Business contingencies: What are they and why should you care?
In a perfect world, business contingencies — that is, gains or losses arising from an anticipated event — wouldn’t exist because everyone would own a crystal ball. In this imperfect world, however, business contingencies must be factored into many appraisals.
Valuation is a hypothetical exercise: Fair market value (FMV) is usually defined as the amount at which property changes hands between a willing buyer and a willing seller when neither party is under any compulsion to buy or sell and both parties have reasonable knowledge of the relevant facts. These facts include a business’s contingencies, because a potential buyer would assign risk to possible adverse consequences and thus would likely pay less for the business.
The accounting treatment of contingent losses differs from that of contingent gains. Examples of contingent losses include pending or threatened litigation, actual or possible claims (such as environmental cleanup liabilities), and debt guarantees. Contingent losses are classified as probable, reasonably possible or remote. When a contingent loss is probable and the amount can be reasonably estimated, it’s accrued through a charge against income. If the loss is reasonably possible, it should be disclosed in the notes to the company’s financial statements.
Contingent gains might include damages recovery in connection with a lawsuit, patent approval or contract execution. For accounting purposes, contingent gains usually aren’t recognized on a company’s financial statements — though they may be disclosed in the footnotes.
When valuing a business, the treatment of contingencies is a bit more complicated. Hypothetical willing buyers and sellers would consider contingencies in arriving at an acceptable purchase price. For a buyer, a contingent loss increases investment risk and, therefore, reduces the price he or she is willing to pay.
For the valuator, the challenge is to quantify any contingencies and adjust the company’s value accordingly. Under an asset-based valuation approach, the valuator adjusts the value of the business’s net assets, if appropriate. With an income-based approach, the valuator increases or decreases the company’s projected future earnings or adjusts the discount or capitalization rate applied to reflect the risk associated with achieving those earnings. Either way, the valuator must rely on judgment and experience in measuring the impact of contingencies on business value.
To determine how to appropriately treat contingencies, the valuator reviews the company’s financial documents and talks with management to assess the probability that the contingencies will occur. If a contingency involves pending or threatened litigation, the valuator consults with counsel to evaluate potential outcomes (including settlement).
In cases where a firm number is required — such as an estate tax valuation or for financial reporting purposes — a valuator must use his or her best judgment to quantify contingent gains or losses. In other instances — such as business transactions, mergers and acquisitions, or divorce valuations — an appraiser can help the parties design provisions that adjust the terms once the contingency has been resolved.