Classifying contingent payments in an acquisition: contingent consideration or post-acquisition compensation?

What’s the issue?

Amounts classified as contingent consideration form part of the cost of acquiring a business and are included as part of goodwill (which is subjected to an annual impairment review), while amounts classified as post-acquisition compensation are not included in goodwill and are typically expensed in the income statement over future periods. Therefore, it is key to understand the nature of the arrangement for amounts paid or payable as part of the sale and purchase agreement, and whether they form part of the cost of acquiring the business or whether they represent a form of future compensation through services provided to the company.

How to assess the classification of contingent payments

Understanding the reasons why the sale and purchase agreement includes a provision for contingent payments, who initiated the arrangement, and when the parties entered into the arrangement may all be helpful in assessing the nature of the arrangement. However, when observed in practice, this may not always provide clear answers, in which case the following additional indicators should be considered:

1. Is a selling shareholder required to remain in continuing employment? Where payments are conditional on remaining in employment and are automatically forfeited on leaving, this will require payments to be accounted for as post-acquisition compensation, regardless of other indicators. Where payments are not automatically forfeited, this would be an indicator of additional consideration.
   
   
2. How long must a selling shareholder remain in continuing employment? Assuming that automatic forfeiture clauses do not apply, the longer the period of mandatory employment, the more likely it may be considered to be remuneration.
   
   
3. How does the level of remuneration compare to other key employees? Where salaries are comparable to other key employees in the organisation, this may indicate that the contingent payments are additional consideration.
   
   
4. How do payments compare with selling shareholders who become employed by the enlarged group vs those who do not? If the employed, selling shareholders earn more on a per-share basis than those who do not, this may indicate that the contingent payments are remuneration.
   
   
5. Do selling shareholders who become employees hold the majority shareholding before the sale? If the selling shareholders who own majority stakes in the target company become employees, this may indicate that the contingent payments are a form of profit-sharing arrangement and represent compensation for post-acquisition services.
   
   
6. How does the initial consideration transferred compare to the valuation of the target? If the initial consideration is closer to the lower end of the range of the target’s valuation, this may indicate that the contingent payments are additional consideration.
   
   
7. What is the formula used for determining the contingent payment? As an example, a contingent payment formula that is more closely linked to a profit-sharing arrangement (e.g., percentage of earnings) would be an indicator of post-acquisition compensation.
   
   
8. Are there other linked agreements that compensate the seller? Other agreements with selling shareholders should also be considered if they are linked to the transaction in a way that compensates for higher or lower payments – for example, leases with off-market rents. Whilst these may not be remuneration-related, these should also be assessed to identify if the contingent payments are attributable to something other than contingent consideration.

What action should finance teams take?

Given the level of complexity, judgement and potential accounting significance of such payments in a transaction, finance teams should work closely with those involved in the transaction (such as legal advisers or corporate development departments) to understand and explain the implications of the draft terms of the sale and purchase agreement before it is signed. In addition to understanding the initial accounting implications of the payments structure, finance teams may want to set out their understanding of the future accounting requirements as well as plan the monitoring process that will be needed at each reporting date – for example where external valuations will be needed for fair value exercises.

This article has been prepared for general guidance on matters of interest only and does not constitute professional advice.

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