ASC 805-20: Explaining Contingent Consideration Transactions with Journal Entries

Posted In | ASC Education | Gridlex Academy

Accounting Standards Codification (ASC) Topic 805-20, "Business Combinations - Identifiable Assets and Liabilities, and Any Noncontrolling Interest," provides guidance on accounting for business combinations, specifically addressing the treatment of contingent consideration. Contingent consideration is a form of purchase consideration in a business combination that depends on future events or the achievement of specific performance targets. This article will explain the concept of contingent consideration transactions under ASC 805-20 and provide examples of journal entries that illustrate the proper accounting treatment for these transactions.

 

Contingent Consideration Transaction

A contingent consideration transaction occurs when the acquirer agrees to pay additional consideration to the seller if certain future events or performance targets are met. The amount of contingent consideration is typically based on a formula that incorporates the achievement of specified financial, operational, or market-related milestones. Under ASC 805-20, the acquirer is required to recognize and measure the fair value of contingent consideration at the acquisition date and classify it as either a liability or equity, depending on its nature.

 

Journal Entries for Contingent Consideration Transaction

To better understand the accounting treatment for contingent consideration transactions, let's look at a hypothetical example.

 

Example:

Company E acquires Company F for a total purchase price of $10 million, which includes $8 million in cash and $2 million in contingent consideration. The contingent consideration will be paid if Company F achieves a revenue target within two years of the acquisition date. Company E determines that the fair value of the contingent consideration at the acquisition date is $2 million.

 

Journal Entry 1: Record the business combination

Company E would record the following journal entry at the acquisition date:

 

Debit: Assets Acquired $10 million

Credit: Cash $8 million

Credit: Contingent Consideration Liability $2 million

 

The debit to assets acquired represents the fair value of Company F's assets and liabilities, while the credit to cash represents the initial cash payment. The credit to contingent consideration liability reflects the fair value of the contingent consideration at the acquisition date.

 

Journal Entry 2: Update the contingent consideration liability (if necessary)

If the fair value of the contingent consideration changes before the performance target is met or not met, Company E would need to adjust the contingent consideration liability accordingly. For example, if the fair value of the contingent consideration increases to $2.5 million due to improved revenue projections, the company would record the following journal entry:

 

Debit: Contingent Consideration Expense $500,000

Credit: Contingent Consideration Liability $500,000

 

This entry adjusts the contingent consideration liability to reflect the updated fair value and records the change as an expense in the income statement.

 

Journal Entry 3: Record the payment of contingent consideration

If the performance target is met and Company E pays the contingent consideration, the company would record the following journal entry:

 

Debit: Contingent Consideration Liability $2 million

Credit: Cash $2 million

 

This entry removes the contingent consideration liability and records the cash outflow for the payment.

ASC 805-20 provides guidance on accounting for contingent consideration in business combinations, ensuring that the financial statements accurately reflect the value of the acquired assets and liabilities and the associated risks. By following the principles outlined in ASC 805-20, companies can properly account for and disclose contingent consideration transactions, providing useful information to investors and other stakeholders. It is essential for accountants and financial professionals to understand and apply the principles of ASC 805-20 when dealing with contingent consideration transactions in business combinations.