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

Abstract

This study explores the unintended consequences of fair valuing earnouts as required by IFRS 3 (2008). Using a sample of acquisitions completed by Australian firms after IFRS 3 (2008) took effect, we find that a significant portion of acquirers overstate initial earnout liabilities, with subsequent reversals recorded as operating income. Cross-sectional analysis suggests that firms under investment- and performance-related pressure tend to overstate earnout liabilities, while high-quality auditors and debt-financed deals curtail managers’ reporting discretion. In addition, an overstatement of earnout liabilities inflates goodwill, which we find is less value relevant. Further, a difference-in-difference analysis shows that IFRS 3 (2008) leads to a significant increase in both the frequency and magnitude of earnout use in public acquirers’ transactions. Overall, we highlight an accounting side benefit of using earnouts for acquirers.

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

JEL Classification: G34, M41