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Appraisal Foundation: Final Version of Guidance on the Valuation of Contingent Consideration has been released

In February 2019, the Appraisal Foundation has released the final version of the Valuation in Financial Reporting (VFR) Valuation Advisory #4 on the Valuation of Contingent Consideration. ASC 805 and IFRS 3R define contingent consideration as an obligation of the acquirer to transfer additional assets or equity interests to the form owners of the acquire as part of the exchange for control of the acquire if specified or future conditions occur. For an investment funds, contingent consideration typically arises upon the sale of a portfolio company investment, when part of the sale price is due subsequent to the closing and is contingent upon, for instance, the portfolio company meeting certain EBITDA or other performance targets. Under U.S. GAAP, contingent consideration must be included in the purchase price in a business combination, and measured at fair value on the acquisition date. From the perspective of a fund selling its interest in a portfolio company, contingent consideration must be included in the balance sheet as an asset and measured at fair value together with the remaining portfolio investments. The new guidance highlights the use of scenario-based methods and of option pricing methods in the valuation of contingent consideration. Among others, the guidance sets the stage for a more extensive use of OPM modelling techniques in the valuation of contingent considerations, for instance, in cases when the risk of the underlying metric is non-diversifiable and the payoff structure has thresholds, caps, tiers or other nonlinearities, and of Monte Carlo simulation if the payoff structure is path dependent or is based on multiple independent metrics.