The Information Content and Contracting Consequences of SFAS 141(R): The Case of Earnout Provisions

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1 The Information Content and Contracting Consequences of SFAS 141(R): The Case of Earnout Provisions Brian Cadman David Eccles School of Business, University of Utah Richard Carrizosa David Eccles School of Business, University of Utah Lucile Faurel Paul Merage School of Business, University of California, Irvine * First Draft: September 2011 This Draft: February 2012 ABSTRACT SFAS 141(R) requires firms to recognize the fair value of contingent considerations ( earnouts ) included in acquisition agreements. This new accounting standard alters the information environment surrounding earnouts and impacts the acquiring firms financial statements. We find that fair value estimates and subsequent fair value adjustments of earnout provisions provide valuable information to market participants beyond the financial statement effects. We also document that the use of earnout provisions increased following the adoption of SFAS 141(R), on average, while use by acquiring firms with greater financial reporting concerns declined. Together, our results provide evidence that fair value disclosures help reconcile information asymmetries between insiders and market participants, and shed light on the influence of accounting standards on contract design. * We thank Novia Chen and Qin Li for excellent research assistance. We benefited from helpful comments and suggestions by workshop participants at Arizona State University, Boston College, and University of Washington.

2 The Information Content and Contracting Consequences of SFAS 141(R): The Case of Earnout Provisions 1. Introduction Contingent considerations (hereafter earnouts ) are provisions of acquisition agreements that provide sellers with payments conditional on the occurrence of specified future events or meeting certain conditions. These contracted outcomes, which generally extend up to five years after the acquisition, are often based on financial performance metrics, such as revenue and earnings targets, and/or non-financial performance hurdles, such as FDA approval and clinical trial success. Until recently, firms did not recognize earnouts at the time of the acquisition. Rather, earnouts were recognized when the corresponding contingencies were resolved and the payments made (or when it was reasonably assured that payments will be made). Consequently, the impact of earnouts on acquirers financial statements was minimal. Recently, Statement of Financial Accounting Standards (SFAS) 141(R) (2007) significantly altered the accounting treatment of earnouts. The revised standard requires firms to estimate and recognize the fair value of earnouts at the acquisition date, include earnout fair values in the acquisition purchase price, and adjust earnout fair values in each reporting period. 1 This study investigates the information content of earnout fair values and subsequent fair value adjustments, and focuses on the market valuation of this new information. We also explore whether and how the adoption of SFAS 141(R) influences the use of earnout provisions in acquisition agreements. SFAS 141(R) alters the information environment of acquisitions that contain earnout provisions on at least three dimensions: i) estimating, recording, and adjusting earnout fair values 1 Section 2 provides a detailed description of the change in the accounting treatment of earnouts, the disclosure and recognition requirements, and the financial reporting implications. 1

3 introduce additional subjectivity and complexity to the reporting process of acquisitions, ii) recognizing earnout fair values increases the reported purchase price of acquisitions, iii) earnout fair values and subsequent fair value adjustments provide additional information to the market about acquiring firms expectations regarding the value of the target firms and the likelihood that the targets will achieve the contracted outcomes. In addition, this new accounting treatment alters the costs and benefits of this contract feature for acquiring firms. Based on the new information recognized with the adoption of SFAS 141(R), we address three research questions. First, we study whether market participants incorporate the information revealed by earnout fair values into their valuation of acquisitions. We then examine how market participants respond to subsequent earnout fair value adjustments and examine the information content of this newly recognized information. Finally, we investigate the relation between SFAS 141(R) and the propensity to include earnout provisions in acquisition agreements while considering the reporting implications of the revised accounting standard. Prior studies shed light on the benefits of earnout provisions, and primarily examine the determinants of earnout provision inclusion in acquisition agreements. Kohers and Ang (2000), Datar et al. (2001), and Chatterjee et al. (2004) suggest that earnouts help acquiring firms hedge risk and reduce the costs of acquisition when there is greater information asymmetry about the target firms. Kohers and Ang (2000) and Chatterjee et al. (2004) also provide evidence that acquisition premiums are greater when earnouts are included in acquisition agreements. More recently, Cain et al. (2011) find that earnouts are larger when targets operate in industries with high growth or high return volatility, consistent with earnouts being structured to minimize the costs of valuation uncertainty. Our study contributes to this stream of literature by focusing on 2

4 how the change in the accounting for earnouts influences the information environment surrounding this contract feature and its use in acquisition agreements. We document that earnout fair value estimates and subsequent earnout fair value adjustments required by SFAS 141(R) provide value-relevant information to market participants. Specifically, we find evidence that market participants use the information revealed by earnout fair values in their valuation of acquisitions. We also find evidence that subsequent fair value adjustments provide valuable information to the market beyond their financial statement effects. In addition, consistent with the new accounting standard altering the costs and benefits of contracting with earnout provisions, we find that earnouts are more commonly included in acquisition agreements in the period following the adoption of SFAS 141(R), after controlling for other known determinants of earnout provisions. Despite the average increase in earnouts, we find evidence that financial reporting concerns about reporting additional leverage reduce the probability of including earnout provisions after the adoption of SFAS 141(R). The results of our study shed light on how the market values information contained in fair value estimates and subsequent adjustments. We also provide evidence on how changes in financial reporting standards influence contract design. Together, our findings contribute to understanding how accounting standards shape contract design, and show how mandated disclosures recognized in financial statements can improve the information environment in a way that is relevant to market participants. 3

5 2. Earnouts 2.1. Accounting for Earnouts The accounting for earnouts was initially specified in Accounting Principles Board Opinion (APB) No. 16 (1970). Under APB 16, future payments to be made as part of a business combination agreement were included in the purchase price and recorded at the acquisition date if these payments were made unconditionally with amounts determinable at the acquisition date (e.g., amounts placed in escrow for a specific period of time). However, if payments were contingent on the outcome of future events, as for earnouts, then these contingent payments were disclosed at the time of acquisition, but not recorded as a liability until the contingency was resolved. When the contingency was resolved, the corresponding payments were recognized as an addition to the purchase price and generally recorded as an increase to goodwill. Statement of Financial Accounting Standards (SFAS) No. 141 (2001) superseded APB 16 but did not substantially modify the accounting for, or the disclosure of earnouts. In 2007, however, SFAS 141 was revised to include significant changes to the accounting treatment of earnouts. Specifically, SFAS 141(R) requires the acquirer to recognize all assets acquired and liabilities assumed, measured at their fair values as of the acquisition date. 2 Accordingly, the fair value of an earnout must be estimated and included in the acquisition s purchase price as of the acquisition date. When earnout payments are in the form of cash payments, transfers of other assets, and/or equity payments settled with a variable number of shares, the earnout fair value is recorded as a liability. Subsequent adjustments to the fair value of the earnout liability must be recorded through earnings at each reporting date until the contingency is resolved. When earnout 2 SFAS 141(R) applies to acquisitions completed on or after the beginning of the first annual reporting period beginning on or after December 15, SFAS 141(R) is now Accounting Standards Codification (ASC) 805. For familiarity reasons, we will refer to SFAS 141(R) throughout this study when referring to the current accounting standard for business combinations, i.e., SFAS 141(R) and ASC

6 payments are in the form of equity payments settled with a fixed number of shares, the earnout fair value is recorded as equity, and subsequent settlement differences are accounted for within equity as the contingency is resolved. In our sample, approximately three percent of the earnout provisions in the post-sfas 141(R) period are classified as equity. As a result, our discussion focuses on liability classified earnouts. The FASB Staff Position (FSP) No. FAS 141(R)-1 issued in April 2009 amends and clarifies SFAS 141(R) to address application issues raised by practitioners regarding the initial recognition of earnout fair values and their subsequent re-measurement. This FSP confirms that earnout fair values should be recognized at the time of acquisition, as stated in SFAS 141(R). However, the FSP clarifies that if earnout fair values cannot be reasonably estimated at the time of acquisition, then acquiring firms should recognize them in subsequent periods following other applicable Generally Accepted Accounting Principles as appropriate (including SFAS 5). 3 Prior to the adoption of SFAS 141(R), the earnout related information disclosed and the corresponding financial reporting implications were minimal. An acquirer disclosed in the financial statement footnotes the following information pertaining to earnouts: the maximum amount of earnout payments (almost systematically), the expiration date of the earnout period (frequently), the payment schedule (occasionally), and the earnout thresholds that the target firm must meet to receive the payments (rarely). 4 The details of earnout provisions were generally provided as part of the acquisition agreement attached to the corresponding 8-K, 10-Q, or 10-K filing. In addition, an earnout impacted the acquirer s financial statements only when the 3 FSP FAS 141(R)-1 also eliminates the requirement stated in SFAS 141(R) of disclosing in the financial statement footnotes the range of expected outcomes for the recognized contingency. However, firms may still voluntarily disclose this information and, from our hand-collection exercise, we noticed that a number of firms continue to disclose this information even after the issuance of this FSP. Also, this information can be approximately inferred from the earnout fair values. 4 These frequencies are based on our inspection of a hand-collected subsample. 5

7 contingency was resolved, and earnout payments were made, or it was reasonably assured they would be made. More specifically, on the balance sheet, (short-term) liabilities were recognized after the contingency was resolved but before the payments were made (usually for an average of a few months). The only income statement effect associated with earnouts prior to the adoption of SFAS 141(R) involved impairments and related expenses associated with the assets recorded when earnout payments were made (generally goodwill). 5 The new accounting treatment of earnouts introduced by SFAS 141(R) considerably increases both the disclosed earnout details, and the impact of earnouts on the acquirer s financial statements. In addition to the information provided in the pre-sfas 141(R) period, an acquirer must now provide the fair value of the earnout at the time of acquisition and re-measure this fair value every quarter. On the balance sheet, the earnout fair value is estimated and recognized in the purchase price as of the acquisition date, which increases assets by the fair value of the contingent payment. Additionally, the earnout fair value is recognized as a liability for liability classified earnouts. Earnout payments are typically settled one to five years after the acquisition, thus earnout liabilities are mostly recognized as long-term liabilities. Furthermore, in each reporting period after the acquisition date and until the contingency is resolved, changes in earnout liabilities are recorded through earnings on the income statement. 6 Finally, in addition to the impact of earnouts on acquirers financial statements, SFAS 141(R) introduces the following financial reporting costs for acquirers: i) the determination, recording, and re-measurement of earnout fair values introduce further subjectivity and complexity to the reporting process of acquisitions; ii) the recognition of earnout fair values in 5 Note that this income statement effect was indirect and may have occurred long after the acquisition was completed, the contingency was resolved, and earnout payments were made. 6 See Appendix A for an example of the earnout related information available in corporate filings and Appendix B for a simplified hypothetical example of accounting for a liability classified earnout. 6

8 the purchase price increases the reported cost of an acquisition; iii) the quarterly gains/losses recorded when adjusting earnout fair values is opposite to the underlying performance of the acquired business, e.g., if the acquired business performs well (poorly), the earnout fair value may be adjusted up (down) with a resulting loss (gain) recorded. 7 These financial reporting costs are discussed in numerous practitioner articles and echoed in arguments set forth in the 110 comment letters sent to the Financial Accounting Standards Board (FASB) Prior Literature on Earnouts Although numerous papers examine mergers and acquisitions, only a few papers consider earnouts. The prior work sheds light on the benefits of earnouts, primarily examining the circumstances where earnout provisions are more likely to be included in acquisition agreements. Kohers and Ang (2000) study a sample of earnout provisions over the period 1984 to 1996, Datar et al. (2001) analyze acquisitions completed between 1990 and 1997, and Chatterjee et al. (2004) examine a sample of earnouts in the U.K. from 1998 to All three studies reach similar conclusions: earnouts help acquirers hedge risk and reduce acquisition costs when there is greater information asymmetry about the target firm. 9 Overall, they find that earnout provisions are more likely to be included when targets are small, privately held, service companies, with high return on assets and relatively large amounts of intangible assets, from different industries than acquirers, and operating in high-tech industries with high research and development (R&D), high 7 In SFAS 141(R), the FASB discusses the fact that these counterintuitive gains/losses may be (partially) offset by related transactions (such as asset impairments or reductions of other liabilities) (c.f., B358-B360). However, and as discussed in a few comment letters, these counterintuitive gains/losses may not be offset by any related transaction. 8 See Appendix C for a summary of the main arguments in favor and against the change in the accounting for earnouts discussed in the comment letters received by the FASB. 9 Kohers and Ang (2000) also conclude that earnouts serve to retain target managers. Indeed, incentive payments to target managers are occasionally included in earnout provisions. However, for accounting purposes, under APB 16 and SFAS 141(R), such payments are not considered as part of an earnout and are recognized as compensation expense over the appropriate period (generally the length of the earnout). Under SFAS 141(R), these incentive payments are not included in the purchase price along with the estimated earnout fair value. 7

9 sales growth, and high market-to-book ratios. Kohers and Ang (2000) and Chatterjee et al. (2004) also provide evidence that acquisition premiums are greater when earnouts are included in acquisition agreements. More recently, Cain et al. (2011) examine the terms of earnout provisions included in acquisitions completed between 1994 and Their findings suggest that earnouts are larger when the targets operate in industries with high growth or high return volatility, consistent with earnouts being structured to minimize the costs of valuation uncertainty. Finally, in a concurrent study, Allee et al. (2011) find that firms are less likely to include earnout provisions in acquisition agreements after the adoption of SFAS 141(R). 10 We contribute to the stream of literature on earnout provisions by examining the information content of earnout fair value estimates and subsequent earnout fair value adjustments following the adoption of SFAS 141(R). We also study how the change in the accounting for earnouts influences the information environment surrounding earnout provisions and their use in acquisition agreements. As such, our results provide evidence on how required disclosures help reconcile information asymmetries between insiders and market participants, and how accounting standards influence contract design and the information environment. 3. Hypothesis Development Our hypotheses focus on the information content of earnout fair values and earnout fair value adjustments recognized in financial statements following the adoption of SFAS 141(R). As discussed in Section 2.1, the new accounting treatment of earnouts introduced by SFAS 141(R) increased the information provided by acquiring firms related to earnouts and considerably 10 Our paper differs from this study on several dimensions, including our focus on the information content of earnout fair values and fair value adjustments, and our investigation of the determinants of earnout fair value adjustments and associations between earnout fair value adjustments and goodwill impairments. Our sample also spans a greater number of transactions over a longer time period. 8

10 changed the impact of earnouts on acquirers financial statements. Under SFAS 141(R), earnout fair values disclosed at the time of the acquisition provide market participants with information regarding the acquirer s expectations of the target s future performance, and of the likelihood that earnout thresholds will be achieved and corresponding earnout payments made. These expectations shed light on the acquirer s assessment of the target firm s worth and the expected benefits of the acquisition. Moreover, because SFAS 141(R) requires firms to include the earnout fair value in the purchase price and to recognize the fair value in a way that directly impacts financial statements as of the acquisition date, this information is prominent and easily accessible to financial statement users. Furthermore, due to the related financial reporting costs for acquirers discussed in Section 2.1, the earnout information provided and recognized in financial statements under SFAS 141(R) consists of a costly and, therefore, credible signal (e.g., Spence 1973 and Leland and Pyle 1977). Based on the detailed earnout information disclosed, the prominence of this information recognized in acquirers financial statements, and the credibility of the related signal, we predict that earnout fair values mandated by SFAS 141(R) provide valuable information to market participants regarding the acquisition and/or the target s worth. Specifically, we expect that market participants use the information revealed in earnout fair values when considering the return on acquisitions. This leads to our first hypothesis: H1: The market values initial earnout fair values recognized in financial statements following the implementation of SFAS 141(R). For liability classified earnouts, in addition to reporting earnout fair values at the time of the acquisition, SFAS 141(R) requires firms to re-measure these earnout fair values and make appropriate adjustments in each quarterly reporting period. These fair value adjustments provide information to market participants regarding revisions of acquirers expectations of the target 9

11 firms worth and the expected benefits of the acquisitions. Specifically, an increase (decrease) in the earnout fair value (i.e., liability) indicates that the likelihood of achieving the earnout thresholds is greater (lower) than previously anticipated. These fair value adjustments also have a direct effect on earnings where an increase (decrease) in the earnout liability results in a decrease (increase) in earnings. Because an increase (decrease) in the liability has a negative (positive) effect on earnings, but reveals a positive (negative) signal about the likelihood of the target achieving the earnout thresholds, the effect on earnings contradicts the information signal revealed. 11 This contrast introduces a tension in how market participants view the information provided by earnout fair value adjustments. We predict that market participants value the information provided by these earnout fair value adjustments. We do not, however, conjecture whether market participants put more weight on the earnings effect or the information signal revealed by these fair value adjustments. This leads to our second hypothesis: H2: The market values earnout fair value adjustments provided and recognized in financial statements following the implementation of SFAS 141(R). 4. Data and Sample Selection We obtain data from the following sources: the Thomson Reuters Securities Data Company (SDC) Platinum Mergers and Acquisitions database, the Compustat annual and quarterly databases, and the CRSP daily returns database. We identify acquisition agreements that include earnout provisions using the SDC database, which records the maximum amount of earnout payments (if any). We gather an initial sample of 11,581 acquisitions by U.S. public acquiring firms with deal values reported in the SDC database, strictly positive total assets and 11 These contradictory income effects are similar to the fair values of liabilities examined in Barth et al. (2008). 10

12 book value of equity for acquiring firms in the quarterly Compustat database, and sufficient data to construct explanatory variables. 12 The sample period spans July 1, 2001 to May 31, 2011, which begins after the adoption of the original SFAS 141 to ensure a relatively homogeneous reporting environment. Out of these 11,581 acquisitions, 9,896 (1,685) are completed pre- (post-) SFAS 141(R), and 981 contain earnout provisions (804 pre- and 177 post-sfas 141(R)). Table 1 provides the year and industry distribution of this initial sample of 11,581 acquisitions. Panel A of Table 1 indicates a steady increase in the proportion of acquisitions that include earnout provisions, despite a considerable decline in the number of acquisitions towards the latter period of our sample. On average from 2001 to 2011, 8.5 percent of acquisitions include earnouts. However, that proportion increases from between 6.9 to 7.9 percent in to between 9.8 to 11.7 percent in Panel B of Table 1 presents the frequency distribution of acquisitions by target industry based on the Fama-French 10-industry classification. 13 Earnout provisions are most frequently included in acquisition agreements when target firms operate in the healthcare (16 percent of our sample) or high-technology (11 percent) industries. From this comprehensive sample, we select specific subsamples for each of our tests based on the focus and data requirements of the test. We introduce and define each subsample as they are employed in our analyses. 12 The data required to construct explanatory variables are: quarterly Compustat data for the acquiring firm for at least eight of the prior 12 quarters prior to the acquisition announcement date, acquiring firm s closing stock price in the CRSP database prior to the acquisition announcement date, annual Compustat data for at least three firms in the same three-digit SIC industry as the target firm in the year prior to the acquisition announcement date. 13 The 10-industry classification is obtained from Professor Kenneth French s web site (http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html). 11

13 5. Information Content of Earnout Fair Values and Adjustments 5.1. Market Valuation of Earnout Fair Values Our first test focuses on the information content of earnout fair value estimates disclosed after adopting SFAS 141(R). The sample used for this test is restricted to acquisitions with earnout provisions completed after the adoption of SFAS 141(R). From our initial sample identified using the SDC database, we gather 177 acquisitions with earnouts in the post-sfas 141(R). We supplement this sample by hand-collecting information on acquisitions that are covered by the SDC database but marked as having a missing deal value and/or a missing maximum amount of earnout payments. For these acquisitions, we search corporate filings in the Securities Exchange Commission s Electronic Data Gathering, Analysis, and Retrieval (EDGAR) database for any earnout related information, and compile these supplemental observations. For the post-sfas 141(R) period, we are able to identify 122 additional observations. This yields a total sample of 299 acquisitions with earnouts in the post-sfas 141(R) period, which consists of 290 liability classified earnouts, 5 equity classified earnouts, and 4 earnouts with a portion classified as liability and a portion classified as equity. To compile additional detailed information on this sample, we hand-collect initial earnout fair value estimates, subsequent earnout fair value adjustments, and earnout design details (such as starting date, evaluation period, performance metrics, payment structure, etc.) from corporate filings in the EDGAR database (forms 8K, 10Q, and 10K). See Appendix A for an example of the earnout related information available in corporate filings. To provide evidence on whether earnout provisions reveal information to the market, and test our first hypothesis, we examine the relation between reported earnout fair values and abnormal returns around the acquisition. We estimate the following model: 12

14 (1) The dependent variable, BHAR [Ann;10Q/K], is the acquirer s buy-and-hold abnormal returns over the period beginning one trading day prior to the acquisition announcement date through one trading day following the 10Q/K filing date. Buy-and-hold abnormal returns are measured using raw stock returns minus returns on matched size and book-to-market reference portfolios. We select this return window to ensure that the earnout fair value is revealed to the market during this time. This window captures the initial earnout fair value disclosure by the acquirer and the initial recognition in the quarterly report immediately following the acquisition. We include variables to capture the relative size of the transaction and the earnout related amounts. All of these variables are scaled by the acquirer s market value of equity in the most recent quarter prior to the acquisition announcement. We measure the relative size of the transaction in two ways. First, TranVal is the transaction amount, which includes the maximum earnout payment amount. Second, TranValNoEO is the transaction amount after excluding the earnout related component. We exclude the earnout related component from the transaction amount when we explicitly include the earnout component in the model. We measure the earnout component as either i) EOMax, the maximum earnout payment amount, or ii) EOFV, the earnout fair value. EORest is the difference between the maximum earnout payment amount (EOMax) and the earnout fair value (EOFV). To summarize these relations, the following equations hold: (2) (3) We also include target firm and deal characteristics in line with prior research investigating acquisition returns (e.g., Moeller et al. 2005). Specifically, we consider whether the acquisition included stock as a component of the payment (Stock), whether the target operates in 13

15 a different industry than the acquirer (CrossInd), whether the target is a private company (TargetPrivate) or a public company (TargetPublic), and whether the target is in the lower 25 th percentile of the NYSE (TargetSmall). 14 Finally, the sample used for the estimation of Equation (1) is derived from the sample of 299 acquisitions with earnouts in the post-sfas 141(R) period. From this sample, we identify 163 acquisitions with liability classified earnouts that have the necessary data to estimate Equation (1) and for which the acquisition s announcement date is in the same fiscal quarter as the acquisition s effective date. We impose this restriction so that the initial earnout fair value disclosure and initial recognition are in the same quarter to be consistent with the return window used for our dependent variable BHAR [Ann;10Q/K]. Table 2 presents summary statistics of the variables included in Equation (1). The average transaction is about 11 percent of the acquiring firm s market value. The earnout fair value constitutes about 1.6 percent of the acquiring firm s market value. Also, 14 percent of the acquisitions are paid (at least partly) with stock, 46 percent are across industries, and 77 percent are acquisitions of private firms. The maximum earnout payment amounts are, on average, twice as large as earnout fair values (3.5 versus 1.6 percent of the acquirer s market value of equity, on average). This difference in magnitude is interesting because prior to the adoption of SFAS 141(R), the maximum earnout payment amount was often the only earnout information disclosed. Table 3 presents results from the estimation of Equation (1). Column (1) represents the basic model suppressing information about the earnout provisions. We do not find a significant relation between abnormal returns and transaction amounts. The other determinants are not significantly related with abnormal returns, except that acquisitions of public target firms are 14 Note that there are other possible classifications for target firms aside from public or private, such as subsidiary. 14

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