Harrison, Inc. acquires 100% of the voting stock of Rhine Company on January 1, 2012 for $400,000 cash. A contingent payment of $16,500 will be paid on April 15, 2013 if Rhine generates cash flows from operations of $27,000 or more in the next year. Harrison estimates that there is a 20% probability that Rhine will generate at least $27,000 next year, and uses an interest rate of 5% to incorporate the time value of money. The fair value of $16,500 at 5%, using a probability weighted approach, is $3,142.
Assuming Rhine generates cash flow from operations of $27,200 in 2012, how will Harrison record the $16,500 payment of cash on April 15, 2013 in satisfaction of its contingent obligation?

Question

Quizplus · Accepted Answer

Harrison should record the contingent payment of $16,500 using a probability-weighted approach, based on the probability of Rhine generating at least $27,000 cash flows from operations in the next year. Since Rhine actually generated $27,200 cash flows from operations, the full contingent payment of $16,500 is expected to be paid. However, since the fair value of the contingent payment was estimated to be $3,142 at the time of acquisition, Harrison should revalue the contingent obligation and recognize an increase in liability for the difference between the fair value and the expected payment. Therefore, Harrison should make the following entry on April 15, 2013:
Debit Contingent performance obligation $3,142
Debit Loss from revaluation of contingent performance obligation $13,358
Credit Cash $16,500

This entry recognizes the payment of the full contingent amount, but also records a loss on the revaluation of the contingent obligation due to the change in the probability of the payment being made.