Question

A Contingent Consideration Problem

Parent Company acquires 100 % of Sub Company for by exchanging 100,000 shares of its $1 par value common stock with a current market value of $35 per share. The agreement contains a provision that:

If the subsidiary earns a net income of more than $500,000 during the first year following the acquisition, an additional cash payment for 30% of the excess over $500,000 will be paid at that time, and

If the price per share of Parent Company’s stock is below $35 on the first anniversary date of the acquisition, an additional 10,000 shares will be handed over.

On the acquisition date the parent company calculates the probability-adjusted present values at $20,000 for the cash contingency and $50,000 for the contingency related to its share price. Prepare the Parent Company journal entry to record the acquisition.

A year later, the subsidiary reported net income of $700,000 for the first year after the acquisition and Parent Company’s share price was $30. Prepare the Parent Company journal entry for the settlement of the contingencies.

If instead of the facts in (b) the subsidiary reported net income of $400,000 and the Parent Co.’s share price was $36 what would Parent Company’s journal entry for the settlement of the contingencies have been?

Answer 1

Complete details of the acquisition, i.e. net assets, value of non-controlling interest, purchase consideration etc are not provided in the question. Therefore, only a relevant extract of the journal is provided below as a part of the solution:

Journal on acquisition date

Ledger	Dr/Cr	Amount	Comments
Net Assets acquired	Dr	XXXX	Details not provided
Non Controlling interest	Cr	XXXX	Details not provided
Purchase consideration (excluding contingent consideration)	Cr	XXXX	Details not provided
Contingent consideration (liability)	Cr	20,000	Recorded at fair value as a financial liability
Contingent consideration (classified as equity)	Cr	50,000	Recorded at fair value, as a component of equity as the settlement is in fixed number of equity shares

In case of scenario 1, target for share price is not met, but profit is met. In this case, the consideration classified as equity will be transferred to general reserve, as the equity will not be issued. Consideration payable will be USD 60,000 (500,000-300,000=200000*30%). Book value of this liability is USD 20,000. Difference of USD 40,000 will be charged to profit and loss accounts.

Ledger	Dr/Cr	Amount	Comments
Contingent Consideration (liability)	Dr	20,000	Write off of liability for discharge
Profit and loss account	Dr	40,000	Differential amount of liability to be paid
Cash/Bank	Cr	60,000	Amount paid to discharge liability
Contingent Consideration (classified as equity)	Dr	50,000	Component of equity no longer required to be issued transferred to general reserve
General Reserve	Cr	50,000	Component of equity no longer required to be issued transferred to general reserve

In case subsidiary reported a net income of USD 400,000 and share price is USD 36, the liability will not be paid as the profit condition is not met but equity will be issued as share price condition is met. As the profit related condition was recorded as a financial liability, this will be remeasured and reversed fully through profit and loss account. Journal entries will be as follows:

Ledger	Dr/Cr	Amount	Comments
Contingent Consideration (liability)	Dr	20,000	Contingent liability no longer payable written back to profit and loss account
Profit and loss account	Cr	20,000
Contingent Consideration (classified as equity)	Dr	50,000	Equity shares issued as part of contingent consideration. 10,000 shares issued at fair value of USD 50,000, 40,000 recorded as share premium
Equity shares issued	Cr	10,000
Share premium	Cr	40,000