Corporate Law in Bite Size Chunks: Earn-outs and FRS102
How changes to FRS 102 can produce unexpected results
If you're buying or selling a business and part of the price depends on how well the business performs after the sale, then a change from 1 January 2026 in UK accounting rules could unexpectedly affect how performance is measured.
What’s changing?
For accounting periods starting after 1 January 2026, UK businesses using FRS 102 (the accounting standard for many private companies) will have to treat leases differently. Instead of showing lease payments as a regular expense in the profit and loss account, companies will now record them on the balance sheet as assets and liabilities. This means lease costs won’t reduce earnings before interest, tax, depreciation and amortisation (ie EBITDA).
Why it matters
If the earn-out is based on EBITDA (which many are), and lease costs are no longer counted as expenses, then EBITDA will look higher than it otherwise would have been. That could mean that, where the earn out period starts after 1 January 2026, the seller gets paid more than expected, or the buyer ends up overpaying - especially if the target EBITDA was based on old-style accounts drawn up using the previous FRS 102.
What can go wrong?
If the sale agreement doesn’t deal with this change, both sides could end up arguing about what the earn-out should be. The seller might say, 'The target is EBITDA and prepared under FRS 102 in force at the time, so pay up' or the buyer might say, 'This isn’t real a real increase in profit, it’s just an accounting trick.'
What to do about it
Here are a few ways to avoid problems:
- Agree on how EBITDA will be calculated. This applies to both the baseline EBITDA used to set any target and the actual EBITDA at the end of the relevant earn out period. The same accounting policies should be used
- Spell out in the sale agreement the accounting policies to be used in the earn-out period. This is where clarity over accounting policies is crucial.
- Include example calculations in the agreement to show how the earn-out will work.
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Subscribe nowBuyer vs seller viewpoints
There is the potential for both accidental winners and losers in this situation and costly legal disputes. Most parties want to avoid this sort of distraction, so there is a common interest to get it right in the first place. You therefore need to go into the sale process with your eyes open and not follow a precedent sale document blindly.
While this is mostly an accounting issue, ultimately it needs to be dealt within the sale documents. Thus we are already proactively raising this with clients to ensure that it gets picked up early on in the drafting process.
