Contingent consideration that arises from earn-out clauses in M&A transaction agreements receives accounting recognition in accordance with FASB ASC 805, Business Combinations. Earn-out clauses provide for future adjustments to the acquisition price based on the target company's performance or based on the occurrence of future events. A well thought-out plan for measuring contingent consideration is important because it helps protect future earnings from swings caused by changes in the fair value of the earn-out. The chapter will cover common earn-out structures and features, as well as the accounting requirements for the initial and subsequent measurement of contingent consideration. The chapter will also provide guidance for measuring the fair value of contingent consideration using three different methods, the Probability Weighted Expected Return Method, the Black-Scholes Options Pricing Model, and Monte Carlo Simulation.
CONTINGENT CONSIDERATION: EARN-OUTS IN BUSINESS COMBINATIONS
The application of fair value measurements to business combinations may require the evaluation and measurement of contingencies; the FASB Master Glossary defines a contingency as “an existing condition, situation or set of circumstances involving uncertainty as to possible gain or loss . . . that will ultimately be resolved when one or more future events occur or fail to occur.” In business combinations, one of the more common contingencies is an earn-out ...