Earnings Predictability, Auditor Verification, and Financial Contracting: Evidence from Earnouts and SFAS 141(R)
54 Pages Posted: 31 Aug 2011 Last revised: 1 Nov 2016
Date Written: October 29, 2016
We examine the effects of changes in financial reporting and contracting costs on financial contracts following a change in accounting standards for mergers and acquisitions. SFAS 141(R) requires recognition and periodic re-measurement of liabilities in “earnout” contracts. Remeasurement of the liability results in gains or losses that flow through post-acquisition earnings. As a result of these changes in financial reporting, auditors must monitor earnout contracts more closely to provide assurance on these contingent liabilities. Consistent with a financial reporting cost hypothesis, we find earnouts are used less frequently under the new standard when firms have stronger incentives to report predictable earnings (i.e., they issue management earnings guidance). In contrast, we conduct a series of tests suggesting that increased monitoring by high-quality auditors enhances the contracting efficiency of accounting-based earnouts under SFAS 141(R). By exploiting the features of this unique research setting, our findings shed new light on how firms make tradeoffs between contracting benefits and financial reporting outcomes associated with changes in accounting standards.
Keywords: acquisitions; earnouts; financial contracting; earnings guidance; auditors
JEL Classification: G34, M41, M42
Suggested Citation: Suggested Citation