17. Do earnouts create the right incentives? Earnings management around earnout-based acquisitions

Coelho, A. P., & Loureiro, G. (2025). Do earnouts create the right incentives? Earnings management around earnout-based acquisitions. Journal of Financial Research. https://doi.org/10.1111/jfir.70007This article examines whether acquiring firms engage in earnings management during earnout periods in mergers and acquisitions. Using a sample of 517 U.S. acquisitions with earnout clauses between 1998 and 2017, compared with nearly 4,000 transactions without earnouts, the study finds systematic evidence of downward earnings manipulation. Acquirers reduce reported performance during the earnout period to lower contingent payments to target shareholders, decreasing payouts by an estimated US$3.5 to US$5.25 million. The manipulation occurs mainly through real activities, such as increasing discretionary expenses in R&D or sales, since these actions are harder to detect than accrual-based adjustments. However, in short earnout periods, managers rely more on accruals due to their immediate impact. Incentives for downward manipulation are stronger in cash-financed deals, while stock-based payments mitigate such behavior because target shareholders become owners and monitor performance. The retention of target managers limits real manipulation but not accrual adjustments. Overall, earnouts create agency problems requiring stronger monitoring mechanisms.