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 accounting for changes in financial liabilities, acquirers are likely to overstate earnout liabilities, with a reversal of unpaid earnout liability recorded as a fair value gain over the earnout period. Using a sample of completed 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) is associated with a significant increase in the frequency and magnitude of earnouts in public acquirers’ transactions. In addition, firms with 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, we do not observe a mechanical relation between the reversal of earnout liability and goodwill impairment. Overall, we highlight an unintended consequence of fair value accounting on earnout contracting and acquirers’ financial reporting.