Fair Value of Earnouts: Valuation Uncertainty or Cookie Jar Reserve?

61 Pages Posted: 13 Jul 2021 Last revised: 7 Oct 2021

See all articles by Andrew Ferguson

Andrew Ferguson

Department of Accounting, UTS

Cecilia Wei Hu

Deakin University

Peter Lam

University of Technology, Sydney - Discipline of Accounting; Financial Research Network (FIRN)

Date Written: July 12, 2021

Abstract

This study investigates the economic consequences of fair valuing earnouts required by
IFRS 3 (2008). Due to the counterintuitive income statement effects of fair value accounting
for changes in financial liabilities, acquirers are motivated to overstate earnout liabilities, with
a subsequent reversal of unpaid earnout liabilities recorded as income. Using a sample of
acquisitions by Australian firms over 2001–2017, we find evidence of managerial opportunism
in earnout accounting. We show that IFRS 3 (2008) leads to a significant increase in both the
frequency and magnitude of earnouts in public acquirers’ transactions. In addition, firms with
ex-ante higher leverage, greater operating cash flow, and lower profitability are more likely to
overstate earnout liabilities, while high-quality auditors help curtail such reporting discretion.
Further, investors are able to assess overstated earnout liabilities and related goodwill. Overall,
we highlight the unintended consequences of fair value accounting on earnout contracting and
acquirers’ financial reporting.

Keywords: acquisitions, earnouts, contingent consideration, fair value accounting, financial liability, IFRS 3, IFRS 9

JEL Classification: G34, M41

Suggested Citation

Ferguson, Andrew and Hu, Wei and Lam, Peter, Fair Value of Earnouts: Valuation Uncertainty or Cookie Jar Reserve? (July 12, 2021). Available at SSRN: https://ssrn.com/abstract=3884775 or http://dx.doi.org/10.2139/ssrn.3884775

Andrew Ferguson (Contact Author)

Department of Accounting, UTS ( email )

PO Box 123 Broadway
Sydney, NSW 2007
Australia
61 2 9514 3565 (Phone)

Wei Hu

Deakin University

221 Burwood Hwy, Burwood
Victoria, Victoria 3125
Australia

Peter Lam

University of Technology, Sydney - Discipline of Accounting ( email )

P.O. Box 123 Broadway
Sydney, NSW 2007
Australia
02 9514 3926 (Phone)
02 9514 3669 (Fax)

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

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