Earn-out arrangements are a common mechanism within Sale and Purchase Agreements (SPA). When they've been properly designed they can deliver significant value and opportunities to both parties. However, the accounting consequences of including them in an SPA are sometimes misunderstood and should be carefully considered when drafting any SPA.
What are earn-outs?
Consideration for an acquired business may be split over time, with an initial amount due on completion – often subject to the deal completion mechanism adjustments – and further amounts due later, contingent on certain conditions having to be fulfilled. Where those contingencies relate to the business reaching certain performance targets in the post-acquisition period, the contingent consideration is called an earn-out.
Earn-outs often include 'bad leaver' clauses. This means that if the incumbent vendor (or management) leaves employment during the earn-out period, they may receive a reduced level of consideration from having sold their business. Earn-out arrangements documented in an SPA need to be anchored to a specific generally accepted accounting principle (GAAP). In the UK this would typically be either Financial Reporting Standard 102 (FRS 102) or UK-adopted International Financial Reporting Standards (IFRS).
Bad leaver clauses and application of GAAP are our key focus areas here, but first we'll go through how to account for an earn-out.
How to achieve a successful earn-out
Watch the webinar recording for insights from our expert panel that explain why earn-outs are used, how to account for them, and dispute resolution.
Accounting for earn-outs
The accounting treatment of an earn-out depends on which GAAP is applied. Let's look first at FRS 102, before considering the differences in accounting under IFRS.
The first area to look at is whether the earn-out arrangement contains any bad leaver clauses. FRS 102 is clear that if the amount of consideration is linked in any way to continued employment then that element of the consideration must be considered employee remuneration rather than contingent consideration for the sale of the business.
The key accounting impact of this is that employee remuneration is recognised as an expense within the statement of profit or loss, whereas contingent consideration is recognised in the balance sheet as an additional component of the initial cost of investment. The financial consequence of this may have wide-ranging implications, such as covenant compliance and the management of key stakeholders.
Once you know whether the arrangement needs to be accounted for as post-deal remuneration, contingent consideration – or in some instances a combination of the two – the following initial recognition and subsequent measurement applies.
- Reflected in the calculation of goodwill
- Include in cost of investment
- Classified as contingent liability
- Changes in Fair Value recognised in goodwill
- Recognise an expense and accrue as a liability unit paid if:
- There is a preset legal or construction obligation
- A reliable estimate of the obligation can be made
- Recognise expense and liability/equity
While IFRS is broadly aligned with FRS 102 in differentiating between remuneration and contingent consideration, and initial recognition, there's a key difference when it comes to accounting for the earn-out. Under IFRS any changes to the fair value of the contingent consideration must be recognised in the statement of profit or loss; it can't be accounted for as an adjustment to goodwill. This may result in volatility in the profit or loss, so it should be taken into account when assessing the earn-out arrangement.
FRS 102 proposals may affect earn-outs structures
Proposed changes to FRS 102 – in a Financial Reporting Exposure Draft (FRED 82) – may have a significant impact on accounting for revenue and leases, which in turn could affect the proposed earn-out arrangements. In particular, any business which is a lessee in an operating lease arrangement will see substantial changes to their EBITDA figures and balance sheet presentation because of the amendments.
Entities with lease portfolios of retail spaces, vehicle fleets, or other such properties will be significantly affected. Operating profit and EBITDA will likely increase, as part of the cost of the lease will now sit in finance costs and depreciation charge, and both gross assets and liabilities will increase as a result of the on-balance sheet lease commitments. As a result, it's important to either lock in the GAAP as at the date of signing the SPA, or to accurately forecast the expected impact of FRED 82.
Assess the accounting before signing
As noted earlier, the accounting for earn-outs can lead to increased volatility in the statement of profit or loss, and both FRS 102 and IFRS are firm in their requirement to treat any consideration linked to continued employment as remuneration rather than contingent consideration. Therefore, it's important to assess the accounting during the SPA negotiation because once the SPA is signed the accounting is often locked in.
For more insight and guidance, get in touch with Pinkesh Patel.