Contingencies in a business combination

Video Jul 19, 2017

Need a refresher on contingencies acquired in a business combination? Here are two reasons why: an acquired contingency may or may not result in recognizing an asset or liability, and, if the contingency is recognized, it may be valued in different ways. Listen to Steve Wasko discuss these items and a few examples to help put it in context.

Contingencies in a business combination

Watch now for a refresher on contingencies acquired in a business combination.

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Hi, I’m Steve Wasko.

In acquisition accounting, assets and liabilities of the acquiree are generally recorded at fair value but there are exceptions when that’s not the case.

Contingencies of the acquiree can sometimes be recognized at fair value and sometimes not, depending on the circumstances. Typically, contingencies are things like warranties or litigation. Here’s a quick refresher on how to recognize contingencies in an acquisition. So, to start, contingencies assumed in an acquisition need to be recognized at fair value if you can determine the fair value during the measurement period. For example, an acquirer will generally have sufficient historical information to determine the fair value of a warranty obligation it has assumed in an acquisition. The same goes for contractual contingencies such as penalty provisions. In contrast, the fair value of most legal contingencies assumed in an acquisition is not likely to be determinable.

So, what should you do if you can’t determine the fair value of a contingency at the acquisition date? Well, it doesn’t mean that you get a free pass on recognizing the contingency. Rather, if it's probable that an asset existed or a liability was incurred at the acquisition date and that amount can be reasonably estimated, then the contingency should be recognized at the acquisition date. This criteria is consistent with recording contingencies outside of an acquisition.

Lastly, if the contingency isn’t probable and estimable then the acquirer should not recognize an asset or liability for the contingency at the acquisition date. One thing to keep in mind, generally, contingent assets will not meet the recognition criteria.

So, to summarize, an acquired contingency may or may not result in recognizing an asset or liability and if the contingency is recognized, it may be valued in different ways.

And if that’s not enough to think about, what we just discussed only addresses how you account for a contingency on the acquisition date. What happens subsequent to that date can lead to other complexities but before we get to that, let’s look at two common contingency examples, warranties and litigation, and run through the decision tree to see how they should be accounted for.

Consider a warranty liability. You may have good data, observable inputs, historical claim information, expected term, etc., and can calculate a fair value. So, the warranty obligation would be recognized at fair value on the acquisition date. Pretty straightforward, right?

Now, consider a litigation matter that’s still in discovery. Neither the acquirer or the target have much previous experience dealing with the matter and the attorneys have advised that results in this type of case can vary significantly based on facts and circumstances. The lawyers think that it's reasonably possible that the company is legally responsible and will have to pay damages, but the bottom line is that no one knows where the litigation will end up or the potential settlement amounts that might be involved. So, in this case, a contingent liability for the litigation would not be recognized at fair value since fair value can’t be determined. Further, since the outcome is neither probable nor reasonably estimable, no liability would be recognized at the acquisition date.

Now, let’s change the fact pattern up a bit. Maybe the case is further down the road and the acquirer decides to negotiate to settle the ongoing legal matter concurrent with the acquisition to avoid further damage to its brand or incur further costs to defend the case. The settlement is accepted and finalized shortly after the close of the acquisition and within the measurement period. Since the settlement occurs within the measurement period and relates to facts and circumstances that existed as of the acquisition date, the acquirer would record a liability for the amount of the settlement as of the acquisition date. The rationale here is that the decision to pay a settlement amount indicates that it is probable that the company has incurred a liability on the acquisition date and the amount of the liability can be reasonably estimated.

That brings us to the subsequent accounting considerations. The acquirer should develop a systematic and rational approach for subsequently measuring and accounting for contingencies that may have been recognized at fair value in an acquisition. Often times, this will require the exercise of judgment. Remember, it's never appropriate to recognize an acquired contingency at fair value on the acquisition date and then immediately value the acquired contingency in accordance with existing contingency accounting requirements, which generally result in recognizing a gain or loss for the difference. Also, keep in mind that continuing to record a contingency at fair value, unless other GAAP requires you to do so, is not considered a systematic or rational approach.

So, let’s summarize where we are. As we just discussed, in those cases, which are often limited, when a contingency is recorded at fair value in conjunction with an acquisition, be mindful that the acquirer will need to develop a policy for transitioning from the initial fair value measurement to subsequent measurement and accounting at amounts other than fair value. On the other hand, legal contingencies will generally be recorded under existing contingency accounting requirements at the acquisition date which eases the complexity of the subsequent accounting, you’re already in the existing contingency accounting requirements for both acquisition accounting and for subsequent measurement.

The takeaways here are to obtain the necessary information to understand the nature of the contingency, and whether its fair value is determinable. With that understanding use the decision tree to determine the accounting at the acquisition date.

For more information on this topic, refer to the Business combination guide available on CFOdirect.com.

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