Question

Harrison, Inc. acquires 100% of the voting stock of Rhine Company on January 1, 2020 for $400,000 cash. A contingent payment of $16,500 will be paid on April 15, 2021 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 2020, how will Harrison record the $16,500 payment of cash on April 15, 2021 in satisfaction of its contingent obligation?

Answer 1

To record a potential or contingent liability in the financial statements, it needs to clear two basic criteria based on the probability of occurrence and its related value as discussed below:

1. The likelihood of occurrence of contingent liability is high (i.e., more than 50%) and
2. Estimation of the value of the contingent liability is possible.

Since the liklihood is 20% in this case, the contingent liability will not be recorded in 2020.

Only a disclosure in the notes to accounts will be required.

In 2021, Harrison will record the payment as

selling and admin expenses A/c 16500

To Cash A/c 16500