Earn-Out Accounting: 6 Things to Settle Before You Close the Deal

Earn-Out Accounting: 6 Things to Settle Before You Close the Deal

Earn-out accounting is hard because an earn-out is a promise about the future, written before anyone knows what the future holds. If the purchase agreement leaves the metric loose, the books cannot follow it, and buyer and seller end up arguing over a number neither can reconstruct.

Here are six things to settle before closing. This checklist is not ranked. If you want a finance partner for the post-close work, System Six is a Seattle firm that does bookkeeping and fractional CFO work for businesses with $1 million to $10 million in revenue. System Six is a paid featured member of Sam's List.

1. Define the Metric, the Period and the Calculation in Writing

The agreement should say which measure drives the payment (revenue, gross profit, EBITDA), over what period, and exactly how it is calculated. "EBITDA" alone is not a definition: which expenses count, whether owner perks are added back, and who allocates shared costs all change the answer. Attach a worked example with made-up numbers, have both sides initial it, and name the accounting method.

The limitation: detail adds negotiating friction, and no definition covers every future event. Have your attorney draft it and name an independent accountant to resolve disputes.

2. Know How Earn-Out Accounting Treats Contingent Consideration

When a buyer applies US GAAP to a business combination, an earn-out is generally contingent consideration under ASC 805. It is recorded at fair value on the acquisition date as part of the price paid. If it is classified as a liability, which is common for cash earn-outs, it is remeasured to fair value at each reporting date, with changes running through earnings. An amount classified as equity is generally not remeasured.

In plain terms, a buyer expecting to pay a lot may book a large liability on day one, and a business that outperforms can produce an income statement charge.

The limitation: classification and valuation depend on the exact terms, and a private company that does not issue GAAP statements may follow different practices. Confirm the treatment with your auditor before you sign.

3. Run the Earn-Out vs Compensation Test

Not every payment labeled an earn-out is purchase price. Under ASC 805, a payment that is automatically forfeited when the seller's employment ends is an indicator of compensation for post-close services, and it applies mainly when the seller stays on as an employee. Other indicators include a payment level low compared with the seller's ordinary pay.

Why it matters: purchase price and compensation differ in timing, presentation and tax. Compensation is generally a buyer expense as services are provided, and for the seller it can mean ordinary income and payroll tax rather than sale proceeds.

The limitation: no single indicator decides it, and reasonable advisers can read the same facts differently. Raise it with your tax professional and attorney while the terms can still change.

4. Understand How the Seller Will Be Taxed

For a seller, the tax character of earn-out payments depends on the terms. If the sale is of property and at least one payment arrives after the year of sale, the installment method under IRC section 453 generally applies unless the seller elects out, with exceptions such as inventory and dealer sales. Gain may be capital or ordinary depending on what was sold, and any payment that is really pay for services is ordinary income.

Part of a deferred payment may be treated as interest under IRC sections 483 and 1274 when payments are due more than a year after the sale and the agreement states too little interest.

The limitation: results turn on the deal, the entities and the year. Get a tax professional's view before signing, not after the first payment.

5. Keep a Separate Earn-Out Ledger

Build a dedicated schedule showing each input, its source (ledger account, report or invoice), the formula, the result and the reviewer. Keep it outside the day-to-day books so a reclassification does not silently change it.

Here is an illustrative table with made-up figures. The deal pays 20% of gross profit above $500,000 each year for three years.

Illustrative year	Gross profit	Amount above $500,000	Payment at 20%
Year 1	$620,000	$120,000	$24,000
Year 2	$540,000	$40,000	$8,000
Year 3	$480,000	$0	$0

The total is $32,000. One document gives both sides something to review and an audit trail for disputes.

The limitation: a separate ledger is extra work every period and helps only if someone keeps it current. Assign an owner, and agree how often the buyer shares it with the seller.

6. Guard the Earn-Out Metric Against Integration Drift

After closing, buyers often change systems and rebuild the chart of accounts, which can move numbers in or out of the metric. In the table above, suppose a post-close cleanup moves $30,000 of Year 2 shipping cost into cost of sales. Gross profit drops to $510,000, and the Year 2 payment falls from $8,000 to $2,000, a $6,000 difference no customer or product caused.

Require consistent accounting policies, or restatement to the pre-close method, and have the buyer give notice of system and policy changes.

The limitation: locking in old methods can be impractical if the buyer must move to its own reporting. Both sides may need a bridge schedule mapping old categories to new ones.

When to Get Help With Earn-Out Accounting: System Six

System Six is a Seattle firm founded in 2009 with about 41 employees. It lists bookkeeping and fractional CFO services, serves small businesses with $1 million to $10 million in revenue, and prices on a monthly fixed fee from $800 per month. It was acquired by a searcher in 2021, and its profile says it helps organizations modernizing a finance function after an acquisition, where earn-out tracking and chart-of-accounts changes tend to collide.

The limitation, plainly: System Six's review history is too thin to cite a count, so judge it on specialty, tenure and team size. A $1 million revenue minimum puts smaller deals outside its range. The profile does not say it handles earn-out calculations, fair value measurement or tax advice, so ask what the monthly fee covers and who would prepare the schedule. Ask for references.

Frequently Asked Questions

What is earn-out accounting?

It is how a buyer and seller record and track purchase price that depends on future results. For a buyer applying US GAAP, it is generally contingent consideration, recorded at fair value at closing and often remeasured later. For a seller, tax treatment depends on the terms. Confirm both with your accountant.

What is contingent consideration?

Contingent consideration is a payment a buyer owes only if a future event happens, such as hitting a profit target. Under ASC 805 it is generally measured at fair value on the acquisition date. Whether it is remeasured later depends on its classification, so check the terms with your auditor.

How do I tell an earn-out from compensation?

Look at whether the payment depends on the seller staying employed. If it is forfeited when employment ends, it may be compensation for services rather than purchase price. No single fact decides it, so have your attorney and tax professional review the agreement.

Who should track the earn-out calculation?

Name one person on the buyer side to prepare the schedule, and give the seller a right to review it. A fractional CFO or outside accountant can prepare it if you lack staff.

If you want a finance partner for the post-close work, you can browse fractional CFOs on Sam's List, including the firm above, and ask each how they would document an earn-out calculation.

---

About the author: Kimberly Green is cofounder of Sam’s List, a directory and matching platform for financial professionals.