contract to post collateral at any point or for any reason (however, see Changing Lanes discussion below).

These conditions are discussed in detail in ASC 815-40-25, and entities should consider them carefully in determining whether an arrangement would be classified in equity. In addition, entities must reassess a contingent consideration arrangement as of each reporting date. If equity classification is no longer appropriate, the arrangement must be reclassified as a liability. Similarly, if equity classification becomes appropriate, the arrangement must be reclassified as equity as of the date of the event that caused the reclassification. For additional discussion, see Deloitte’s Roadmap Contracts on an Entity’s Own Equity.

Changing Lanes

In August 2020, the FASB issued ASU 2020-06, which simplifies the accounting for certain financial instruments with characteristics of liabilities and equity, including convertible instruments and contracts on an entity’s own equity. ASU 2020-06 amends ASC 815-40-25 to remove the following three conditions for equity classification related to an entity’s ability to settle a contract on its own equity by delivering shares:

Settlement permitted in unregistered shares; however, the ASU clarifies that if a contract explicitly states that cash settlement is required if registered shares are unavailable, the contract will not qualify as equity.
There are no provisions in the arrangement that indicate that the seller has rights that rank higher than those of a holder of the shares underlying the contract.
There is no requirement in the contract to post collateral at any point or for any reason.

For more information about ASU 2020-06, see Deloitte’s August 5, 2020, Heads Up.

Example 5-13

Determining the Classification of Contingent Consideration Under ASC 815-40-25 — Issuance of a Fixed Number of the Acquirer’s Shares on the Basis of an Earnings Target

Company A acquires Company B for 1 million shares of A’s common stock and an agreement to issue an additional 250,000 shares if the earnings of B exceed a specified target for the 12-month period after the acquisition. Company A has not adopted ASU 2020-06. The arrangement was previously determined (1) not to be within the scope of ASC 480-10 (see Example 5-4) and (2) to be indexed to A’s shares in accordance with ASC 815-40-15 (see Example 5-8).

The arrangement requires A to physically deliver shares to the former owners if the contingency is met. In addition, A must consider the other conditions in ASC 815-40-25 for equity classification, including:

Whether the arrangement limits the number of shares A would have to deliver (250,000).
Whether A has sufficient authorized and unissued shares. In making that determination, A must consider all of its other commitments and any potentially dilutive instruments that may require the issuance of its shares during the 12-month period in which the arrangement will be outstanding.

After reviewing all of its other arrangements (e.g., options, warrants, convertible arrangements), A determines that it has sufficient shares available. Further, the arrangement does not include any:

Provisions that require A to settle in registered shares.
Required cash payments to the former owners if the acquirer fails to make timely filings with the SEC.
Cash-settled top-off or make-whole provisions.
Provisions that indicate that the former owners have rights that rank higher than those of a shareholder of the shares underlying the contract.
Requirements related to posting collateral.

If the above criteria are met, and after considering the guidance in ASC 480-10, ASC 815-40-15, and ASC 815-40-25, A could conclude that the contingent consideration arrangement qualifies for equity classification.

5.7.3 Subsequent Accounting for Contingent Consideration

ASC 805-30

35-1 Some changes in the fair value of contingent consideration that the acquirer recognizes after the acquisition date may be the result of additional information about facts and circumstances that existed at the acquisition date that the acquirer obtained after that date. Such changes are measurement period adjustments in accordance with paragraphs 805-10-25-13 through 25-18 and Section 805-10-30. However, changes resulting from events after the acquisition date, such as meeting an earnings target, reaching a specified share price, or reaching a milestone on a research and development project, are not measurement period adjustments. The acquirer shall account for changes in the fair value of contingent consideration that are not measurement period adjustments as follows:

Contingent consideration classified as equity shall not be remeasured and its subsequent settlement shall be accounted for within equity.
Contingent consideration classified as an asset or a liability shall be remeasured to fair value at each reporting date until the contingency is resolved. The changes in fair value shall be recognized in earnings unless the arrangement is a hedging instrument for which Topic 815 requires the changes to be initially recognized in other comprehensive income.

A contingent consideration arrangement that is classified as an asset or a liability is remeasured at fair value each reporting period until the contingency is resolved. The acquirer recognizes changes in fair value in earnings each period unless it designates the arrangement as a cash flow hedging instrument that is subject to ASC 815-10.

If the contingent consideration is classified as an equity instrument, it is not remeasured. The initial amount recognized for contingent consideration classified as equity is not adjusted even if the fair value of the arrangement changes. The subsequent settlement of the arrangement on the date the contingency is resolved is accounted for in equity.

Adjustments made during the measurement period that pertain to facts and circumstances that existed as of the acquisition date are recognized as adjustments to goodwill. The acquirer must consider all pertinent factors in determining whether information obtained after the acquisition date should result in an adjustment to the provisional amounts recognized or whether that information results from events that occurred after the acquisition date. Changes in fair value resulting from events that occur after the acquisition date are recognized in earnings and not as adjustments to goodwill.

ASC 350-20-35-30 requires entities to test a reporting unit’s goodwill for impairment between annual dates if an event occurs or circumstances change that would more likely than not reduce the reporting unit’s fair value below its carrying amount. The acquirer should consider whether a reduced likelihood that a contingent consideration payment will be made is an indicator of impairment for any reporting units to which the arrangement is related (e.g., the earnings targets specified in an arrangement are no longer expected to be achieved or the likelihood of achievement is significantly reduced).

Example 5-14

Subsequent Accounting for a Contingent Consideration Arrangement Classified as a Liability

Company A acquires Company B for $15 million and an agreement to pay an additional $6 million to the former owners if the cumulative net income of B reaches $10 million within three years of the acquisition date. The contingent consideration arrangement is classified as a liability and has an acquisition-date fair value of $4 million.

At the end of each reporting period after the acquisition date, the arrangement is remeasured at its fair value, with changes in fair value recorded in earnings. For example, if the likelihood of meeting the target increases, the fair value of the contingent consideration would most likely increase. If the target is met and the $6 million contingent consideration is payable, $2 million will have been recorded cumulatively in the income statement (the difference between the $6 million payment and the $4 million originally recorded on the acquisition date) by the time the $6 million is paid. Conversely, if the contingency is not met or its fair value declines, any accrued liability would be reversed in the income statement.

5.7.4 Effect of Contingently Issuable Equity on EPS Calculations

Contingent consideration agreements under which the acquirer is obligated to issue additional common shares upon resolution of a contingency may affect the acquirer’s computation of EPS, if presented, during the contingency period. ASC 260-10-45-13 and ASC 260-10-45-48 through 45-57 address the accounting for contingently issuable shares. Such shares, which include shares placed in escrow and shares that are issued but contingently returnable, are those whose issuance is contingent on the satisfaction of certain conditions. An agreement that requires an entity to issue common shares or potential common shares after the mere passage of time is not considered a contingently issuable share arrangement because the passage of time is not a contingency.

For additional discussion of the effect of contingently issuable shares on EPS calculations, see Deloitte’s Roadmap Earnings per Share.

5.7.5 Acquiree Contingent Consideration Arrangements Assumed by the Acquirer

If an acquired entity was a party to a contingent consideration arrangement from a previous business combination, the accounting would depend on whether the acquiree was the acquirer or the acquiree in that previous transaction.

5.7.5.1 Acquiree Was the Acquirer in a Previous Business Combination

ASC 805-20

25-15A Contingent consideration arrangements of an acquiree assumed by the acquirer in a business combination shall be recognized initially at fair value in accordance with the guidance for contingent consideration arrangements in paragraph 805-30-25-5.

30-9A Contingent consideration arrangements of an acquiree assumed by the acquirer in a business combination shall be measured initially at fair value in accordance with the guidance for contingent consideration arrangements in paragraph 805-30-25-5.

35-4C Contingent consideration arrangements of an acquiree assumed by the acquirer in a business combination shall be measured subsequently in accordance with the guidance for contingent consideration arrangements in paragraph 805-30-35-1.

ASC 805-30

35-1A Contingent consideration arrangements of an acquiree assumed by the acquirer in a business combination shall be measured subsequently in accordance with the guidance for contingent consideration arrangements in the preceding paragraph.

Before the acquisition date, an acquiree may have completed a prior business combination in which it was the acquirer and had issued contingent consideration to the seller. Consequently, at the time of the new acquisition, the acquiree may have a liability (or asset) recognized for the contingent consideration. The nature of contingent consideration does not change because of the subsequent acquisition of the acquirer. Therefore, if an acquirer assumes a preexisting contingent consideration liability (or asset) in a business combination, the acquirer measures and recognizes that arrangement at fair value and classifies it in the same manner as if it had entered into that arrangement at the same time as the current business combination.

After initial recognition, such contingent consideration arrangements are accounted for in accordance with the requirements for acquirer contingent consideration in ASC 805-30-35-1. However, acquiree contingent consideration arrangements are assumed liabilities (or acquired assets) rather than part of the consideration transferred in the business combination because they are payable to (or receivable from) parties other than the sellers in the current business combination.

5.7.5.2 Acquiree Was the Seller in a Previous Business Combination

An acquirer may obtain the right to receive contingent consideration from an acquiree that previously was the seller of a business. The acquirer should account for that acquired right to receive (or obligation to pay) contingent consideration as an asset (or liability) arising from a contingency (see Section 4.3.6). Therefore, if the acquirer can determine the acquisition-date fair value during the measurement period, the acquiree’s contingent consideration should be recognized and measured at fair value. In accordance with ASC 805-20-25-20, if an acquirer cannot determine the acquisition-date fair value of a contingency during the measurement period, it recognizes the contingency at its estimated amount if (1) “it is probable that an asset existed or that a liability had been incurred at the acquisition date” and (2) “[t]he amount of the asset or liability can be reasonably estimated.” If an asset or liability arising from a contingency does not qualify for recognition during the measurement period, it would be accounted for in accordance with other GAAP (e.g., ASC 450) separately from the business combination.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.