Auditor monitoring and verification in financial contracts: evidence from earnouts and SFAS 141(R)
47 Pages Posted: 31 Aug 2011 Last revised: 23 Sep 2018
Date Written: September 13, 2018
We study how monitoring and verification of accounting-based performance benchmarks influences the design and efficiency of earnout contracts. Earnouts are commonly used to resolve agency conflicts arising in mergers and acquisitions, but these contracts create measurement and other agency problems when contingent payments are tied to future accounting-based performance. Exploiting changes in auditor monitoring of earnouts that arose as a consequence of SFAS 141(R), we find that acquisition contracts are more likely to incorporate accounting-based earnouts and that contingent payments tied to accounting-based performance benchmarks make up a larger portion of the consideration when acquiring firms have high-quality auditors. We also find that market reactions to announcements of earnout deals are more positive after SFAS 141(R) for acquisitions most susceptible to disputes over accounting-based performance metrics and these results are more pronounced for acquiring firms with high-quality auditors. By exploiting the features of this unique setting, we illuminate the role of monitoring and verification of accounting information in financial contracts.
Keywords: acquisitions; earnouts; financial contracting; earnings guidance; auditors
JEL Classification: G34, M41, M42
Suggested Citation: Suggested Citation