Direct Answer
Earnouts and deferred consideration are additional purchase price a buyer agrees to pay a seller after an acquisition closes, contingent on the acquired business hitting specified performance milestones. Under ASC 805, that contingent obligation is recognized as a liability at fair value on the acquisition date and remeasured every subsequent period, with the change in fair value running through the income statement rather than being capitalized into goodwill.
Key Takeaways
- An earnout is contingent purchase price tied to the acquired business hitting a specified milestone - usually revenue, EBITDA, or a product/regulatory event - after the deal closes.
- ASC 805 requires the earnout liability to be recognized at its acquisition-date fair value and remeasured each period, with fair-value changes flowing through the income statement.
- A growing earnout liability generally means the acquired business is outperforming its targets; a shrinking one means it's falling short - and either move can look like unrelated earnings noise if you don't know where to look.
- Earnouts show up more often when the buyer and seller disagree on value - they bridge a valuation gap instead of forcing either side to accept a price they don't believe in.
- The fair value measurement footnote's Level 3 rollforward is where you find the earnout's remeasurement history period over period.
- This page focuses specifically on earnout mechanics and remeasurement; see the companion guide for the broader purchase price allocation and goodwill that an acquisition also creates.
What Is an Earnout in an Acquisition?
An earnout is additional consideration the buyer agrees to pay the seller after closing, contingent on the acquired business achieving specified performance milestones over a defined period - commonly one to three years. The milestones are usually financial (revenue or EBITDA targets) but can also be a product launch, a regulatory approval, or a customer-retention threshold, depending on what the deal is trying to protect against.
The mechanism exists because the buyer and seller are both taking on uncertainty at closing: the seller wants credit for growth they believe is coming, and the buyer doesn't want to pay cash today for results that haven't happened yet. An earnout lets the deal close at a lower guaranteed price while leaving room for the seller to capture more value if their projections prove out - and for the buyer to pay less if they don't.
How Is an Earnout Liability Accounted for Under ASC 805?
Under FASB ASC 805 (Business Combinations), an earnout is a form of contingent consideration and must be recognized as part of the total consideration transferred - as a liability (or, less commonly, equity) measured at its fair value on the acquisition date, not at its maximum possible payout or at zero. That initial fair value is typically estimated with a probability-weighted scenario analysis or an option-pricing model, applying a discount rate that reflects the risk of the contingent payment, and it becomes part of the total purchase price used to calculate goodwill at acquisition.
The critical rule for what happens next: the earnout liability is remeasured to fair value at each subsequent reporting date for as long as it remains outstanding. Unlike the rest of the purchase price allocation, which is locked in once the measurement period closes, the earnout keeps moving - and the change in its fair value each period is recognized as a gain or loss in the income statement. It is not added to or subtracted from goodwill after the acquisition date is finalized, which is a common point of confusion since goodwill itself is the "catch-all" for the rest of the purchase price.
| Event | Where it's recognized | Effect |
|---|---|---|
| Acquisition date | Contingent consideration liability, part of total purchase price | Fair value at close feeds into the goodwill calculation |
| Each subsequent period | Income statement (operating or non-operating expense line) | Change in fair value is a gain or loss - not a goodwill adjustment |
| Payment / expiration | Balance sheet | Liability is settled in cash (or stock) or reverses to zero if the milestone is missed |
Why Do Earnout Remeasurements Create Earnings Volatility?
Because the fair-value change runs through the income statement every period, an earnout can move reported earnings without any change in the acquirer's own core operating performance. If the acquired business is tracking ahead of its milestone, the probability-weighted payout increases, the liability grows, and the increase is booked as an expense - even though the underlying business is doing exactly what the buyer hoped it would when they signed the deal.
The reverse is just as disorienting: if the acquired business is falling behind its targets, the liability shrinks and the decrease is booked as a gain. Read in isolation, a quarter where the acquirer reports a large non-operating gain because an earnout target looks less likely to be hit can look like good news on the income statement while actually reflecting the acquired business underperforming. This is exactly the kind of remeasurement noise that has nothing to do with the parent company's own operations and needs to be separated out before drawing a conclusion about earnings quality.
Worked Example: An Earnout Remeasurement
Suppose an acquirer closes a deal with a maximum earnout of $50 million, payable if the acquired business hits a two-year revenue target. At the acquisition date, management's probability-weighted analysis assigns roughly a 60% chance of hitting the full target, so the earnout liability is initially recognized at a fair value of $30 million ($50M × 60%, simplified for illustration - a real valuation would also discount for time value and risk).
One year later, the acquired business is running well ahead of plan. Management revises its probability-weighted assessment upward, and the earnout is remeasured to a fair value of $45 million. The $15 million increase in the liability is recognized as an expense in the income statement that period - a real charge against reported earnings, even though it's actually evidence the acquisition is working better than expected, not worse.
| Point in time | Fair value of earnout liability | Income statement effect |
|---|---|---|
| Acquisition date | $30.0M (60% probability-weighted) | None - part of total purchase price used to calculate goodwill |
| Year 1 remeasurement | $45.0M (business outperforming) | $15.0M expense recognized |
| Milestone met, payout | $50.0M (if target fully achieved) | Any further increase to $50.0M also expensed before settlement |
An analyst reading only the income statement might see a $15 million charge and assume something went wrong. The footnote's fair value rollforward tells the opposite story: the acquired business is outperforming the assumptions used at closing, which is the reason the liability - and the expense that comes with remeasuring it - grew.
Where Do You Find Earnout Disclosures in the Footnotes?
- Acquisition footnote. Discloses the earnout's terms (milestones, measurement period, maximum payout) and its initial fair value and valuation method at the acquisition date.
- Fair value measurement footnote. For material earnouts classified as Level 3 (unobservable inputs), companies disclose a rollforward showing the beginning balance, remeasurement gains or losses, payments made, and the ending balance each period - this is the single best place to track how the liability has actually moved.
- MD&A. Often explains in plain language what drove a material remeasurement gain or loss that period, which is useful context the rollforward table alone doesn't provide.
Why Are Earnouts More Common When There's a Valuation Gap?
Earnouts show up most often in deals where the buyer and seller genuinely disagree about what the business is worth - typically because the seller is more confident in near-term growth, a new product, or a pending contract than the buyer is willing to underwrite in cash up front. Rather than let that disagreement kill the deal, an earnout functions as a bridge: the buyer pays a lower guaranteed price today and agrees to pay more later only if the seller's optimism turns out to be justified.
This makes an earnout's mere presence in a deal a useful signal on its own. A large earnout relative to total deal value often means the two sides couldn't agree on a single number for the business - which is also why earnouts are especially common in early-stage technology, biotech, and services acquisitions, where the acquired business's near-term trajectory is harder to underwrite with confidence than an established company's historical cash flows.
Common Mistakes and How to Avoid Them
| Mistake | Why it causes problems | Better practice |
|---|---|---|
| Assuming a remeasurement gain means good news | A gain from a shrinking earnout liability usually means the acquired business is falling short of its targets, not that anything positive happened operationally. | Check the direction of the underlying business performance in the rollforward before interpreting the sign of the remeasurement. |
| Treating remeasurement changes as capitalized into goodwill | Goodwill is fixed once the measurement period closes; post-acquisition earnout remeasurements never adjust it. | Track earnout fair-value changes as income statement items, separate from the goodwill balance. |
| Ignoring earnout remeasurement noise in earnings quality analysis | A material earnout swing can meaningfully move reported operating or non-operating income in a period with no change in the core business. | Back out material earnout remeasurement gains and losses when assessing underlying operating trends. |
| Confusing the maximum payout with the recognized liability | The disclosed maximum earnout amount is a ceiling, not the balance sheet liability - the recognized amount reflects a probability-weighted fair value that is usually well below the maximum. | Use the fair value measurement footnote's actual carrying balance, not the deal's headline earnout figure, when assessing the current liability. |
Risks and Limitations
Fair value estimates rely on management's own probability assumptions. The initial and each subsequent fair value of an earnout depend on management's judgment about the likelihood of hitting the milestone, which is inherently uncertain and can be revised in ways that are difficult for an outside analyst to independently verify.
Remeasurement volatility can obscure real operating trends. A large earnout swing in a single period can make reported earnings look more (or less) volatile than the underlying business actually is, especially for acquirers with several active earnouts remeasuring at different times.
Disclosure detail varies by materiality. Smaller earnouts may only appear as a single line item without a full Level 3 rollforward, which limits how precisely an outside analyst can track the remeasurement history.
An earnout liability is a live estimate, not a settled fact - pair its disclosed rollforward with the acquired business's actual reported performance before drawing a conclusion about what a remeasurement gain or loss is really telling you.
Frequently Asked Questions
What is an earnout in an acquisition?
An earnout is additional purchase price the buyer agrees to pay the seller after closing, contingent on the acquired business hitting specified performance milestones - typically revenue, EBITDA, or a product/regulatory milestone measured over one to several years. It lets the buyer defer part of the price until the seller's projections are proven out, rather than paying the full amount up front.
How is an earnout liability accounted for under ASC 805?
Under ASC 805, an earnout is contingent consideration recognized as a liability at its acquisition-date fair value, estimated using a probability-weighted or option-pricing model over the possible payout outcomes. That liability is then remeasured to fair value at each subsequent reporting date, and the change in fair value is recognized as a gain or loss in the income statement - it is not added to goodwill.
Why do earnout remeasurements create earnings volatility?
Because the change in an earnout's fair value each period flows directly through operating or non-operating expense, a swing in the probability of hitting the milestone can move reported earnings up or down without any change in the acquirer's own core operations. A business beating its earnout targets increases the liability and books an expense; missing them decreases the liability and books a gain, both unrelated to how the rest of the company performed that quarter.
Where do you find earnout disclosures in a company's filings?
Earnout liabilities appear in the acquisition footnote (initial fair value and valuation method) and, for public companies with material earnouts, in a fair value measurement footnote showing a Level 3 rollforward - the beginning balance, remeasurement gains or losses, any payments made, and the ending balance each period. The MD&A section often explains what drove a material remeasurement.
Why are earnouts more common when buyer and seller disagree on value?
An earnout acts as a bridge when the seller believes the business is worth more than the buyer is willing to pay for certain today, often because the seller is more optimistic about near-term growth or a specific catalyst. Structuring part of the price as contingent on hitting those projections lets both sides agree to a deal without either one paying for or accepting a valuation gap in cash up front.
Related Reading
- Financial Footnotes & Accounting Policies - the hub this page is part of.
- Acquisition, Goodwill & Intangibles - the broader purchase price allocation an earnout is one part of.
- Integration Costs and Acquisition-Related Amortization - the other recurring post-close costs that show up alongside an earnout.
- Separating Organic Growth From Acquired Growth - why isolating acquisition effects matters for reading reported growth.
- Impairment Footnotes - how the goodwill created alongside an earnout is later tested for impairment.