Auditors’ Role in Financial Contracting: Evidence from SFAS 141(R)
Kristian D. Allee
University of Wisconsin - Madison
Michigan State University
August 23, 2013
We examine how auditing affects the design of financial contracts following a change in accounting standards. SFAS 141(R) requires recognition and periodic re-measurement of liabilities for contingent earnout payments incorporated in acquisition contracts. Consequently, auditors must now provide assurance on contingent earnout liabilities and directly verify whether acquiring firms are contractually obligated to make additional earnout payments to target-firm shareholders. Consistent with a financial reporting cost hypothesis, we find earnouts are used less frequently under the new standard. However, we find the presence of a high-quality auditor moderates the effects of financial reporting costs arising from earnouts under SFAS 141(R). We also document that earnout contracts are more likely to include accounting-based performance benchmarks in the presence of a high-quality auditor under SFAS 141(R). Our results provide evidence that firms trade-off expected financial reporting costs for contracting benefits which arise from expected auditor verification of accounting numbers used in financial contracts.
Number of Pages in PDF File: 51
Keywords: acquisitions, auditors, earnouts, financial contracting
JEL Classification: G34, M41, M42
Date posted: August 31, 2011 ; Last revised: August 24, 2013
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