How is contingent consideration treated in a purchase price allocation?

Full Explanation

Contingent consideration represents additional payments the acquirer may make to the seller based on future performance milestones — typically revenue targets, EBITDA thresholds, or product development milestones. Under IFRS 3, contingent consideration is classified as either equity or a financial liability at the acquisition date. If classified as a liability, it must be measured at fair value, with subsequent changes in fair value recognised in profit or loss. The acquisition-date fair value is included in total consideration for PPA purposes. Valuing contingent consideration typically involves: modelling the probability-weighted expected payments under various performance scenarios, applying a discount rate that reflects the time value of money and the specific risk of the contingent payment, and considering the maximum payment cap and any performance floors. For example, an earnout paying up to £5M if revenue exceeds £20M within two years might have a fair value of £2.8M if there is a 70% probability of partial achievement and a 40% probability of full achievement. The fair value of contingent consideration directly affects how much total consideration is available for allocation to identifiable intangible assets and goodwill. Higher contingent consideration means more total consideration, potentially more goodwill, and ongoing fair value remeasurement affecting future earnings. Getting the initial measurement right is critical because it anchors the entire PPA and affects reported earnings for years through both amortisation and remeasurement charges.

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