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

68 Pages Posted: 13 Jul 2021 Last revised: 13 Aug 2021

See all articles by Andrew Ferguson

Andrew Ferguson

Department of Accounting, UTS

Wei Hu

University of Technology Sydney (UTS)

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 value disclosure of earnouts required by IFRS 3 (2008). Due to the counterintuitive income statement effects of fair value accounting for changes in financial liabilities, acquirers are likely to overstate earnout liabilities at the acquisition date, with a reversal of unpaid earnout liability recorded as income over post-acquisition periods. Using a sample of acquisitions by Australian firms over 2001–2017, we find evidence of managerial opportunism in earnout accounting. We show that the enactment of IFRS 3 (2008) leads to a significant increase in 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 analyses suggest that investors seem to be able to correctly assess 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

University of Technology Sydney (UTS) ( email )

15 Broadway, Ultimo
PO Box 123
Sydney, NSW 2007
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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