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

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.