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

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