An earnout is the part of the purchase price that the buyer pays only if the acquired business hits a target. It looks like a footnote in the purchase agreement and behaves like a derivative on the income statement. The buyer measures it at fair value on the closing date, then marks it to fair value every reporting date until it settles. Each mark runs through earnings, not goodwill. Auditors who skip the earnout schedule on a deal year find the error late, because the number sits inside a liability account that nobody reconciles to the agreement.
This guide covers the three decisions that drive the accounting: whether the payment is consideration or compensation, whether it is a liability or equity, and how to remeasure it. It then walks a worked entry set and the audit procedures.
Decision 1: Is the payment consideration or compensation?
The purchase agreement may label a payment an earnout and still be paying for services after the closing date. If it is compensation, it is not part of the business combination at all. It is post-combination expense recognized under other GAAP, such as compensation guidance.
ASC 805 directs the acquirer to look at the reasons for the arrangement, who initiated it and when it was agreed. Crowe and KPMG both describe indicators such as these:
- Continuing employment. A contingent payment that is forfeited when a selling shareholder leaves is a persuasive indicator of compensation.
- Pro rata payout. Payments made in proportion to ownership at closing, with no employment condition, point to consideration.
- Employee-sellers paid more. Extra payments that go only to sellers who stay on point to compensation.
- Last-man-standing pools. Forfeited amounts that are reallocated among the remaining employees work like compensation, a point KPMG's handbook also covers.
- Clawbacks for fraud or breached representations. These protect the value the buyer acquired and are consistent with consideration.
One agreement can contain both. Split it into units of account and document the split. This is the first file the reviewer opens when an earnout appears, because the answer changes the income statement for every period the payment is outstanding.
Decision 2: Liability or equity?
If the payment is consideration, the buyer decides how to classify the obligation by applying ASC 480 and, where relevant, ASC 815-40. ASC 805 itself governs how the obligation is measured, but classification comes from those other topics.
- A payment settled in cash is a liability. KPMG's handbook uses a cash-settled, earnings-based earnout as its example of a liability with no equity analysis needed.
- A payment that can be settled in the buyer's own shares, or whose payoff varies with the buyer's own share price, needs the ASC 480 and ASC 815-40 analysis. A payment settled in a variable number of shares for a fixed or predominantly fixed amount is generally a liability.
- A payment settled in a fixed number of the buyer's own shares can qualify for equity classification only if it meets the equity criteria of ASC 815-40.
Treat equity classification as a conclusion that needs a written analysis, not a default.
The distinction matters for subsequent accounting. An equity-classified earnout is not remeasured, and settlement is recorded in equity. A liability-classified earnout is remeasured to fair value at every reporting date with changes recognized in earnings.
Decision 3: How is it measured and remeasured?
At the acquisition date, contingent consideration is measured at fair value and included in the total consideration transferred. That raises goodwill. The fair value reflects the probability of reaching each target and the time value of money.
After the acquisition date, a liability-classified earnout is remeasured at each reporting date until settlement. The change goes to earnings. It does not adjust goodwill, with one exception: a change caused by information about facts that existed at the acquisition date, learned within the measurement period, is a measurement-period adjustment and does adjust goodwill. A change caused by the business performing better or worse than expected is a post-closing event and goes to earnings.
Worked journal entries
An illustration. A buyer acquires a company for $4,000,000 in cash plus an earnout of up to $1,000,000 payable in cash if the acquired business reaches a revenue target in year two. The seller's payout is pro rata to ownership and has no employment condition, so it is consideration and a liability. The acquisition-date fair value of the earnout is $400,000.
Acquisition date. The earnout adds $400,000 to consideration transferred. The cash and earnout entries, with the identifiable net assets at $3,200,000 for illustration:
| Account | Debit | Credit |
|---|---|---|
| Identifiable net assets (individual accounts) | 3,200,000 | |
| Goodwill | 1,200,000 | |
| Cash | 4,000,000 | |
| Contingent consideration liability | 400,000 |
First year-end. Forecasts improve and the fair value rises to $650,000.
| Account | Debit | Credit |
|---|---|---|
| Change in fair value of contingent consideration (expense) | 250,000 | |
| Contingent consideration liability | 250,000 |
Settlement. The target is met in part and the buyer pays $700,000. Remeasure first, then settle.
| Account | Debit | Credit |
|---|---|---|
| Change in fair value of contingent consideration (expense) | 50,000 | |
| Contingent consideration liability | 50,000 | |
| Contingent consideration liability | 700,000 | |
| Cash | 700,000 |
If the target is missed entirely, the liability is reversed and the remaining balance is a gain in the same income statement line.
Where does the cash payment appear in the statement of cash flows?
Under ASU 2016-15, a payment made soon after the acquisition date is an investing outflow. A payment made later is split: the amount up to the acquisition-date fair value of the liability, including measurement-period adjustments, is a financing outflow, and anything above that is operating. Tie the split to the liability rollforward.
Audit angle
The earnout is an accounting estimate, so AU-C 540 applies and so does the work on valuation inputs. See /us/blog/auditing-accounting-estimates-au-c-540-sas-143 for the framework. A usable test plan for the file:
- Agree the terms. Read the purchase agreement, not the management summary. Tie the metric, target, cap, measurement period and payment date to the model.
- Test the classification memo. Check that the consideration vs compensation conclusion addresses employment conditions, and that the liability vs equity conclusion addresses ASC 480 and ASC 815-40.
- Test the model. Recompute the fair value, evaluate the discount rate and the probability weights, and compare the forecasts to the budget and to actual results since closing.
- Consider a specialist when the payout structure is complex. See /us/blog/using-the-work-of-a-specialist-au-c-620 for the auditor's specialist requirements.
- Roll the liability forward. Opening balance, remeasurement, payments, closing balance. Agree each to the ledger and to the income statement line.
- Check the disclosure. The note needs the range of outcomes, the change in the liability and the valuation technique.
Common misstatements: remeasuring through goodwill after the measurement period closed, leaving the liability at its closing-date value, recording a retention payment to a selling owner-manager as purchase price, and omitting the remeasurement expense from the cash-flow reconciliation.
Why the file needs more than the agreement
The deal closes once, but the remeasurement repeats every year. Keep a single earnout schedule in the permanent file that shows the model inputs, the prior-year and current-year fair value and the support for each change. The reviewer can then move through the workpaper in minutes.
CORAA prepares ready-to-review audit files for US CPA firms from QuickBooks books; you review and sign. See /us.
Sources
- Crowe, Consideration or Compensation? Applying ASC 805: https://www.crowe.com/insights/take-into-account/consideration-or-compensation-applying-asc-805
- KPMG, Handbook: Business combinations (classification of contingent consideration, compensation vs consideration indicators): https://kpmg.com/us/en/frv/reference-library/2026/handbook-business-combinations.html
- PwC Viewpoint, Business combinations guide, 2.6 Recognizing and measuring contingent consideration: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/business_combination/business_combination__28_US/chapter_2_acquisitio_US/26_recognizing_and_m_US.html
- FASB, Accounting Standards Update 2016-15, Classification of Certain Cash Receipts and Cash Payments (contingent consideration payments): https://storage.fasb.org/ASU%202016-15.pdf
Part of CORAA University · US GAAP for private companies: related guides, calculators and templates.
AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error