With many acquirers spending 2009 on the sidelines, the new accounting treatment for contingent consideration arrangements under SFAS 141R remains largely untested. When markets thaw, however, we expect that acquirers will be anxious to make up for lost time, and a resumption of deal activity will spark new conversations with auditors regarding the appropriate treatment of earnouts and other forms of contingent consideration.

As an expression of our faith in the future of the economy, we offer a few cautionary notes regarding the accounting for contingent consideration.

1. Auditors will expect detailed, supportable analysis regarding fair value. It may seem that the fair value of a contingent consideration agreement is unknowable; after all, if you and the seller could have reached an agreement on price, you would have. However, the FASB believes that fair value can be reasonably estimated. From the standpoint of your auditors, the midpoint of the potential payout range is not sufficient. Be prepared to offer reasoned probability assessments regarding the range of likely outcomes.
2. Fair value measurement for contingent consideration liabilities can be complex. Estimating the fair value of contingent consideration liabilities requires a different set of tools than that ordinarily applied to measure the fair value of assets. Expected value techniques for cash flow estimation and discount rate development will be much more prevalent when determining the amount that would be paid to a market participant to assume the contingent consideration liability. This is a subtle, but significant shift from determining the amount that would be received from a market participant in exchange for an asset.
3. There is no one-size-fits-all valuation model. Every contingent consideration agreement is unique. With the wide array of potential performance metrics, measurement periods, performance hurdles, and payment terms, the valuation model will have to be tailored to each particular liability.
4. Contingent consideration liabilities require ongoing monitoring and assessment. Veterans of fair value accounting for goodwill and other intangible assets have grown accustomed to annual impairment testing under SFAS 142 and 144. While there is no impairment testing for contingent consideration liabilities, remeasurement is required at every balance sheet date. So, for public companies, the ongoing monitoring and assessment requirements for contingent consideration can actually be more onerous than for goodwill or other intangible assets.
5. A robust acquisition date fair value estimate is the best defense against future earnings volatility. The most common concern we hear from clients is the potential for future earnings volatility stemming from the requirement to remeasure the contingent consideration liability at each balance sheet date. An increase in fair value will result in a charge to earnings, while a decrease in fair value will trigger a credit to the P&L. While changes to fair value are inevitable, a well-reasoned estimate of fair value on the front end is the best tool for mitigating undesirable earnings volatility.

Reprinted from Mercer Capital's Financial Reporting Flash, published November 6, 2009.

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