Latest / PwC's accounting podcast / Decoding the accounting for contingent consideration in a bus com

Transcript

Decoding the accounting for contingent consideration in a bus com · PwC's accounting podcast

• 0:00
  SPEAKER_03: Thought Leadership from PWC.
• 0:07
  SPEAKER_00: Welcome to PWC's Accounting Podcast.
• 0:10
  SPEAKER_00: I'm Heather Horn.
• 0:12
  SPEAKER_00: Thanks for joining me as we continue our Tuesday series in which one of our all-star podcast guests takes over the podcast, picking the topics of the month and joining me on all the episodes.
• 0:24
  SPEAKER_00: For the month of July, our takeover guest is Jay Celeber, a partner in PWC's national office who specializes in business combinations.
• 0:33
  SPEAKER_00: This month, Jay is taking over the podcast to discuss this highly judgmental topic that may not be top of mind until it needs to be.
• 0:41
  SPEAKER_00: And by then, a deal may be well in the works.
• 0:44
  SPEAKER_00: Jay takes us on a journey through a deal, beginning with the complexities of the overall acquisition accounting model, then diving into some of the more complex questions, such as how to identify the accounting acquirer, accounting for contingent consideration, and reporting with the SEC.
• 1:00
  SPEAKER_01: But it's great opportunity and it's important for, say, if you're on the financial reporting side, to stay very close to the deal folks as they're working through these deals.
• 1:09
  SPEAKER_01: As Chip said, small differences in the way the deals are structured can have big accounting implications.
• 1:17
  SPEAKER_02: Don't assume that the current transaction you entered into is the same as previous agreements or same as what you understand other companies have done.
• 1:44
  SPEAKER_00: That was Jay with Chip Curry, a national office partner with a focus on financial instruments.
• 1:50
  SPEAKER_00: Jay and Chip discussed the intersection between contingent consideration and acquisition accounting and the key decision points in the multi-step accounting model, including the complex judgments from the perspective of the acquirer.
• 2:03
  SPEAKER_00: Contingent consideration continues to be the subject of frequent questions due to the combination of two nuanced topics.
• 2:10
  SPEAKER_00: So listen in as Jay and Chip help us navigate the complexities.
• 2:15
  SPEAKER_00: With that, here is our conversation.
• 2:24
  SPEAKER_00: Jay, welcome back for another episode in your series on business combinations.
• 2:28
  SPEAKER_00: And Chip, so nice to have you on the podcast to talk today about contingent consideration, which I know Jay, we alluded to earlier this month because it's such a common question.
• 2:39
  SPEAKER_00: So I'm glad we're coming together to talk about that.
• 2:42
  SPEAKER_00: But first, maybe Jay, it's if you want to give some background about why specifically you did pick this topic.
• 2:50
  SPEAKER_01: Sure.
• 2:50
  SPEAKER_01: Thanks.
• 2:50
  SPEAKER_01: Thanks for having me back here, Heather.
• 2:52
  SPEAKER_01: And Chip, thanks for joining me in the studio to talk about this topic.
• 2:56
  SPEAKER_01: You know, you're you're right, Heather.
• 2:57
  SPEAKER_01: It's definitely one we run into a lot when we're dealing with figuring out how much consideration is transferred into business combination, like we we talked about a couple of weeks ago.
• 3:07
  SPEAKER_01: These arrangements are often hard to account for and hard to value.
• 3:10
  SPEAKER_01: And we're not gonna deal with the valuation side of it today, but we're gonna try to talk through some of the tough accounting judgments that have to be made, along with touch on some of the EPS and statement of cash flow considerations as well, so that we don't lose sight of those uh in the in the process, too.
• 3:24
  SPEAKER_01: Now we are just gonna talk about the buyer's accounting for business combinations today, because there is different guidance that applies to the seller.
• 3:31
  SPEAKER_01: Uh, but I think there's plenty to talk about on the buyer's side as well.
• 3:34
  SPEAKER_01: So I'm excited to get into it.
• 3:35
  SPEAKER_00: All right, that sounds perfect.
• 3:37
  SPEAKER_00: And definitely um we will get into some of the accounting.
• 3:41
  SPEAKER_00: But Chip, so nice, as I said, to have you back.
• 3:43
  SPEAKER_00: But I was interested because you're coming at this from a financial instruments background.
• 3:47
  SPEAKER_00: And so I guess what's the connection with contingent consideration and financial instruments and why do we even see these in a deal?
• 3:55
  SPEAKER_02: Yeah, so as I guess we'll talk about today, you get to go through the business combination guidance and added bonus, you get to go through the financial instruments guidance, which gets to your point of why it's a complex topic and whatnot.
• 4:06
  SPEAKER_02: Um but why does it exist?
• 4:08
  SPEAKER_02: Um Well, first of all, you might hear it called a whole bunch of different things.
• 4:11
  SPEAKER_02: You might hear it called contingent consideration, you might hear it called an earnout, you might hear it called a clawback, but they all mean sort of the same thing.
• 4:19
  SPEAKER_02: It's basically an arrangement where you're trying to bridge the gap between the buyer and seller of a business.
• 4:25
  SPEAKER_02: Like the buyer may think it's worth A, the seller thinks it's worth B.
• 4:29
  SPEAKER_02: You'll only know based upon the future performance of the company.
• 4:32
  SPEAKER_02: And so these contingent consideration and earnout agreements are sort of a way to bridge that gap where some of what you'll get in the future, the ultimate you'll get uh for selling the business, will depend upon how the business doves over some period of time.
• 4:46
  SPEAKER_02: Um, you might see it in acquisitions with assets or businesses that are still under development, still in their infancy stages, um, you know, where the buyer and seller have very different expectations of what potential future cash flows and growth protections are, but it's it's it's definitely not limited to those situations.
• 5:04
  SPEAKER_02: Um, you might also see it in situations where you're trying to align the economic interests of the buyer and the seller.
• 5:10
  SPEAKER_02: And Jay, I'll get a little bit into this on the comp side of the house of where you're trying to keep the seller engaged in the business in some way.
• 5:18
  SPEAKER_02: Um, so these things might help get the deal done.
• 5:20
  SPEAKER_02: It might help the bridge the gap between the buyer and seller, but um, it may require a complex accounting analysis, which is why we're all here today to talk about that.
• 5:30
  SPEAKER_02: Um the accounting for this, as we'll learn, ultimately based upon the facts and circumstances of the individual arrangement.
• 5:37
  SPEAKER_02: And it's really important uh that you get into the weeds and you have a detailed understanding of the terms of the arrangement, um, what drives its value, and how the arrangement will ultimately be settled.
• 5:49
  SPEAKER_02: Um, we're stepping into kind of the deep end of the pool here from an accounting perspective.
• 5:54
  SPEAKER_02: Like I said, we get the benefit of going through the BizCom guidance and then a lot of times through the liability and equity guidance.
• 5:59
  SPEAKER_02: And Heather, you and I have done podcasts in the past on that guidance.
• 6:03
  SPEAKER_00: So definitely very complicated.
• 6:06
  SPEAKER_00: So I I know this is definitely an answer is going to be it depends, but maybe from either one of you, would you is do you have a sense of these are, I'm gonna use the word common or relatively less common as we're seeing deals done, particularly today with the way the economic environment is.
• 6:24
  SPEAKER_01: I think it's a reasonably common situation to run into these.
• 6:27
  SPEAKER_01: They're not in every deal, of course, but for all the reasons Chip mentioned, uh we we do see them on a pretty recurring basis.
• 6:34
  SPEAKER_00: Yeah, Chip was pretty persuasive that like why wouldn't you have this, right?
• 6:37
  SPEAKER_00: So they're great.
• 6:38
  SPEAKER_00: Exactly.
• 6:39
  SPEAKER_00: So all right.
• 6:40
  SPEAKER_00: So maybe with that, I know we've used the word complex here, and I'm sure we're gonna get into some of that, but maybe just to start things off, Jay, it would be helpful to remind people of what the definition of contingent consideration is and then some of the common forms we may see in a business combination.
• 6:58
  SPEAKER_01: Right.
• 6:58
  SPEAKER_01: Well, as Chip kind of alluded to, and maybe sort of as it sounds, just the the guidance talks about contingent consideration as being a promise by the buyer in a deal to potentially transfer either more assets, more cash, or more stock to the former owners of the target company if some specified future events happen or certain conditions are met in the future.
• 7:25
  SPEAKER_01: And those can either be financial or non-financial items, and they can be based on either just a single event or multiple events.
• 7:32
  SPEAKER_01: And it could be over, sometimes we see them just for one period of time, like the one year after acquisition, but sometimes they stretch over multiple years after acquisitions, and there's various targets at different times.
• 7:44
  SPEAKER_01: So some of the common financial metrics we might see might be earnings or EBITDA or some other type of income statement item at above a certain target.
• 7:57
  SPEAKER_01: So the the challenges and the earnout is to hit a certain amount of revenue or earnings.
• 8:02
  SPEAKER_01: It could be uh cash flows that come out of the acquired business, how much free cash flow there is, uh, or sometimes it could be tied into the stock price.
• 8:11
  SPEAKER_01: So it could be a guarantee of the equity value of the shares that have been issued to the sellers.
• 8:17
  SPEAKER_01: And then on the non-financial side, some of the common ones we might see might be achieving certain product development milestones, like in the early stage company that you mentioned, chip, or getting approval of certain drugs or certain patents, or maybe generating a certain number of customers.
• 8:33
  SPEAKER_01: All of those things we we see as relatively common non-financial metrics that are trying to uh encourage, you know, they they hopefully tie into value of the company.
• 8:41
  SPEAKER_01: Ideally, the the idea being that if you achieve these targets, that's likely to imply the company is doing well and is becoming more valuable.
• 8:49
  SPEAKER_00: Aaron Powell So, Jay, when I was listening to your list, you made a point that sometimes these will just be for a year, but they may also be for longer, the settlement period.
• 8:59
  SPEAKER_00: And this sounds like it could get, again, to use the word complex, but very complex to even track these numbers and then for the parties to agree on how they're settling.
• 9:09
  SPEAKER_00: So I'm assuming we are not getting involved in disputes, but this does seem like it would be an area where are there typically audit provisions or otherwise to make sure that people have sort of the same view of whether or not the milestones have been met?
• 9:24
  SPEAKER_01: Well, you've definitely hit on sort of some of the downside.
• 9:26
  SPEAKER_01: I think you asked earlier, it's like why wouldn't you do it in one of these deals?
• 9:29
  SPEAKER_01: Well, those are some of the reasons why you might not, because you are, in many cases, needing to track the information separately.
• 9:36
  SPEAKER_01: And obviously, one of the often one of the goals of an acquisition is to integrate it.
• 9:40
  SPEAKER_01: And so if you have to track that acquired business separately, that sometimes is at odds with the goal, the synergy goals, perhaps of trying to integrate it into the rest of your business.
• 9:50
  SPEAKER_01: And then, yes, there often are disputes that arise over, you know, the the the seller say, well, we would have been able to hit a target.
• 9:57
  SPEAKER_01: It's if you change things around, you didn't devote enough resources, you let some people go, you change some RD plans or the like.
• 10:05
  SPEAKER_01: So so yes, we do see disputes arise out of that.
• 10:08
  SPEAKER_01: Maybe that'll be a podcast in a different series.
• 10:11
  SPEAKER_00: All right.
• 10:11
  SPEAKER_00: So that that's helpful.
• 10:12
  SPEAKER_00: But then the other thing that really struck me when you were running through that list is it sounds like it's practically anything that's not settled sort of on the day that the deal closes.
• 10:21
  SPEAKER_00: But Chip, is that the case, or are there exceptions to kind of how we look at what is considered contingent consideration?
• 10:28
  SPEAKER_02: Yeah, I mean, it's certainly a broad definition, you know, Heather, like you point out and Jay, the list of things that you went through.
• 10:35
  SPEAKER_02: Um the things that we typically see that don't meet the definition of contingent consideration that Jay laid out is where the future payout is not based upon a future event or a future condition.
• 10:47
  SPEAKER_02: It's um it's based on something that already happened.
• 10:51
  SPEAKER_02: So, for example, you might see amounts that get held in escrow uh for general reps and warranties of the seller.
• 10:59
  SPEAKER_02: The rep and warranty is representing something that you know is true at the date of the merger.
• 11:04
  SPEAKER_02: It's not a based upon some future event.
• 11:07
  SPEAKER_02: Um, certain indemnifications that sellers provide, like on tax or environmental matters that exist at the business combination date and working capital adjustments.
• 11:16
  SPEAKER_02: So at the business combination date, this is what working capital is estimated to be.
• 11:20
  SPEAKER_02: And then you might find out a little bit later, there's some small tweaks to what working capital is.
• 11:24
  SPEAKER_02: Again, that's an event, not a future event, that's one that kind of existed at the um at the merger date.
• 11:31
  SPEAKER_02: Um, so all of those items, it might take some time for them to ultimately get resolved or the value to ultimately to determine.
• 11:37
  SPEAKER_02: But again, the real key is that's not based upon a future event or a future result.
• 11:42
  SPEAKER_02: Um, it also doesn't include uh deferred consideration that'll be paid like a fixed amount that'll be paid fixed in the future.
• 11:49
  SPEAKER_02: Like that's not contingent consideration, that's just financing.
• 11:52
  SPEAKER_00: Right.
• 11:52
  SPEAKER_00: So basically you're saying if they split the purchase price and half's paid in six months, that's just debt, basically.
• 11:58
  SPEAKER_00: All right, very helpful.
• 12:00
  SPEAKER_00: So then, Jay, maybe going back to you, what are some of the sort of initial um framework that the um buyer should be running through when they're considering how to account for contingency considerations?
• 12:12
  SPEAKER_00: So we've identified that we have it.
• 12:14
  SPEAKER_00: Now what do you do?
• 12:15
  SPEAKER_01: Right.
• 12:16
  SPEAKER_01: So I would say from the buyer's perspective, there's really two key decisions that have to be made to evaluate it.
• 12:23
  SPEAKER_01: The first one is whether this arrangement is really part of the purchase price, part of the overall price that's paid for the business, or is it post-combination compensation expense?
• 12:35
  SPEAKER_01: That's the first decision.
• 12:36
  SPEAKER_01: And then if you determine that it is purchase price, then you have to make a second assessment about whether it should be liability classified or equity classified.
• 12:45
  SPEAKER_01: So I'm sure we'll we'll take each of those probably in turn.
• 12:48
  SPEAKER_01: Maybe we'll start with the uh the first one here.
• 12:51
  SPEAKER_01: Uh so in determining whether it's part of the purchase price or compensation, what you're ultimately trying to figure out is what it what are you really paying for?
• 13:00
  SPEAKER_01: Are you really trying to just figure out what the value of the business was at the acquisition date, as Chip you were saying, or are you really compensating key people for growing it subsequently to the to the acquisition date?
• 13:11
  SPEAKER_01: Now, obviously, if the seller is just a financial investor and isn't going to continue with the business at all post-merger, then any or notes are probably just going to be trying to figure out the final value of the business and would probably just be additional purchase price.
• 13:28
  SPEAKER_01: But when some or all of the selling shareholders stay on as employees or other service providers to the company after the merger, then it becomes a lot more complicated.
• 13:38
  SPEAKER_01: So when you're dealing with that, you know, the guidance lays out eight factors to think about in order to try to make that decision of is it compensation or is it purchase price?
• 13:47
  SPEAKER_01: And that's includes things like who's receiving the contingent consideration, uh, are all shareholders of the target being treated the same way on a proportional basis?
• 13:58
  SPEAKER_01: What's the formula for calculating the earnout?
• 14:01
  SPEAKER_01: Are the people who are receiving the earnout going to be providing continuing services afterwards or not?
• 14:08
  SPEAKER_01: How long, if they are, how long are those employment agreements, and sort of what's their compensation level normally or post-deal compared to other comparable people at the target company and the buyer in in both cases.
• 14:24
  SPEAKER_01: So while you do have to think about all of those factors, there's one that's laid out in the guidance that explicitly can override the others.
• 14:32
  SPEAKER_01: So that one is if individuals would forfeit their right to get the earn out payment if they stop working for the company or providing services for the company before a certain period of time.
• 14:44
  SPEAKER_01: The guidance says that automatically makes that arrangement compensatory, regardless of what all the other factors might point to.
• 14:53
  SPEAKER_01: So that one kind of overrides all the others.
• 14:55
  SPEAKER_01: Although that the same isn't necessarily true in reverse, you know, just because that it isn't explicitly tied into vesting or forfeiture provisions, that doesn't automatically make it additional purchase price, you would have to go through all the other factors as well.
• 15:09
  SPEAKER_02: Yeah, Jay, and I know you mentioned that's the one factor that's determinative.
• 15:13
  SPEAKER_02: Um, another one that you know may not be a hundred percent determinative.
• 15:18
  SPEAKER_02: I don't know if pretty determinative is acceptable language to use in the accounting literature, but it would be situations where you see different shareholders get different amounts of contingent consideration, and the shareholders who are getting more contingent consideration are the ones that come over as employees of the company.
• 15:38
  SPEAKER_02: What that would tell you or likely lead you to a conclusion is at least the excess, like the amount of additional contingent consideration that the employee shareholders are getting is likely compensation.
• 15:51
  SPEAKER_00: So I guess Chip, that's a good point.
• 15:53
  SPEAKER_00: It's not an all or nothing either.
• 15:55
  SPEAKER_00: You could there you could sort of have both in the arrangement.
• 15:58
  SPEAKER_00: Absolutely.
• 15:59
  SPEAKER_00: All right, that's helpful.
• 16:00
  SPEAKER_00: And then Jay, I know that you said again, we use the word um complicated, but what if we're trying to make this determination, if it is either compensation or or part of the deal consideration, what is you know some of the pitfalls that companies should be thinking about as they're making this assessment?
• 16:21
  SPEAKER_01: Well, I would say what's always hard is that while sometimes there's this explicit investing requirement that's in there, and and that that's kind of easy to do because the guidance tells you what to do.
• 16:34
  SPEAKER_01: What can be hard is that a lot of times there's you can almost sort of view it as a bit of an implicit uh notion that they need to stay and work because you know maybe the the the likelihood of the acquired company hitting whatever target there is may be harder to do if the key people don't stick around, right?
• 16:55
  SPEAKER_01: So there's always a bit of tension that is out there in those cases.
• 17:00
  SPEAKER_01: So those are often hard.
• 17:02
  SPEAKER_01: And you know, just because they they are staying around and there's kind of implicit linkage between the people staying and being successful, the target company being successful post-merger, you know, that's not in and of itself a problem.
• 17:17
  SPEAKER_01: Uh like all of this, you have to kind of look through all of the factors, you have to look pretty carefully at all of them, make a lot of judgments about that.
• 17:24
  SPEAKER_01: Maybe you think about things like what industry the company is in, how really critical that one key person is to the value of the business going forward, whether there's long-term non-compete agreements that sort of preclude them from uh going elsewhere and and applying their trade elsewhere and the like.
• 17:43
  SPEAKER_01: And so you have to just really think hard about all the other ones.
• 17:46
  SPEAKER_01: But that's really where a lot of the tension is.
• 17:47
  SPEAKER_01: There's almost always an element of well, if the person doesn't stay or the key people don't stay, what are the likelihoods of really being able to hit that target?
• 17:57
  SPEAKER_02: Yeah, Jade, your point, it's it's important to look at these agreements and focus on the substance of those agreements because they're not always labeled like the accountants, you know.
• 18:07
  SPEAKER_02: It would be helpful.
• 18:08
  SPEAKER_02: Yeah.
• 18:09
  SPEAKER_02: Yeah.
• 18:09
  SPEAKER_00: Um, hits it with the flashing red side.
• 18:11
  SPEAKER_02: Exactly, exactly.
• 18:12
  SPEAKER_02: So so a good, you know, we've seen examples where you know the buyer pays all of the money up front to the selling shareholders, but some of the selling shareholders are employees of the target company and and they're going to stay on post-merger.
• 18:26
  SPEAKER_02: And there's a provision in the agreement that talks about liquidated damages.
• 18:29
  SPEAKER_02: And you're like, well, liquidated damages.
• 18:31
  SPEAKER_02: But when you get through the substance of what that is, it's really a clawback of amounts that were paid up front.
• 18:38
  SPEAKER_02: And so it it operates economically just like contingent consideration.
• 18:43
  SPEAKER_02: It's variable amounts that depend upon the results of uh of something that occurs in the future.
• 18:49
  SPEAKER_02: And even though it's structured differently as opposed to we pay more at the end, as opposed this is we paid some up front, but we claw it back, that would also be something that would be contingent consideration and possibly then follow under the um the compensation guidance.
• 19:03
  SPEAKER_01: Right.
• 19:03
  SPEAKER_01: Especially if they have to work to get it.
• 19:05
  SPEAKER_01: And I think in your example, it sounds like if they don't stay long enough, then they have to give the money back.
• 19:10
  SPEAKER_01: Well, I think we would say that's tied into vesting, continued service.
• 19:13
  SPEAKER_01: We would say that is compensation.
• 19:14
  SPEAKER_00: Trevor Burrus, Jr.: So let me ask a clarifying question though, before I'm sure you have other examples, Chip.
• 19:19
  SPEAKER_00: But we you guys have both made the point that these are payments to shareholders that came over as employees.
• 19:27
  SPEAKER_00: But I'm I mean, we often I think see arrangements where key employees just get payments and maybe they are shareholders, but it's sort of in a peripheral way, or maybe they're not even shareholders.
• 19:39
  SPEAKER_00: Is that treated the same way, or is that something that's just post-merger expense?
• 19:46
  SPEAKER_01: Well, anything, certainly there's compensation for people who come over, uh salaries, upfront bonuses, ongoing compensation.
• 19:55
  SPEAKER_01: Those, of course, are compensation.
• 19:56
  SPEAKER_01: The the tension point we're thinking about here is there's a certain number of shares that were owned at the time of the deal, and the buyer, the acquirer, is buying all of those shares.
• 20:10
  SPEAKER_01: And you know, at least in the first instance, if you're paying money to buy shares, that sounds like purchase price.
• 20:15
  SPEAKER_01: That's part of the purchase accounting, and including potentially the contingent, the value of the contingent consideration.
• 20:21
  SPEAKER_01: But what we're trying to get at is, well, if you're both a shareholder and an employee, what am I paying you for?
• 20:27
  SPEAKER_01: Am I paying you for your shares, which is purchase price, or am I paying you for your ongoing services, which would be compensation?
• 20:34
  SPEAKER_01: That's the hard part that we're trying to work through.
• 20:36
  SPEAKER_01: So of course, if they're not a shareholder, but they're a key employee and they're coming over and we're giving them some money, that's definitely compensation because it can't possibly be for any shares if they didn't hold any shares.
• 20:46
  SPEAKER_01: But the hard part is when you're both and you're trying to figure out, you know, is some or all, and it could be both, it could be bits and pieces of both.
• 20:55
  SPEAKER_01: You know, what what are you really paying for?
• 20:57
  SPEAKER_00: All right.
• 20:58
  SPEAKER_00: And I'm sorry to kind of harp on this point, but what if, you know, so often employees are buying shares through like stock purchase plans and otherwise, and so maybe it's not really a material amount of shares that they have, would that still factor into this analysis that like, well, they did have some shares, and so any amount of shares would require you to then kind of do this analysis?
• 21:22
  SPEAKER_01: Yeah, I think if if if what you mean is they own shares of the target company beforehand, then they're a shareholder, so they're going to receive some amount of consideration for the deal.
• 21:33
  SPEAKER_01: So it's getting at is is some of the earnout being directed at them.
• 21:37
  SPEAKER_01: Yeah.
• 21:40
  SPEAKER_01: If if if Chip and I are both owners of the company, but Chip stays on an ongoing as an ongoing employee and I don't, and there's an earnout involved, but only Chip gets the earnout and I don't, well, that probably means it's not paying for the shares that Chip owns.
• 21:57
  SPEAKER_01: I see.
• 21:57
  SPEAKER_01: Because if if Chip's getting paid for the shares he owned, I should.
• 22:00
  SPEAKER_01: Be getting paid for the shares I own.
• 22:01
  SPEAKER_01: But if he's getting the earn out and I'm not, that probably means that we're really not paying him for his shares.
• 22:06
  SPEAKER_01: We're really paying him for his great services after the deal.
• 22:08
  SPEAKER_02: Trevor Burrus And sometimes when you dig into the to the arrangement, you know, Jay, like you said, you might find when you look at the contingent consideration that I had, it's contingent on my continued employment.
• 22:20
  SPEAKER_02: And so that would push you more into saying that's not really contingent consideration, it's really just compensation.
• 22:25
  SPEAKER_00: Yeah.
• 22:26
  SPEAKER_00: What I thought you were going to chime in and say, Chip, is that it's nice to hear that you were a more valuable employee than Jay.
• 22:31
  SPEAKER_00: But I I I appreciated that you um let that go in his example.
• 22:35
  SPEAKER_02: I think Jay was just being generous.
• 22:37
  SPEAKER_02: So appreciate that, Jay.
• 22:38
  SPEAKER_00: Um so Chip, let me go back though to your examples you're giving, because you did, we've used the word earnout here, but it's not always called that, right?
• 22:48
  SPEAKER_02: Yeah, like you said, um it could be called all kinds of things.
• 22:51
  SPEAKER_02: It could be called, you know, clawbacks, it could be called lots of things.
• 22:54
  SPEAKER_02: And like we said, it might get structured differently where instead of it being a payment at the end, it's a payment up front that can be clawed back.
• 23:02
  SPEAKER_02: All of that could be consider contingent consideration, all of that could be compensation arrangements as well.
• 23:08
  SPEAKER_02: It depends upon you just run it through the same model that we've been talking about, and it'll lead you to either continued consideration or compensation.
• 23:16
  SPEAKER_00: All right.
• 23:16
  SPEAKER_00: So let's take the example of compensation expense.
• 23:20
  SPEAKER_00: Then, Jay, how does the buyer account for that?
• 23:23
  SPEAKER_01: So once you conclude that the arrangement is compensatory, then you're basically just following the relevant compensation model.
• 23:30
  SPEAKER_01: So either stock compensation if it's a if it's gonna be settled in shares or cash bonus compensation if it's settled in cash.
• 23:39
  SPEAKER_01: And usually what that means, and this sometimes is confusing for folks, is that if you do have to work in order to get that amount in the future, you're not gonna record anything on day one.
• 23:50
  SPEAKER_01: It's just viewed as a brand new grant of some either stock comp or bonus.
• 23:54
  SPEAKER_01: So on day one, you do no accounting for it.
• 23:56
  SPEAKER_01: You don't record anything for that contingent consideration, which is really compensation arrangement.
• 24:01
  SPEAKER_01: You just start to accrue expense over time, over the relevant period of time that you have to work to get it.
• 24:08
  SPEAKER_00: All right.
• 24:08
  SPEAKER_00: So then that I think kind of covers the side of compensation expense.
• 24:13
  SPEAKER_00: I'm sure we could dive way into more detail there.
• 24:15
  SPEAKER_00: But let me come back then to the case where it actually is part of the consideration transferred.
• 24:21
  SPEAKER_00: And so then, Chip, what does that sort of decision tree look like once you've made that determination?
• 24:27
  SPEAKER_02: So sure.
• 24:27
  SPEAKER_02: So the next thing to think about, which was the second point that Jay kind of mentioned at the top of the podcast.
• 24:33
  SPEAKER_02: So assuming it's not compensation, now we've got to determine if the contingent consideration agreement is gonna be liability or equity classified.
• 24:41
  SPEAKER_02: Um so this is not only just balance sheet presentation, like where does the credit go, liability or equity, it also is determinative of what your uh go forward accounting is gonna be.
• 24:50
  SPEAKER_02: So for contingent consideration, that's reported as a liability.
• 24:54
  SPEAKER_02: Then what we're gonna do is we're gonna report that at fair value, and changes in fair value are gonna be reported in current earnings.
• 25:01
  SPEAKER_02: Um, but if it's classified as equity, then subsequent remeasurement through PL is not on an ongoing basis, is not required.
• 25:08
  SPEAKER_02: Um, so bit of a spoiler alert to our listeners, it's it's quite a hurdle to get to classifying something as equity with no subsequent remeasurement.
• 25:18
  SPEAKER_02: Um, there are a number of paths through the literature that can kind of get you to liability accounting.
• 25:24
  SPEAKER_02: Um, so maybe we'll start with the easiest one.
• 25:26
  SPEAKER_02: Um, if you have a contigent consideration arrangement and it's required to be settled in cash or other assets, it's gonna be liability classified, it's gonna be fair value through through through earnings.
• 25:38
  SPEAKER_02: Um, it becomes a lot more complicated when the acquirer is either required or they have the option to settle in their own shares.
• 25:48
  SPEAKER_02: In those circumstances, we, and this is exciting, we get to consider both the guidance in 480, which is sort of determining what's liability versus what's equity, and we get to determine the the look at the guidance in the derivative guidance in ASCA1540, which is which is really exciting.
• 26:07
  SPEAKER_00: That's the reason I wanted this podcast, because we haven't been talking about derivatives enough, Jeff.
• 26:12
  SPEAKER_02: So I I knew there was a reason I was here.
• 26:14
  SPEAKER_02: Exactly.
• 26:14
  SPEAKER_00: So looking forward to that part of the conversation, but let's start with 480.
• 26:18
  SPEAKER_02: All right.
• 26:18
  SPEAKER_02: So so if we start with 480, so so what does 480 apply to?
• 26:21
  SPEAKER_02: Um it applies to freestanding equity and equity-linked financial instruments um and that have characteristics of both liability and equity.
• 26:29
  SPEAKER_02: Um I won't go through the full 480 model.
• 26:32
  SPEAKER_02: Uh I think we've done that in another podcast.
• 26:35
  SPEAKER_02: And if there's high demand, we can certainly come back and talk about 480 again.
• 26:39
  SPEAKER_02: But what we'll do is focus on the part of 480 that sort of affects contingent consideration agreements.
• 26:46
  SPEAKER_02: Um so the thing to highlight here is 480 requires certain obligations where you're gonna have to issue a variable number of your own shares to be recorded as a liability.
• 26:57
  SPEAKER_02: Often these arrangements in the contingent consideration space off uh require the issuance of a variable number of shares either equal to a fixed dollar amount, like stock settled debt, or a a value that is based either solely or predominantly on something other than stock price.
• 27:17
  SPEAKER_02: So in some cases, you also might see that the the variability of settlement moves in the opposite direction of stock price, like a put option.
• 27:26
  SPEAKER_02: And if you find yourself in in those situations, you're gonna be a liability and you're gonna be fair value through earnings.
• 27:32
  SPEAKER_01: Yeah, and maybe an example that we do run into on a time-to-time basis that illustrates sort of that first scenario of variable shares would be like suppose a company buys another company and there's a contingent consideration arrangement that would require the buyer to issue one million dollars worth of stock if the revenue of the target company exceeds$10 million in the first year after the acquisition.
• 28:00
  SPEAKER_01: But the number of shares that the buyer would issue would be calculated based on the stock price at the date of settlement.
• 28:09
  SPEAKER_01: So if you have to issue shares, you'll take your million dollars, you'll divide it by the stock price at that date, and that's the number of shares that you would give.
• 28:15
  SPEAKER_01: And if you don't hit the$10 million target, then you don't have to issue any shares.
• 28:20
  SPEAKER_01: So in that case, while the arrangement is settled in shares, so it smells a little bit like equity, at the end of the day, the dollar value that the the sellers would get if the target is met is always going to be worth one million dollars.
• 28:32
  SPEAKER_01: Whether the stock price goes up, whether the stock price goes down, the seller really doesn't care because they're always gonna get a million dollars worth of stock.
• 28:39
  SPEAKER_01: So the seller really isn't being affected by changes in the stock price.
• 28:43
  SPEAKER_01: So they're not really in the same position as an equity holder, because usually equity holders care if the stock price goes up or goes down.
• 28:49
  SPEAKER_01: So as you said, Chip, it's really just stock-settled debt for a million dollars, and that would be treated as a liability.
• 28:54
  SPEAKER_00: But I guess in that scenario, then you made the point that they may not have to pay it.
• 28:59
  SPEAKER_00: So how does that go into the uh evaluation of whether or not you're recording this liability?
• 29:05
  SPEAKER_01: Aaron Powell Well, that's just part of the fair value aspect.
• 29:09
  SPEAKER_01: That's part of the hard valuation parts that we're gonna we're not gonna talk about today.
• 29:13
  SPEAKER_01: But you would have to, with anything that's gonna be whether it's liability or equity, you have to come up with some fair value.
• 29:19
  SPEAKER_01: Just with the liability, you have to do it every period.
• 29:21
  SPEAKER_01: You have to keep marking it to that fair value.
• 29:23
  SPEAKER_01: So that fair value would incorporate some complex analysis of the likelihood of hitting the target, the probability of hitting the target, as well as all the other terms.
• 29:32
  SPEAKER_01: So it's, you know, the the value is somewhere between zero and a million.
• 29:35
  SPEAKER_01: It kind of depends on how likely do you think that target uh is of being being met.
• 29:41
  SPEAKER_00: All right, that's helpful.
• 29:42
  SPEAKER_00: So that's definitely a very high-level summary of 480.
• 29:46
  SPEAKER_00: And maybe we do need to go back to that other podcast uh chip, because I did like how it kind of rolled off your tongue when you were describing it.
• 29:53
  SPEAKER_00: But maybe then how about if we get into the the derivative evaluation?
• 29:59
  SPEAKER_00: So what if it's not a liability?
• 30:01
  SPEAKER_02: Yeah, so Heather, you're right.
• 30:02
  SPEAKER_02: So 480 is sort of the first filter.
• 30:04
  SPEAKER_02: If it has to be a liability under a 480, we classify it as a liability, we market to market.
• 30:10
  SPEAKER_02: Um, if it's not required to be classified as a liability under a 480, then what we do is we look into the 81540 guidance to determine if it can be classified as equity.
• 30:22
  SPEAKER_02: So there's there's a two-step analysis in 81540.
• 30:26
  SPEAKER_02: The first step is does the contingent consideration arrangement, is it considered solely indexed to the company's own stock?
• 30:33
  SPEAKER_02: That's sort of your first step.
• 30:35
  SPEAKER_02: If the answer is yes, then we would then go to a second step and see if it meets all of the criteria to be classified in equity.
• 30:46
  SPEAKER_02: Well, so yeah, so I I admit this is a bit confusing, but the first step actually involves two steps.
• 30:53
  SPEAKER_00: So two parts.
• 30:54
  SPEAKER_02: Two parts, part A and part B of step one.
• 30:57
  SPEAKER_00: Perfect.
• 30:58
  SPEAKER_02: Sounds like some of the complex contracts that we read.
• 31:01
  SPEAKER_02: So weart A.
• 31:02
  SPEAKER_02: Okay.
• 31:03
  SPEAKER_02: So part A of step one in determining whether a contract is indexed to your own stock, what we're going to do is evaluate contingent exercise provisions.
• 31:12
  SPEAKER_02: So what is a contingent exercise provision?
• 31:15
  SPEAKER_02: The easiest way to think about it is it's a provision that either makes a contract exercisable, it stops the contract from being exercisable, or it impacts the period of time over which it could be exercised.
• 31:30
  SPEAKER_02: So, for example, if you had a contract that said the you either receive zero or a hundred shares, and that all depends upon whether revenue exceeds ten million dollars.
• 31:41
  SPEAKER_02: So it's different, Jay, than the fact pattern you talked about, because stock price matters because you're getting a fixed number of shares.
• 31:49
  SPEAKER_02: So that would that and contingencies like that, that would generally be okay.
• 31:53
  SPEAKER_02: So contingencies that can only require, you know, delivery of zero or a hundred shares in my example, they're going to be okay unless the contingency is based upon like an observable market or market price other than the buyer's own stock.
• 32:08
  SPEAKER_02: So if that contingency was based upon the S P 500, that would be an issue.
• 32:14
  SPEAKER_02: Or if it's based upon an observable index that's outside of the entity's operations, like interest rates or oil prices, that would be a problem as well.
• 32:24
  SPEAKER_00: Um and sorry, Chip, when you say it's a problem, that means it would not be correct.
• 32:29
  SPEAKER_02: It would not be able to be, you would you would fail part A of step one, therefore it would be liability classified, therefore we would fair value it through.
• 32:38
  SPEAKER_00: Oh, I got it.
• 32:39
  SPEAKER_00: Okay.
• 32:40
  SPEAKER_02: You know, so if you look at the agreement, the example that I gave you, it was the contingent event was based upon the company's own revenues, which is not going to be a market price or a market index other than something that's specifically related to the company's own operations.
• 32:55
  SPEAKER_02: A lot of contingent consideration agreements, um, they would pass sort of part A of step one.
• 33:02
  SPEAKER_00: All right.
• 33:03
  SPEAKER_00: So now how about what happens then when we get to part B?
• 33:08
  SPEAKER_02: So part B is where most of the issues come up with contingent consideration agreements that require them to be liability classified if you know you don't get already tripped up in 480.
• 33:20
  SPEAKER_02: So basically, in part B of step one, determining if it's indexed to your own stock, what we're gonna do is we're gonna focus on the settlement value and the settlement provisions.
• 33:29
  SPEAKER_02: And what the literature is basically saying is hey, does the settlement amount just equal the difference between the fair value of a fixed number of the company's own stock and a fixed monetary amount or strike price?
• 33:43
  SPEAKER_02: But in that case, like a contingent consideration agreement might be zero.
• 33:47
  SPEAKER_02: The strike price might be zero because you might just be issuing shares for free if you if you meet this event.
• 33:52
  SPEAKER_02: If it's a fixed for fixed sort of settlement, you can consider it indexed your own stock.
• 33:57
  SPEAKER_00: So basically that scenario would be that this like you will issue a hundred shares if this revenue target is met.
• 34:06
  SPEAKER_00: That would be a fixed for fixed.
• 34:08
  SPEAKER_02: That would be that would also be past step two of the test or part B of this because you would say it's just the difference once the contingent event is met.
• 34:18
  SPEAKER_02: Yeah, it's the difference between the fair value of common stock and a fixed price, which is zero in this case, because you're issuing them for fixed.
• 34:24
  SPEAKER_00: Right.
• 34:24
  SPEAKER_00: Okay, got it.
• 34:25
  SPEAKER_00: But I'm sure there's more to it than just these fixed for fix.
• 34:28
  SPEAKER_02: So yeah, so so there's lots of agreements that aren't just fixed for fixed, right?
• 34:33
  SPEAKER_02: The number of shares may vary and things like that.
• 34:36
  SPEAKER_02: And and and what we have to look at is there are any adjustments to either the amount of shares or the settlement amount.
• 34:43
  SPEAKER_02: Um, and we we don't think about probability, we don't think about whether the uh the acquirer can control them.
• 34:49
  SPEAKER_02: And what we what we look at is are there factors that can cause changes to the settlement amount that would not be considered inputs to how we would come up with the fair value of a fixed-for-fix contract.
• 35:05
  SPEAKER_02: So if the thing that's causing a variability in the settlement is not driven by an input that goes into a valuation model for like a standard plain vanilla fix-for-fixed contract, it would not be considered indexed to your own stock.
• 35:17
  SPEAKER_02: We would fail part B of step one, and then we would solve that a liability, and changes in fair value would be recorded in earnings.
• 35:25
  SPEAKER_00: All right.
• 35:26
  SPEAKER_00: So definitely a lot to think about.
• 35:27
  SPEAKER_00: And I know that was only step one, and now we have step two.
• 35:32
  unknown: Right.
• 35:32
  SPEAKER_01: Although maybe, maybe just to add in a quick example, you know, building off of some of the other ones that Chip and I were saying, uh, you kind of already talked about, I think you you both of you were talking about the situation where it's all or nothing, right?
• 35:45
  SPEAKER_01: You either get zero if you don't hit the target or a hundred shares if you do hit the target.
• 35:49
  SPEAKER_01: And we said in that case, you might very well pass part B of step one.
• 35:54
  SPEAKER_01: But of course, many of the arrangements we see aren't so binary, right?
• 35:59
  SPEAKER_01: They have uh more of a sliding scale where the higher the revenue is, the more shares they would get.
• 36:05
  SPEAKER_01: So instead of just being zero or a hundred, they can either get zero, fifty, a hundred, or a hundred and fifty, depending on if the revenue is eight million, ten million, or fifteen million or something like that.
• 36:15
  SPEAKER_01: So there's different outcomes with different quantities of shares, which have therefore different fair values.
• 36:22
  SPEAKER_01: Uh those are the types of things I think Chip, you're getting at, those would not pass this test.
• 36:27
  SPEAKER_01: They would fail this step of the test, and they would end up needing to be classified as liabilities.
• 36:32
  SPEAKER_02: Yeah, and and one helpful way to think about that distinction is in the first example we gave where it's either zero or a hundred shares, it's sort of a light switch.
• 36:40
  SPEAKER_02: Yes.
• 36:40
  SPEAKER_02: It's either on or off.
• 36:41
  SPEAKER_02: You're getting something or nothing.
• 36:43
  SPEAKER_02: And this the example you just went through, Jay, it's not a simple light switch.
• 36:47
  SPEAKER_02: Yeah, it's like a dimmer.
• 36:47
  SPEAKER_02: There's a whole bunch of clicks.
• 36:48
  SPEAKER_02: Like you can get 50 shares, 100 shares, whatever.
• 36:51
  SPEAKER_02: In that case, you're going to be more in step uh B of or part B of step one, which is much more difficult to get through.
• 36:57
  SPEAKER_00: All right, it's very helpful.
• 36:58
  SPEAKER_00: And I think the key thing here then is that this liability classification then triggers, and you made the point, um, Chip, fair value measured through earnings.
• 37:08
  SPEAKER_00: And so that adds volatility and and otherwise, versus if you can kind of get through this model.
• 37:13
  SPEAKER_00: So let's assume now you did get all the way through step one.
• 37:17
  SPEAKER_00: I I don't know how many would actually make it through, but let's assume there's there's at least that one with our plain vanilla example, then what happens?
• 37:25
  SPEAKER_02: Yeah.
• 37:25
  SPEAKER_02: So now our journey has gotten through 480, it doesn't have to be classified, and through part A and part B of step one.
• 37:33
  SPEAKER_02: Now we're in step two, which is this does it meet a whole bunch of other criteria to be considered classified in equity?
• 37:40
  SPEAKER_02: And if you look at the guidance, it's a list of criteria that you need to meet.
• 37:43
  SPEAKER_02: If you're trying to figure out like what's the substance behind that, what's it really after?
• 37:48
  SPEAKER_02: Probably the best way to think about it is whether or not it's always within the company's control to settle in shares.
• 37:55
  SPEAKER_02: If it's outside of their control where they might have to settle in cash, then you're gonna generally fail these classification criteria.
• 38:02
  SPEAKER_02: And again, you'll be in liability fair value through PL.
• 38:06
  SPEAKER_02: So we did have a recent standard, um 2020, which made some amendments to this guidance.
• 38:12
  SPEAKER_02: It eliminated some of the provisions, um, it uh it modified some of the provisions, which made it easier for things to be sort of equity classified.
• 38:22
  SPEAKER_02: Um, one thing I want to remind our listeners about is although 2020 simplified that guidance about whether it can be equity classified, we still have to go through the SEC's guidance on temporary equity.
• 38:35
  SPEAKER_02: And that was not similarly modified by 2020.
• 38:38
  SPEAKER_02: So in the world of contingent consideration agreements, I would say the criteria that we see failed if you think about this step two the most frequently is that the company doesn't have enough authorized unissued shares to satisfy this contingent uh consideration agreement after considering all other potentially dilutive agreements like employee options, convertible debt, and things like that.
• 39:04
  SPEAKER_02: Um, that's probably the provision that we see the most that if you make it all the way through here, still gets you to liability.
• 39:11
  SPEAKER_00: Although Chip, that seems like you could cure that by getting additional authorization, but maybe that's more than complicated.
• 39:18
  SPEAKER_02: So it's it's this whole equity classification model is not a set it and forget it.
• 39:23
  SPEAKER_02: What we're gonna do is every reporting period, we're gonna continually reevaluate that contract.
• 39:28
  SPEAKER_02: So to your point, in one period, we may not have enough authorized unissued shares, so it has to be liability classified.
• 39:35
  SPEAKER_02: In the next period, we may have enough authorized unissued shares because we either authorize more or other contracts settle.
• 39:44
  SPEAKER_02: Um, and then that case, we would then reclassify it from a liability to equity.
• 39:49
  SPEAKER_02: So things can jump back and forth between liability and equity as the provisions of the agreement sort of change over time, or as other factors, like you point out, authorized shares change.
• 40:00
  SPEAKER_00: So then, Chip, in the case Elisa goes from liability to equity, is that just a sort of uh debit liability, credit equity, or does is there income statement impact in the period that that happens?
• 40:13
  SPEAKER_02: What we would do in that case is we would do like one final mark to market up to the date of the event.
• 40:19
  SPEAKER_00: Yeah.
• 40:20
  SPEAKER_02: That would go through PL, and then you're absolutely right.
• 40:22
  SPEAKER_02: We would just take the liability and we would flip it into equity at the point.
• 40:26
  SPEAKER_02: Um I'm impressed.
• 40:28
  SPEAKER_02: We did we you we did do a debit and credit on the podcast.
• 40:31
  SPEAKER_00: I know, right?
• 40:32
  SPEAKER_00: Like and I'm not always great with debits and credits.
• 40:34
  SPEAKER_00: You were dead on with that one.
• 40:35
  SPEAKER_00: Thank you.
• 40:35
  SPEAKER_00: That was a pretty easy one, balance sheet only.
• 40:37
  SPEAKER_00: So and then I guess just to close the loop, if you were in equity and you're moving to liability, then you would fair value it at the time that you move it, and that would also go into earnings.
• 40:47
  SPEAKER_02: That would go into equity.
• 40:48
  SPEAKER_00: Oh, it would.
• 40:49
  SPEAKER_00: So it's same same model that you adjust it and then reclassify it.
• 40:53
  SPEAKER_00: Okay.
• 40:54
  SPEAKER_00: That's good.
• 40:54
  SPEAKER_01: Ongoing accounting would then go through earnings.
• 40:56
  SPEAKER_01: But the initial movement from equity to liability would go through equity.
• 41:00
  SPEAKER_00: Okay.
• 41:01
  SPEAKER_00: Definitely a lot to get through.
• 41:02
  SPEAKER_00: Do you see companies, Chip, just saying I'm gonna just put it as a liability or it's not an optional model, right?
• 41:09
  SPEAKER_02: Like we've got to follow the model.
• 41:10
  SPEAKER_02: If it meets all the criteria to be classified at equity, we have to put it into equity.
• 41:15
  SPEAKER_02: But I would say the the vast majority of the arrangements don't make it all the way through that.
• 41:21
  SPEAKER_00: Yeah, they get trapped somewhere.
• 41:23
  SPEAKER_02: They get trapped somewhere.
• 41:24
  SPEAKER_02: And look, if if you want it to be a liability, it's really not that hard to put a feature in there that's gonna get liability accounting.
• 41:31
  SPEAKER_00: Yeah, that definitely makes sense.
• 41:32
  SPEAKER_00: Although it seems like equity classification may be more desirable.
• 41:35
  SPEAKER_00: So let's let's get away from this fascinating discussion of liabilities for equity and maybe go to EPS and cash flow, because I know that's another thing we need to consider here.
• 41:47
  SPEAKER_00: So, Jay, what what would you consider there?
• 41:50
  SPEAKER_01: Right.
• 41:50
  SPEAKER_01: Well, certainly you know, back to the easy versus hard stuff.
• 41:55
  SPEAKER_01: You know, Chip said if something's settled in cash, it's obviously a liability.
• 41:58
  SPEAKER_01: Well, it's also obviously not an EPS if it has to be settled in cash.
• 42:01
  SPEAKER_01: So that's the easy one.
• 42:03
  SPEAKER_01: But of course, if it can be settled in shares, either has to be or can be settled in shares, then you probably do have to think about it.
• 42:09
  SPEAKER_01: And probably you do have to think about it for your EPS purposes.
• 42:13
  SPEAKER_01: And that's true whether it ends up being classified as compensation, whether it gets up being classified as liability or ends up being classified as equity, just the models might be a little different, but you do have to think about it.
• 42:22
  SPEAKER_01: Trevor Burrus, Jr.
• 42:23
  SPEAKER_02: And when you say it is not going to impact EPS, like if it's being fair valued through PL, it's it's impacting PS is going to be enumerated.
• 42:30
  SPEAKER_01: Right.
• 42:30
  SPEAKER_01: I'm thinking denominated side.
• 42:32
  SPEAKER_00: Very good point though, Jay.
• 42:33
  SPEAKER_00: I mean, yeah, well, both chip and Jay.
• 42:37
  SPEAKER_01: Now on the basic EPS, the first part of EPS, uh, for the most part, if if the sh issuance of the shares is still contingent upon something, either hitting a target in the future or someone needing to work long enough to be able to receive those shares, you would not put them in basic EPS.
• 42:54
  SPEAKER_01: Because basic EPS is supposed to be only those shares that are absolutely, positively going to be issued and won't come back.
• 43:01
  SPEAKER_01: So that's probably not too hard.
• 43:03
  SPEAKER_01: Those are usually out until the thing gets resolved and you actually issue the shares.
• 43:06
  SPEAKER_01: But on the diluted EPS side, generally these arrangements would be considered in diluted EPS.
• 43:12
  SPEAKER_01: And you would look at them uh based on whether the conditions that result in issuance of the shares, whether those conditions are being met as of the end of each uh reporting period.
• 43:27
  SPEAKER_01: It's it's complicated guidance, probably won't get into wanna want to get into all the details of it here, but it basically says, you know, to try to be objective and not try to project the future.
• 43:38
  SPEAKER_01: It just says, as of the end of each reporting period, are you meeting the target or aren't you meeting the target?
• 43:43
  SPEAKER_01: Even though the target may not be measured for a while, but are you meeting it or aren't you meeting it?
• 43:47
  SPEAKER_01: And if you're meeting it, it's in, and if you're not meeting it, it's out.
• 43:50
  SPEAKER_01: Now that's quite a simplification to a complex bunch of rules that we talk about in our in our guidance, but that's the general that's the general idea.
• 44:00
  SPEAKER_01: Of course, the mechanics will differ.
• 44:01
  SPEAKER_01: If it's compensation, you're going to follow more of a treasury stock type model.
• 44:04
  SPEAKER_01: If it's equity, it's going to follow one model.
• 44:07
  SPEAKER_01: If it's liability classified, there's some other adjustments you make to the numerator as well as the denominator.
• 44:11
  SPEAKER_01: So some complicating factors that if you're dealing with it, you probably want to work your way through the guidance.
• 44:16
  SPEAKER_01: But that's sort of the general idea.
• 44:18
  SPEAKER_02: Yeah, and maybe we can pivot for a moment from EPS to the statement of cash flows.
• 44:26
  SPEAKER_02: If the buyer ends up issuing shares to satisfy the arrangement, obviously that's not an impact on the statement of cash flows because cash didn't move, but we will have to disclose that obviously as sort of a non-cash activity that we satisfy an agreement via the issuance of equity.
• 44:44
  SPEAKER_02: If the earnout is compensatory, so go back to the beginning of the podcast that we we think it's compensatory, then what we'll do is we'll follow the statement of cash flow guidance that applies to compensation arrangements.
• 44:54
  SPEAKER_02: And generally cash flows on compensation agreements are going to be classified as operating, you know, sort of cash outflows.
• 45:01
  SPEAKER_02: Liability classified uh contingent consideration agreements that are not compensation, um, those obviously get settled frequently at an amount of cash that differs from sort of the initial fair value that we established sort of at the at the uh Bizcom date for that for that liability.
• 45:20
  SPEAKER_02: Um so what does the accounting guidance say about those things?
• 45:24
  SPEAKER_02: Um well the first thing it says is if if the settlement of that contingent consideration happens within three months of the acquisition date, then we put it into an uh into investing cash outflow because it's really just part of the business combination because it's happening within within three months.
• 45:42
  SPEAKER_02: If the payment happens beyond three months after the acquisition date, which is what we normally see, Jay.
• 45:48
  SPEAKER_00: Yeah, three months is really fast.
• 45:50
  SPEAKER_02: Yeah, something would have to happen very, very quickly.
• 45:52
  SPEAKER_02: Um, for for three months.
• 45:53
  SPEAKER_02: And Jay, you mentioned earlier these things can go on a year and they can be out for for multiple years.
• 45:58
  SPEAKER_02: Um, then what we're gonna do is we're gonna look at the ultimate settlement amount as compared to what the fair value was that we established for this liability at the business combination date.
• 46:10
  SPEAKER_02: So if we settle the liability for an amount that's equal to or less than what we had established as part of the initial fair value, which then went into the purchase price, then we're gonna consider that cash payment as similar to um seller financing, and we're gonna classify that as a financing cash outflow.
• 46:29
  SPEAKER_02: We're just gonna treat it as if we had financed part of the purchase price.
• 46:32
  SPEAKER_02: If we ultimately settle the contingent consideration at an amount that was greater than the initial fair value, so at an amount that's greater than went into the purchase price, um, then the portion of that payment that equals the original fair value, we're gonna call that just a financing cash outflow.
• 46:53
  SPEAKER_02: It's just like sort of we we finance the acquisition.
• 46:56
  SPEAKER_02: For the portion of the payment that's in excess of the initial fair value, that's gonna be an operating cash outflow.
• 47:04
  SPEAKER_02: So in those situations, in determining the statement of cash flow treatment, it's gonna depend upon what the ultimate settlement amount is versus what the original liability is.
• 47:14
  SPEAKER_02: Probably the easiest way to think about it is it's it's a little bit like financing.
• 47:18
  SPEAKER_02: If we're all we end up doing is paying the amount that we established at inception or less, it's all in financing.
• 47:24
  SPEAKER_02: To the extent we pay more, that excess is treating as operating.
• 47:29
  SPEAKER_02: A little bit like where we put interest on a financing also goes to operating.
• 47:34
  SPEAKER_01: Well, I think part of it too is that it went through the income statement, right?
• 47:36
  SPEAKER_01: That I mean, obviously so to dot so to decrease is also went through the income statement.
• 47:40
  SPEAKER_01: It's not an it's not a symmetrical model.
• 47:43
  SPEAKER_01: But the the way the the guidance got laid out is that to the extent you pay more than what you started out with on the original acquisition date, you've taken a charge through the PL.
• 47:52
  SPEAKER_01: So it's run through your income statement.
• 47:54
  SPEAKER_01: So ultimately when you pay it, that's just just um viewing that as paying some operating results, as you said, like like an interest payment.
• 48:02
  SPEAKER_00: Yeah, although it's interesting on this, is just given especially timing and otherwise, this definitely seems like it's something that would be easy to miss.
• 48:10
  SPEAKER_00: And so, I don't know, some notation when you do original purchase accounting or otherwise to make sure you're you're watching this seems like it would be helpful from a control perspective.
• 48:20
  SPEAKER_00: So definitely a lot to think about here.
• 48:22
  SPEAKER_00: I think, Jay, of all of our topics we've hit, this actually could be the most complicated, which I know is is one of the reasons you picked it.
• 48:30
  SPEAKER_01: And that's why I brought Chip.
• 48:32
  SPEAKER_01: Phone a friend.
• 48:33
  SPEAKER_00: Any financial instruments is always complicated, is probably what Chip would say.
• 48:37
  SPEAKER_00: But um so given the fact that this is new to many people or it's something they're they don't deal with often, I always like to ask if there's any advice for the listeners.
• 48:46
  SPEAKER_00: So maybe Chip starting with you.
• 48:49
  SPEAKER_02: I get I guess you know, we've we've hit on the accounting and we've clearly talked about how the accounting is complex.
• 48:54
  SPEAKER_02: But one thing I would remind people, and my piece of advice is not only is the accounting complex, but the terms of the agreement can be very complex.
• 49:02
  SPEAKER_02: Um so provisions of contracts that may not have a material impact on like the economic value of the arrangement can have a very significant impact on the accounting, particularly when you're in the financial instrument space and you're trying to work your way through 480 and 815.40.
• 49:19
  SPEAKER_02: Um, I'd also say don't assume that the current transaction you entered into is the same as previous agreements or same as what you understand other companies have done.
• 49:30
  SPEAKER_02: You know, um legal counsel, advisors, and others involved with the deal are frequently adding or changing provisions in these contingent consideration agreements.
• 49:39
  SPEAKER_02: There's no like standard contract or standard agreement.
• 49:42
  SPEAKER_02: And so uh I guess that's a really long-winded way of saying details matter.
• 49:47
  SPEAKER_00: Yes, I think that's a very good point, um, particularly again with these models.
• 49:51
  SPEAKER_00: And Jay, how about from your point of view?
• 49:53
  SPEAKER_01: Well, I would say, and this is something I think we've said on a number of these podcasts during during the series, but it's great opportunity, and it's important for, say, if you're on the financial reporting side to stay very close to the deal folks as they're working through these deals, is you know as Chip said, small differences in the way the deals are structured can have big accounting implications.
• 50:13
  SPEAKER_01: And I think what we find when when we talk with our our teams and our clients about this is that they're often very surprised by the outcome of this accounting analysis that Chip and I have gone through today.
• 50:27
  SPEAKER_01: I think people just sort of think that it's going to be purchase price and that it's going to be equity, right?
• 50:33
  SPEAKER_01: That's sort of how many people come in and talk to us and think it will be treated that way.
• 50:38
  SPEAKER_01: And they're often quite unpleasantly surprised when they find out that actually there's some compensation involved, perhaps, or if it's not compensation, that it's liability classified.
• 50:49
  SPEAKER_01: And so to the extent you can get ahead of that on the front end as the deals are being uh drafted by the by the deals side of the of the house, um, because they m may or may not be that familiar with the accounting implications of it.
• 51:05
  SPEAKER_01: And so the more you can all work together to make sure you know how to structure it, and obviously the transaction should reflect what makes sense from a business perspective and from a synergies perspective and an integration perspective.
• 51:19
  SPEAKER_01: So don't let the accounting drive the deal.
• 51:22
  SPEAKER_01: But it's always helpful to know what the accounting is going to be.
• 51:25
  SPEAKER_01: To the point you said uh I think earlier, Chip, that you know, people want to know what the outcome is going to be as they start thinking about how to model the deal and the like.
• 51:34
  SPEAKER_01: So this is one where uh you can really get sideways quickly that we find.
• 51:38
  SPEAKER_00: All right.
• 51:38
  SPEAKER_00: And then I always like to ask if people want to read more on this topic, where should they go look?
• 51:44
  SPEAKER_01: Well, we we've touched on a lot of different topics today.
• 51:47
  SPEAKER_01: So there are a few different places.
• 51:48
  SPEAKER_01: Uh a lot of the stuff that we talked about, especially uh about compensation, is something compensation or not, and even at least a lot of the equity versus liability discussion that Chip went through, that's in our business combinations guide, especially chapters two and chapters three cover that.
• 52:06
  SPEAKER_02: Chapter five of our financing guide also has a lot of information about the you know liability versus equity classification um guide.
• 52:13
  SPEAKER_02: So that's another place you can look.
• 52:15
  SPEAKER_01: And then at the end, we talked about EPS and cash flows, and those are both included in our financial statement presentation guide.
• 52:21
  SPEAKER_01: I think EPS is chapter seven, and uh cash flows is chapter six, and I think both of us have all of us have talked about a bunch of other podcasts that we have in our library that have gone a little deeper into some of these topics as well.
• 52:32
  SPEAKER_01: So lots of information out there for listeners to look for.
• 52:35
  SPEAKER_00: Great, and we'll include some links to that in the show notes.
• 52:38
  SPEAKER_00: So, Jay Chip, as always so nice to talk to you and pleasure having you on.
• 52:42
  SPEAKER_00: Thanks so much for joining me.
• 52:43
  SPEAKER_01: Yeah, thanks for having us.
• 52:44
  SPEAKER_00: Thanks.
• 52:46
  SPEAKER_00: That's our show for today.
• 52:48
  SPEAKER_00: Tune in next week for more fresh episodes so that you never miss any of our audio content.
• 52:54
  SPEAKER_00: Follow the PWC Accounting Podcast wherever you listen to your podcasts.
• 52:58
  SPEAKER_00: And to stay up to date on all our latest accounting and reporting news, sign up for our newsletter at viewpoint.pwc.com.
• 53:08
  SPEAKER_00: From thought leadership at PWC, I'm Heather Horn.
• 53:12
  SPEAKER_00: Thanks for tuning in.
• 53:19
  SPEAKER_03: This podcast is brought to you by PWC, all rights reserved.
• 53:23
  SPEAKER_03: PwC refers to the U.S.
• 53:25
  SPEAKER_03: member firm or one of its subsidiaries or affiliates, and they sometimes refer to the PWC network.
• 53:31
  SPEAKER_03: Each member firm is a separate legal entity.
• 53:34
  SPEAKER_03: Please see www.pwc.com slash structure for further details.
• 53:40
  SPEAKER_03: This podcast is for general information purposes only and should not be used as a substitute for consultation with professional advisors.