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the date at which the acquirer obtains control of the target. Earn-outs can incorporate general or specific objectives. an earn-out can place the total transaction proceeds at a place on the risk-return spectrum that effectively balances the requirements of the buyer and the seller. Under current GAAP. The determinaMARCH 2009 / THE CPA JOURNAL 38 . the FASB released SFAS 141(R). 2008. Valuation approaches and other issues related to earnouts and acquired contingencies must be considered. ■ Transaction costs and related expenses (including restructuring expenses) are excluded from purchase consideration. There are three critical provisions in SFAS 141(R) to consider: ■ All forms of purchase consideration (including acquirer stock) are measured as of the acquisition date. While SFAS 141(R) includes several minor changes to current GAAP. earn-out payments are recorded in the acquirer’s financial statements only if and when they are earned. the items are expensed as incurred. The income approach generally estimates value by discounting expected future cash flows to the present through a rate of return (i. buyers are willing to pay for sustainable earnings and current achievements. include financial or nonfinancial targets. the treatment of certain items under SFAS 141(R) will dramatically affect the initial and subsequent recording of a transaction in the acquirer’s financial statements. while at the same time providing the buyer with “downside protection” through the seller’s strong interest in the success of the postcombination company.A C C O U N T I N G & A U D business valuation I T I N G The Valuation of Earn-outs and Acquired Contingencies Under SFAS 141(R) By Marc Asbra and Karen Miles t the end of 2007. earn-out payments will be recorded at fair value as of the acquisition date. the forward-looking characteristics of earn-outs typically mean that the optimal method for quantifying their fair value is the income approach. ■ Earn-outs.e. As with many aspects of M&A negotiations. particularly when the buyer and seller have divergent views about the potential future success of the target company. While the first and second items deserve attention in their own right. contain single or multiple elements. Under SFAS 141(R). other forms of contingent consideration.. and may even influence the structuring of certain deals. Whether simple or complex. however. which governs the financial accounting for mergers and acquisitions (M&A) that have closed on or after the first annual reporting period beginning on or after December 15. A Earn-outs An earn-out can be a valuable device in structuring an M&A transaction. and involve cash or other forms of consideration. Business Combinations. The future payments give the seller an opportunity to realize more “equity upside” from the sale of the business. discount rate) that accounts for both the time value of money and investment risk factors. but temper their expectations of yet-to-be-exploited opportunities. Sellers seek compensation for future market opportuni- ties they believe their business can exploit. cover short or long periods. the elements and structure of an earn-out are limited only by the ability of the buyer and seller to think creatively about the future. If structured properly. and certain acquired contingencies (assets and liabilities) are recorded at fair value as of the acquisition date. determining the fair value of contingent elements in a transaction will present new challenges to financial statement preparers. Conversely.

taxes. Exhibit 1 uses a single.3 million. Exhibit 1 shows that the earn-out is based on the buyer’s projected EBITDA levels and could result in the payment of an additional $4. however.500 12.000 10. which may expose the acquirer to a higher likelihood of potential goodwill impairment charges in the event the earn-out targets are not achieved and the business experiences other challenges.500 Year 2 $1. is determined to be approximately $3. and amortization (EBITDA).000 3.500 7. For more complex structures. divergent fair value conclusions can result from even small differences in the valuation assumptions used.300 Year 2 $40. Similarly.0 0.134 Year 3 $47. The target company achieved $5 million in EBITDA on $25 million in sales in the year immediately prior to the transaction and presented a business plan to the buyer that demonstrated substantial future growth in revenue and profit. Not only is the determination of the fair value of an earn-out critically important for allocating the purchase price at the time of the transaction. and fully documented. If the target business successfully achieves the earnout payments. the final amount of goodwill will actually be lower under SFAS 141(R) than it would under prior GAAP. Exhibit 2 presents the implications of SFAS 141(R) as it relates to goodwill impairment testing.756 $1. The fair value of the earn-out.500 1. which are often developed from similar income-based approaches.000 Year 1 $32.500 $12.658 $1. likely scenario in determining the fair value of the earn-out. but it is also significant for the acquirer’s future goodwill impairment testing. plus a three-year earn-out.000 $10.000 15. This lower amount is placed on the acquirer’s balance sheet immediately.315 Year 4 $0 4.572 $0 Year 4 $55.0 0.500 $7. The lower fair value results from the application of a 15% discount rate to capture the inherent risk that the target company will not achieve the projected EBITDA targets.0 0. Particular care needs to be exercised in constructing the probability weighting scheme. depreciation.000 1.000 5.870 $870 $3.5 million of consideration. The higher EXHIBIT 1 Fair Value of Earn-out Projected Seller Projections and Earn-out Sales EBITDA Earn-out Target EBITDA Earn-out Payments Income Approach Earn-out Payments Discount Period Discount Rate Present Value of Cash Flow Fair Valu e ( R ounded) 15. as the selection of probability factors can significantly affect the ultimate fair value conclusion. an alternative analysis would utilize various projected scenarios and employ a probability-weighting scheme to estimate fair value.tion of the fair value of an earn-out under this approach presents a number of challenges and prompts several questions: ■ What is the likelihood that the earn-out will be achieved? ■ What cash flows or other activities are directly associated with the earn-out? ■ What is the level of risk in achieving the earn-out? ■ What type of discount rate should be used in the analysis? ■ How would that rate compare to the overall discount rate for other assets and liabilities being valued in the transaction? ■ What adjustments are needed if the earn-outs are noncash? As one can imagine. This alternative would provide flexibility in modeling the various future events and assessing the potential earnout payments. the buyer and seller may have dramatically different opinions on these questions and the underlying issues. The buyer successfully negotiated the purchase of the target company for an initial price of $23 million. Because of the relatively simple structure in this example.000 Year 1 $1.500 2. Example The following discussion focuses on the valuation of a relatively common earn-out based on the target business achieving cer- tain thresholds of earnings before interest.0 0. or more than 25% below the nominal amount. however. Like all other fair value analyses done for acquisition accounting purposes. supported by reasonable assumptions.000 Year 3 $2.000 1. Care must also be taken to ensure that the financial projections utilized to determine the fair value of the earn-out are consistent with those used to estimate the fair values of the acquired intangible assets. the valuation study for earn-outs must be thorough. however.000 MARCH 2009 / THE CPA JOURNAL 39 .500 2.0% Actual $25.

which might lessen the potential likelihood for goodwill impairment charges. contingent liabilities related to contracts (referred to as contractual contingencies) are measured at fair value as of their acquisition date. Accounting for Contingencies.200) (1.500 4. As such.500 9.000 0 23. situation.000 3.300 9.200) Current GAAP Purchase Price Earn-outs Total Transaction Value Net Tangible and Intangible Assets G oodwi l l Initial $ 23. in practical terms. contingencies that might result in gains usually are not reflected on the balance sheet. and 2) the amount of loss can be reasonably estimated.500 4.000 9. Moreover.200) 0 ( $ 1 .2 0 0 ) 40 MARCH 2009 / THE CPA JOURNAL . For all other noncontractual contingencies. is placed on the balance sheet only after the earn-out targets have been reached.000 $ 4.000 $ 1 8 . The payment of the earn-outs could indicate that the postcombination business is enjoying some degree of success. Acquired Contingencies M&A transactions often include acquired contingencies on both sides of the target company’s balance sheet: assets and liabilities.300 26. the amount of goodwill initially recorded under current GAAP provides a “cushion” to the acquirer in the event profit expectations do not materialize. Specifically.000 4. While SFAS 5 technically deals with assets (gains) and liabilities (losses). in contrast.0 0 0 Interim $ 0 4. Current GAAP permits deferred recognition of acquired (pre-acquisition) contingencies until these recognition criteria are met. A contingent liability under SFAS 5 must meet two criteria: 1) it is probable that a liability had been incurred (or an asset had been impaired) at the measurement date. has less stringent criteria in recognizing acquired contingencies and further segments between contractual and noncontractual contingencies. which defines a contingency as an existing condition.300 Difference $ 0 (1.200) 0 ($1. That is.500 SFAS 141(R) $23.000 $18. the probability of having a goodwill impairment charge is lower under prior GAAP because the goodwill related to the earn-out elements has not yet been placed on the balance sheet. all else being equal.amount of goodwill finally recorded under prior GAAP. Including the fair value of an earnout in the purchase price also has implications beyond financial reporting. One of the more notable examples on the right-hand side is pending or threatened litigation.500 27.5 0 0 SFAS 141(R) $ 23.000 $ 1 7 . however.000 Interim $ 0 4.500 Final $ 23.300 9.000 $17.300 26. or set of circumstances involving uncertainty as to possible gain or loss to an entity that will ultimately be resolved when one or more future events occurs or fails to occur. SFAS 5 deals mainly with the world of contingent liabilities.3 0 0 Difference $ 0 (1. whereby the seller contractually indemnifies the acquirer for the outcome of a contingency or uncertainty related to all or part of a specific asset or liability. investors and analysts may pressure acquirer management teams for comprehensive disclosures regarding the nature of the earnout and the assumptions used to determine its fair value. These and other contingencies are generally governed by SFAS 5. SFAS 141(R). comparisons to prior transaction multiples or industry rules of thumb will require a more complicated analysis.000 0 $ 23. To the extent an earn-out represents a significant component of the purchase price. since to do so might be to recognize revenue prior to its realization.000 9.000 3. One of the more notable examples on the left-hand side is an indemnification asset. Because valuation multiples implied from earn-out transactions under SFAS 141(R) will necessarily be higher than those under current GAAP.500 Final $23.500 9.200) (1. the acquirer must recognize EXHIBIT 2 Recording of Goodwill Current GAAP Initial Purchase Price Earn-outs Total Transaction Value Net Tangible and Intangible Assets Goodwill $23.500 27.000 1 4 .000 $14.

probability factors are assigned at each of the nodes representing the likelihood of each potential path occurring. If it is deemed more likely than not. In the case of a lawsuit or other financial claim. NY 10017 downturn on pension plans I Accounting and reporting pronouncements relating to pensions and other postretirement benefits I ERISA fiduciary matters I Nonqualified deferred compensation update for 2009 Course Code: 25621911 Member Fee: $350 Nonmember Fee: $450 CPE Credit Hours: 8 Field of Study: Advisory Services. NY 10036 Course Code: 25558911 Member Fee: $350 Nonmember Fee: $450 CPE Credit Hours: 8 Field of Study: Specialized Knowledge and Applications foundation for accounting Employee Benefits Conference Thursday. which can greatly influence a company’s legal strategy. While more complex models certainly exist. visit www. Sign up for POP & save on this conference. As illustrated below. Auditing. While this simple framework is useful in demonstrating an effective quantification technique. While the ultimate reality might be different. management should disclose the following: ■ The amounts recognized at the acquisition date. May 14. and Taxation For more information. or an explanation of why no amount was recognized. To find out how. ■ An estimate of the range of outcomes (undiscounted) for contingencies (recognized and unrecognized). lawsuits and other contingent claims are often valued utilizing a decision-tree analysis. that fact and the reason behind it should be disclosed.a liability only if it is more likely than not (i. including expected legal costs and the time value of money. SFAS 141(R) eliminates the condition that the liability be reasonably estimable. As the name suggests.nysscpa. if a range cannot be estimated. SFAS 141(R) allows an acquirer in a transaction involving multiple acquired contingencies to aggregate disclosures for liabilities (and assets) arising from similar Other factors also warrant consideration. the noncontractual liability is recorded at fair value as of the acquisition date. Public companies have the added sensitivity of financial statement disclosures related to acquired contingencies.e. FAE education Have You Signed Up for POP yet? Call 800-537-3635 to get yours today. Broker/ Dealer Conference Wednesday. for liabilities arising from contingencies. the valuation of a pending claim in the real world is more complex and requires thoughtful consideration and an analysis of the facts and circumstances of both the parties and the case. May 13. at 45th Street New York. consistent with the treatment of contractual contingencies. foundation for accounting For more information.nysscpa. SFAS 141(R) states that. FAE education MARCH 2009 / THE CPA JOURNAL 41 . ■ The nature of recognized and unrecognized contingencies. the sum of the probability-weighted payment amounts serves as an indication of the fair value of the claim underlying the lawsuit. 2009 New York Marriott Marquis Times Square 1535 Broadway. 2009 TOPICS TO INCLUDE: New York Helmsley Hotel I What’s new at the Department of Labor? 212 East 42nd Street I Impact of the economic New York. greater than 50%) that a liability exists at the acquisition date. Credit and Regulation: Practicing in the securities industry in today’s environment. the presumption of most readers of SFAS 141(R) is that noncontractual contingencies will be identified and valued more frequently than under prior GAAP. While the aggregation of Save The Date! Valuation. Consider pending litigation as an example. or call 800-537-3635. call 800-537-3635. payment amounts are also estimated for the various outcomes. a decision tree generally incorporates various future outcomes along as many potential branches as the user deems The complexities of such analyses often prompt companies to seek outside assistance from lawyers and valuation spe- cialists when developing reasonable and supportable fair value estimates. go to www. or call 800-537-3635. As the branches diverge over time. as well as the impact from the general disruption to the business and the diversion of management’s time and attention during the litigation.

If the fair value cannot be reasonably determined.000 $120. The FASB responded on December 15. CPA. 2008. but it does so with the added cost of certain complexities. then the acquirer would follow the guidance set forth in SFAS 5.000 Medium Damages 25% (80%) (60%) (50%) $500.000.000 Low Damages (80%) (60%) (25%) Total Expected Value $250.000 $120.000 $30. Karen Miles. Management should be aware of the changes SFAS 141(R) represents. Increased Complexity From a purely academic perspective. the disclosure of any sensitive information is likely to be met with strong resistance by an acquirer’s management and legal counsel. is a a senior vice president in Houlihan Lokey’s Los Angeles office. however. EXHIBIT 3 Lawsuit Decision-Tree Analysis Conditional Probabilities W i thdraw (1%) Payment Nominal Probability Amount Weighted $0 $0 1% L i ti gati on Claim 19% Settl e (19%) $ 2 0 0 . CFA.000 $308.information would limit the counterparty’s ability to glean information about the lawsuit. M&A transactions should be evaluated according to their underlying economics— net present value. as it will be increasingly important to assess the initial and subsequent financial statement implications as early as possible when structuring an M&A transaction. SFAS 141(R) will likely improve the consistency and transparency of financial reporting for M&A transactions. The treatment of acquired contingent liabilities in SFAS 141(R) was the subject of significant debate leading up to its release. Fair Value Measurements. heads Houlihan Lokey’s financial opinions and advisory services business for Southern California. While the FSP had not been finalized at the time of this publication. investment return. Marc Asbra. if approved as currently drafted. particularly as they relate to earn-outs and acquired contingencies. if the acquisition-date fair value can be reasonably determined.0 0 0 80% Litigate Win 40% (80%) (40%) $0 $0 25% 60% Lose 50% High Damages (80%) (60%) (25%) $1. M&A transactions are not completed in the classroom. or some other cash-flowbased financial metric—and not judged by the financial statement impact caused by GAAP accounting requirements.0 0 0 $ 3 8 . with a proposed FASB Staff Position (FSP) that would amend SFAS 141(R) to require that contingent assets and liabilities be recognized at fair value per SFAS 157. the effect of the FSP would generally be a reversion back to current practice under SFAS 141 regarding acquired ❑ contingencies. and earnings-per-share figures are not ignored by investors. economic value added.000 42 MARCH 2009 / THE CPA JOURNAL .

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