Auditors’ Role in Financial Contracting: Evidence from SFAS 141(R)

Abstract:     
We examine how auditing can affect the design of financial contracts following a change in accounting standards. Effective December 15, 2008, 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 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 this effect. 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 arising from enhanced monitoring of financial contracts by a high-quality auditor following a change in accounting standards.

Number of Pages in PDF File: 51

Keywords: acquisitions, auditors, earnouts, financial contracting

JEL Classification: G34, G41, M41

working papers series