Earn-out agreed – implications for accounting?

In earn-out agreements part of the purchase price payment is linked to the achievement of certain operational targets. This allows the operational risks to be shared between the contracting parties, information asymmetries to be taken into account and, ultimately, valuation differences to be bridged, which enables carrying out the transactions. In most cases, the contingent consideration extends over a period of 12 to 36 months, in which revenue or earnings ratios (e.g. EBIT, EBITDA) are usually decisive as determinants for the future payment of the contingent purchase price. In order to avoid problems early on, it is of great importance to design the structure as well as specifying details of how the agreed earn-out will be calculated already at the outset. On the one hand, complex or non-transparent structures may lead to disputes between the contracting parties later on, and, on the other hand, challenges in terms of valuation and accounting may arise subsequently.

With regards to the accounting of earn-outs, there may be significant differences between the IFRS and HGB accounting systems, especially when it comes to the identification of contingent considerations. Accounting in line with the International Accounting Standards is governed by IFRS 3 “Business combinations”. Therefore, a distinction should be made as to whether the purchase agreement actually involves an earn-out component or rather a variable remuneration component. The standard provides guidance as to how to make this distinction (IFRS 3 B.55). If the earn-out clause involves a contingent consideration according to IFRS 3, it must be included in the purchase price (“consideration transferred”) and recognised as contingent liability at fair value at the acquisition date and compounded in subsequent periods through profit or loss. Upon the occurrence of a condition, the contingent liability becomes a liability to the seller. Changes in the valuation generally lead to an adjustment of the contingent liability through profit or loss (exception: “12-month window”). However, goodwill is not adjusted immediately in the consolidated financial statements.

In accounting according to German-GAAP (HGB), there are no specific regulations regarding the accounting for earn-outs. The German Accounting Standard (DRS) 23 provides a remedy. In accordance with this standard, the acquisition cost principle also applies to conditional purchase price components (Sec. 255 HGB). They are only recognised if they can be reliably measured and it is probable that the condition will occur. If recognised, the expected earn-out payments should be disclosed in the individual financial statements as acquisition costs of the shares at present value at the time of the acquisition. At the same time, a provision should be recognised as a liability and compounded in subsequent periods. If the valuation and thus the acquisition costs increase or decrease in subsequent periods, the provision must also be increased or decreased. The increase or decrease in the acquisition costs of the shares in the individual financial statements must also be taken into account in the consolidated financial statements and recognised as goodwill, not affecting the income statement.

The fair value of contingent purchase price payments according to IFRS 3 is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an at arm's length transaction. Valuation at fair value is defined in IFRS 13 “Fair Value Measurement”, but the standard does not contain any specific requirements or guidance for the valuation of earn-outs. Due to the diverse measurement practices, the Appraisal Foundation published a sort of guidance on the valuation of contingent purchase price components in 2019. Depending on the risk profile and payment structure of the earn-out, the authors recommend the use of simulation-based methods or option pricing valuation methods. In practice, the valuation is usually carried out based on the Monte Carlo simulation, as the procedure allows modelling also more complex earn-out mechanisms with path dependencies (“carry-forwards”, “catch-up features”, “multi-year caps”) using statistical distribution functions. Finally, the choice of an adequate discount rate is often a challenge in practice.

The earn-outs, or the contingent considerations, which are usually popular in practice in M&A transactions must be recorded, valued and also subsequently measured in line with IFRS and HGB. Complex structures as well as the need for performing the valuation using simulations always pose a challenge.