People
Negotiations over closing statements can have a huge impact on the final purchase price.
Everyone hears the thunderclap when a big deal is announced, but a lot has to happen before the transaction actually closes. In the current deal environment, with lengthy timelines and complex carve-outs, buyers and sellers have plenty on their plates to successfully complete a deal. And while strategic and operational considerations are rightly top of mind, deal makers should not lose sight of the purchase agreement’s finer points.
One element, the closing statement, represents the integration of the buyer’s financial diligence and the seller’s accounting practices, and often puts significant value into play. Eleventh-hour calls to hammer out accounting practices put millions of dollars on the line. The party that realizes this—and prepares accordingly—could find themselves in the driver’s seat later on.
Why closing statements matter
A deal isn’t truly done until the ink is dry on the closing statement and post-closing adjustment provisions. One commonly disputed contract measurement mechanism is the working capital adjustment. In accounting terms, working capital is determined based on the entity’s balance sheet and is generally defined as current assets, less current liabilities (typically excluding cash & cash equivalents and current portion of debt). Operationally, working capital is used to determine and measure the amount of liquidity the seller provides to support the operations of the business after the transaction closes.
Invested parties risk paying the price if they enter post-closing negotiations without a solid understanding of their strategic priorities. And they frequently do, in part because the closing statement and accounting policy negotiations fall into a complex Bermuda triangle of the M&A process, in which dealmakers, attorneys, and accountants’ expertise and priorities all intersect.
Here, we explain how and why working capital adjustment disputes arise, and demonstrate why companies need to invest in better preparation as deal structures become increasingly complex.
Why disputes arise
Disputes can ultimately be traced back to a few common elements: ambiguity (in the contract or accounting), parties’ divergent interests, and asymmetric information about the business. Accounting for a business’ operations is a complex undertaking even before having to account for these deal-specific factors. Add in the pressure of deal timelines, the push and pull of negotiations, and the dollars at stake and it is no surprise that opinions diverge after the ink dries.
Once parties are engaged in the post-closing process, their responsibilities change, and the buyer takes control of the accounting records. With the acquired business firmly under the purview of new ownership, there is ample opportunity for new (and old) disagreements to resurface. We see a higher likelihood of disagreements when:
- There is ambiguity over which accounts should be included in the working capital adjustment. This can occur when the purchase agreement’s post-closing mechanism and supporting schedules contain limited accounting detail or lack precise definitions about the composition of balance sheet accounts. For example, the parties may include a balance sheet at the financial statement line-item level, rather than a more granular trial balance view of accounts.
- There are discrepancies between how the parties measure the balance sheet before and after the deal. For example, the amount of working capital promised in the deal (commonly referred to as a working capital “peg”) may be established using a method that diverges from the prescribed calculation of the post-closing balance sheet accounts.
- The purchase agreement references examples or illustrations of accounting practices but not the entity’s actual operating practice.
- The underlying accounting for the sold entity is complex.
- The timing of the deal does not align with its traditional financial close process.
- The purchase agreement prescribes a framework for measuring the balance sheet (e.g., U.S. Generally Accepted Accounting Principles (GAAP), or International Financial Reporting Standards (IFRS)) that conflicts with the prior accounting practices for the sold entity.
- The purchase agreement references GAAP or IFRS “consistently applied” but fails to specify whether GAAP/IFRS or consistently applied takes precedence if the historical financial statements were not prepared in accordance with GAAP/IFRS.
Understanding a bit of the why and how, we now look to the “what” of these disputes—specifically, which accounts and measurements are frequently at the center of disputes.
Common balance sheet disputes
A lack of alignment (for any of the aforementioned reasons) between the buyer and seller will manifest in specific accounting disagreements, such as the application of technical accounting guidance, the accounting impact of events occurring subsequent to the closing of the deal, and methods for estimating the assets and liabilities of the acquired company.
While accounting disputes are as diverse as the entities themselves, the following are commonly disputed accounts and potential stumbling blocks:
- Measurement of accounts receivable, including estimates for allowances for doubtful accounts.
- Inventory, including estimates for related obsolescence reserves.
- Accounts subject to complex estimates and those subject to judgment, such as construction in progress.
- Accounts payable, including payment terms and application of credits.
- Accruals for compensation, including determining the party responsible for payment.
- Contingent liabilities, including estimated accruals such as litigation accruals.
- Potential deferred revenue accruals, and the timing of revenue recognition.
Exactly how disruptive or complex the disputes and post-closing negotiations typically depends on the sophistication of, and detail in, the purchase agreement. Absent red flags like changes in historical accounting practices and carve-out financial statements, parties can move toward the purchase adjustment confidently. Planning early, documenting specifics, not losing sight of the closing statement details among all the other moving pieces, and bringing consistency to the table (we will cover more of this preparation in the second part of this series), will help minimize the risk of a post-closing dispute.
After the agreement is signed, both parties have the same end-goal: to see the deal through. However, when post-closing disputes arise, they will have to roll up their sleeves again.
For part two, we will analyze navigating post-closing balance sheet disputes, keys to avoiding disputes, and explain why you need people on your team with specific expertise in this area.
