Essays on Earnouts

Rita Nevada Gunn

doi:https://doi.org/10.21985/N2XX2Z

Work

Essays on Earnouts

Public Deposited

Download PDF

Download All Files (.zip)

I use the current accounting rules for earnouts and the previous changes in the accounting rules for earnouts to examine three research questions. My first research question is whether accounting regulation has real effects on the use of earnouts. My second research question is whether the earnout liability represents the fair value of the future earnout payments. My last research question is whether earnouts are used to smooth earnings and, if they are, whether the resulting earnings smoothing is informative to investors. In chapter 1, I detail the current accounting for earnouts, the accounting for earnouts under the prior rules, and the major differences between the regimes. Accounting Principles Board (APB) 16 was the first accounting rule governing earnouts effective between August 1970 and June 30, 2001, when it was superseded by Financial Accounting Standard (FAS) 141. The current accounting standard governing earnouts, Accounting Standards Codification (ASC) 805, became effective December 15, 2008. In chapter 2, I use the change in the accounting for earnouts to explore the effects of accounting changes on the use of earnouts. I conclude there are three primary benefits of including an earnout in the purchase price: reducing the information asymmetry between the seller and the buyer, reducing moral hazard, and providing a financing mechanism to the acquirer. There are also two primary costs: the costs of litigation and the costs of monitoring. In addition to the primary benefits and costs, I find there are additional secondary benefits and costs that result from the accounting for earnouts. I determine that following the enactment of FAS 141on July 1, 2001 the use of earnouts increased. I then find that following the enactment of ASC 805 on December 15, 2008 the use of earnouts increased further, despite an additional cost of increased auditor assurance. Overall, I conclude that accounting regulation changes the probability an earnout is included in the purchase price. In chapter 3, I use the current accounting rules for earnouts detailed in ASC 805 to examine the usefulness of fair values. The Conceptual Framework requires financial information be faithfully represented and relevant in order for it to be deemed useful. I conclude the earnout liability is not a faithful representation of the future earnout payments due to significant bias in the measurement of the earnout liability and incomplete disclosures surrounding the contingencies and discount rate used. I find the bias in the measurement of the earnout liability to be associated with the acquiring management’s desire to retain and incentivize target managers and acquiring management’s desire to create a cookie-jar reserve. My results indicate that the earnout liability is not a faithful representation; However, I find the earnout liability to be valued by the market and useful to users in predicting future cash flows. I conclude that the earnout liability provides information beyond the expected future earnout payments. In chapter 4, I examine what information, other than possible future earnout payments, is provided by the earnout liability. I explore the use of the earnout liability as a cookie-jar reserve. I find the earnout liability is used by managers to smooth earnings. When the transaction results in an earnout cookie-jar, the earnout liability is valued by the market and predictive of future cash flows from operations. Thus, the earnings smoothing accomplished using the earnout liability is informative by allowing managers to remove transient shocks to earnings. In addition, managers are willing to reduce returns at the time of transaction announcement in order to create an earnout cookie-jar to smooth earnings and increase returns in the future.

Last modified