How is an earn-out (contingent consideration) measured at acquisition and subsequently remeasured?

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AcadiFi · Accepted Answer

Contingent consideration (earn-outs) is one of the trickiest areas in business combination accounting. The acquirer records the earn-out at **fair value on the acquisition date**, and changes in that fair value flow through the income statement — not goodwill. **Day-One Measurement** The earn-out is classified as either a **financial liability** (most common — cash payments) or **equity** (settled in a fixed number of shares). For a cash earn-out, fair value is typically estimated using: - **Probability-weighted scenarios** (simple approach) - **Option pricing models** (when tied to a single threshold) - **Monte Carlo simulation** (complex, multi-factor earn-outs) **Worked Example — Caliber Holdings acquires Northfield Solutions:** Caliber will pay $30 million if Northfield's Year 2 EBITDA exceeds $50 million. At acquisition, the PPA team estimates: | Scenario | Probability | Payout | Weighted Value | |---|---|---|---| | EBITDA > $50M (target hit) | 55% | $30M | $16.5M | | EBITDA ≤ $50M (target missed) | 45% | $0 | $0 | | **Expected value** | | | **$16.5M** | | **PV @ 8% discount, 2 years** | | | **$14.15M** | \`\`\`mermaid flowchart TD A["Acquisition Date
Earn-Out FV = $14.15M"] --> B["Record as Liability
Credit: Contingent Consideration"] B --> C["Increases Purchase Price
→ Increases Goodwill"] A --> D["Year 1 Reporting Date"] D --> E{"Update Probability
& Discount Factor"} E -->|"EBITDA trending above $50M"| F["FV Increases to $22M
Loss of $7.85M in P&L"] E -->|"EBITDA trending below $50M"| G["FV Decreases to $8M
Gain of $6.15M in P&L"] F --> H["Year 2: Settlement"] G --> H \`\`\` **Subsequent Remeasurement** At each reporting date, the earn-out liability is remeasured to fair value. Changes are recognized in **profit or loss** — not as adjustments to goodwill. This is a critical rule: | Event | Accounting Treatment | |---|---| | Earn-out probability increases | Loss in P&L (liability increases) | | Earn-out probability decreases | Gain in P&L (liability decreases) | | Earn-out settled at $30M | Debit liability, credit cash | | Earn-out expires unmet | Gain in P&L (liability derecognized) | **Why This Matters for Analysis:** 1. Earn-out remeasurement gains/losses create **earnings volatility** that analysts typically adjust out as non-recurring. 2. The day-one fair value increases the purchase price and therefore goodwill — a higher earn-out estimate means more goodwill. 3. Under both IFRS and US GAAP, earn-outs classified as liabilities are remeasured through P&L. The only exception is equity-classified contingent consideration, which is not remeasured. 4. If the earn-out is based on the seller's continued employment, it may be reclassified as **compensation expense** rather than purchase price — reducing goodwill. **Exam Trap:** Changes in earn-out fair value after acquisition do NOT adjust goodwill (measurement period adjustments are different — those correct day-one errors within 12 months). Explore earn-out accounting and practice problems in our CFA Level II FRA modules.

How is an earn-out (contingent consideration) measured at acquisition and subsequently remeasured?

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