Contingent consideration (earnouts) are future payments tied to acquisition targets being met. They increase the initial consideration, then are remeasured each reporting period— creating post-acquisition volatility that auditors scrutinize heavily. This guide covers measurement, remeasurement mechanics, and the audit challenges.
What is Contingent Consideration?
Payment obligations that depend on future events or conditions:
- Revenue earnout: "Pay additional £10m if revenue hits £50m in Year 1"
- EBITDA earnout: "Pay 2× EBITDA over £5m in Year 2"
- Milestone: "Pay £5m on FDA approval of drug"
- Closing balance sheet adjustment: "Pay/receive £1m per £1m variation in net working capital"
Initial Recognition (Acquisition Date)
Measure contingent consideration at fair value, using one of two approaches:
Probability-Weighted Approach
Fair Value = (Scenario 1 Payout × Probability 1) + (Scenario 2 Payout × Probability 2) + ...
Example: Earnout of £10m if revenue ≥ £50m in Year 1
— 70% probability of hitting target: £10m
— 30% probability of missing: £0m
Fair value = (£10m × 70%) + (£0m × 30%) = £7m
Most Likely Amount Approach
Used when only two outcomes likely and one significantly more probable. Less common but acceptable.
Time Value of Money
If contingent consideration won't be paid for >1 year, discount to present value:
Discount Rate Selection
- Probability-weighted expected rate: Discount rate reflecting the specific risk of that payment
- Typically 5— 10% depending on certainty of outcome
- Lower rate for high-probability items; higher for uncertain outcomes
Remeasurement After Acquisition (Subsequent Reporting Periods)
Key Rule: Not Goodwill
Critical: Changes in fair value of contingent consideration do NOT adjust goodwill. Remeasurement gains/losses go to P&L (or OCI if equity-settled).
Remeasurement Timing
- Each reporting date (quarterly/annually): Remeasure at fair value
- Recognition: Gain or loss in P&L (line item: "Contingent consideration remeasurement")
Worked Example: Software Acquisition Earnout Accounting
Deal Details
Acquisition date: 1 January 2025
Base consideration: £80m cash
Contingent consideration (earnout): "Pay additional £20m if ARR (annual recurring revenue) reaches £15m by 31 Dec 2025"
Current ARR: £12m
Management estimate of likelihood: 60% probability
Initial Recognition (1 Jan 2025)
Fair value of contingent consideration: £20m × 60% = £12m
No time value discount needed (due within 1 year, but still discount at say 4%)
PV = £12m / 1.04 = £11.54m
Consideration transferred: £80m + £11.54m = £91.54m
Mid-Year Reassessment (30 June 2025)
ARR tracking suggests 75% probability of hitting £15m target by year-end.
- New fair value: £20m × 75% = £15m
- PV discount (6 months remaining): £15m / 1.02 = £14.71m
- Increase from opening balance: £14.71m −’ £11.54m = £3.17m
- P&L Entry: Dr Contingent Consideration Liability £3.17m / Cr Contingent Consideration Remeasurement Gain £3.17m
Year-End (31 Dec 2025)
ARR confirmed at £15.2m. Target met. Fair value = £20m (cash payment imminent).
- Change from 30 June: £20m −’ £14.71m = £5.29m
- P&L Entry: Dr Contingent Consideration Liability £5.29m / Cr Contingent Consideration Remeasurement Gain £5.29m
Payment (January 2026)
Cash paid £20m against the liability. No P&L impact (already accrued).
Audit Red Flags: Contingent Consideration
Red Flag 1: Unrealistic Probability Estimates
Finding: Management estimates 90% probability of hitting ambitious EBITDA target with no supporting analysis.
Auditor action: Review historical performance of acquired company, industry benchmarks, management credibility. Adjust probability downward if unsupported.
Red Flag 2: Contingent Liability Not Remeasured
Finding: Contingent consideration recognized at £10m on acquisition date, but not remeasured in subsequent quarters despite changing market conditions.
Auditor action: Require remeasurement; significant P&L impact likely.
Red Flag 3: Time Value Not Considered
Finding: Earnout of £50m due in 3 years recognized at nominal £50m without discounting.
Auditor action: Apply present value discount (5% = £43.1m); adjust liability and goodwill (if within the measurement period) or P&L (if after measurement period closes).
Red Flag 4: Measurement Period Confusion
Finding: Adjustment for earnout reversal booked to goodwill 18 months post-acquisition (outside the 12-month measurement period).
Auditor action: Measurement period is 12 months only. After that, remeasurement goes to P&L, not goodwill.
Earnout Accounting Summary
| Event | Accounting |
|---|---|
| Initial recognition (acquisition date) | Fair value (PW or most likely) in consideration; affects goodwill |
| Remeasurement within 12-month measurement period | Adjust contingent liability AND goodwill (if probability/PV changes) |
| Remeasurement after 12-month period | Adjust contingent liability; remeasurement gain/loss to P&L |
| Payment | Cash out; reduce liability (no P&L impact if previously accrued) |
Real-Life Case Study: An Earn-Out That Moves After the Deal
Scenario. An acquirer agrees £20m upfront plus up to £5m if the target hits profit targets over two years. At acquisition, the earn-out's fair value is estimated at £3m.
Treatment. Consideration is £23m; the £3m contingent element is a liability. Because it is classified as a financial liability (cash-settled), later remeasurement to fair value goes through profit or loss, not goodwill. When performance exceeds expectations and the payout rises to £4.5m, the extra £1.5m is a P&L expense.
Takeaway. Post-acquisition changes in a cash-settled earn-out hit earnings, they do not adjust goodwill. Buyers are sometimes surprised that a target's success creates an accounting charge.
Illustrative composite scenario for educational purposes. Figures are indicative and do not represent any specific company.
→ IFRS 3 Business Combinations Hub
• IFRS 3 PPA: Step-by-Step Purchase Price Allocation with Worked Example
• IFRS 3 Fair Value Measurement: Valuing Intangible Assets
• IFRS 3 Reverse Acquisitions: Accounting for Control Transfers
• IFRS 3 Step Acquisitions: Staged Purchases & Fair Value Remeasurement