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March 1993

Avoiding or resolving purchase-price disputes.

by Schector, David

    Abstract- Disputes can sometimes arise from purchase price adjustment provisions contained in contracts for the acquisition of a company. The most common reasons for the occurence of conflicts are unclear purchase contract language, failure to document representations in the contract, and failure to incorporate expressed intentions into the contract. Such disputes can be resolved through an accounting arbitration, a less expensive alternative to ligitation. CPAs can assist in this process by identifying the disputed issues, preparing formal position papers regarding the disputed items, planning a response to the other party's position, analyzing and identifying the essence of the matters in dispute, and listening to oral testimony. CPAs can also help ensure that the arbitrator's ruling will be fair by recommending that the disputing parties receive a draft copy of the report before its final issuance.

Most contracts for the acquisition of a company contain provisions for adjustment of the purchase price based on financial factors determined after the contract is signed. These provisions may lead to disputes between the parties. Here is how a CPA can assist in either avoiding or settling such disputes.

Smith Manufacturing Company's Board of Directors decided to accept Jones & Co.'s offer to buy the company. Jones made the offer after a thorough due diligence review of Smith's business operations and financial condition as reflected in its March 31 interim financial statements. The parties agreed to a purchase price based on a multiple of the prior twelve months' earnings and entered into a purchase agreement dated April 20. Because the transaction was not expected to close until June 1, the purchase agreement had the following clause:

Within 30 days after the closing date, the seller shall deliver to the buyer a closing-date balance sheet prepared in accordance with generally accepted accounting principles on a basis consistent with the company's March 31, 1992, balance sheet. To the extent the net worth set forth on the closing date balance sheet is less than the net worth set forth on the March 31, 1992, balance sheet, the purchase price shall be reduced by the amount of such deficiency. To the extent the closing net worth is greater than the March 31, 1992, net worth, the purchase price shall be increased by the amount of such excess.

Such clauses, which provide for a post-closing adjustment of the price to be paid to acquire a company, are commonly included as a part of acquisition contracts. Arbitrations, frequently decided by experienced CPAs, are being used to resolve disputes arising in the calculation of a purchase-price adjustment. To maximize the potential benefit, financial executives and entrepreneurs are calling on CPAs to help design, calculate, or evaluate purchase-price adjustments.

Purchase-Price Adjustments and the CPAs Role

The popularity of purchase price adjustments in agreements results from a combination of factors, from legal complexities to economic volatility, including--

* Lengthy periods between the execution of an acquisition contract to the closing date. Tasks, such as modifying debt covenants, obtaining regulatory approvals, and finalizing specific contract provisions, may require several months to complete.

* An unwillingness on the part of a buyer to bear the risk of the target company's financial deterioration should the seller fail to manage the target company properly to the closing date.

* An element of protection for the buyer against misrepresentations by the seller related to the target company's financial position. Frequently, closing-date financial statements, which generally serve as the basis for purchase-price adjustments, are subjected to an independent audit. A purchase-price adjustment may serve as an automatic and timely means of recovering for certain types of misrepresentations that can be uncovered by an audit.

* A desire by the seller to benefit from the ongoing efforts to effectively manage the target company's operations for the period between the contract date and the closing date.

Purchase-price adjustments may take several different forms. A purchase- price adjustment based on the change in net assets, such as the one illustrated earlier, is perhaps the most common form. Other common purchase-price adjustments include changes in working capital, cash flows, or income between the contract and closing dates of the transaction.

A CPA assisting either the buyer or the seller in selecting a purchase- price-adjustment mechanism for inclusion in the purchase contract needs to consider carefully the financial impact and future consequences of the type of adjustment mechanism chosen. For example, some contracts provide for an adjustment based on changes in working capital, excluding cash, where the contract provides for the buyer to assume all liabilities and the seller to retain cash balances. Any inherent bias towards manipulating operations during the transition period, notwithstanding "ordinary course-of-business" provisions in most purchase contracts, can be further compounded by such purchase-price adjustments. To illustrate, consider the far different effect on such an adjustment when cash overdrafts are drawn on zero-balance bank accounts with no other cash balances available (a financing and thus a balance sheet liability) or on disbursement accounts with positive cash balances available (a reduction of cash in the balance sheet).

There are many key features that should be considered in structuring an agreement. Several of these drafting considerations also should help to avoid future misunderstandings and disputes with respect to other references to financial statements and financial representations in the purchase contract.

* If the parties intend that the contract balance sheet and the closing date balance sheet are to be prepared in conformity with GAAP, the contract should explicitly refer to that precise phrase. Variations of that phrase may be interpreted differently by one of the parties.

* If GAAP is to be modified to exclude certain assets or liabilities (for example, income tax accruals) or to change the carrying value of an asset or liability (for example, to substitute the fair value of a loan portfolio for historical cost), the contract should explicitly identify those provisions as modifications to GAAP. For example, the contract might provide a seller representation that inventory can be used in the ordinary course of business within one year. However, unless explicitly identified as a contractual modification to GAAP, that representation ordinarily would not cause the target company to change their historical accounting basis for providing for obsolete inventory.

* If the contract and closing date balance sheets are to be prepared in conformity with GAAP as well as in accordance with certain contractual provisions, it is imperative that the contract explicitly detail whether GAAP or the contractual provisions will control in the event of potential inconsistencies in accounting treatment.

* If the parties intend that the contract and closing date balance sheets are to be prepared in accordance with GAAP on a basis consistent with that of the target company's historical financial statements, the contract should address how new GAAP standards are to be implemented, particularly if their result is inconsistent with the historical accounting treatment previously afforded such items.

* If changes in allowance or reserve type accounts are to be excluded from the purchase price adjustment provision (i.e., changes in judgment where no specific events or economic developments have occurred), the nature and type of such excluded accounts should be specifically identified as being so excluded in a schedule to the purchase agreement.

The key to a well-drafted purchase-price-adjustment provision is for each party to carefully consider the economic intent of the adjustment and what unanticipated problems can arise. A CPA's experience and knowledge of accounting can be especially valuable in this respect.

Purchase Price Disputes

Unfortunately, even in the most harmonious of transactions between two parties, disputes can arise over a purchase agreement, and more specifically, a purchase-price adjustment. Some of the more frequent reasons for such disputes include:

* The purchase contract language is not clear. This can be particularly troublesome when both parties believed there was little need to focus on the wording of a purchase price adjustment clause or other financial provisions because of a misconception that there was general agreement between the parties when there was not.

* The parties may have expressed an intention, such as excluding certain assets or liabilities from the transaction, but failed to incorporate that intention into the purchase contract.

* One of the parties may have made certain representations to the other party but the purchase contract failed to clearly document the representation. For example, a poorly worded reference to the collectibility of accounts receivable might lead to a misunderstanding between the parties whether certain receivable balances should be excluded from the closing date balance sheet.

Accounting Arbitrations and the CPAs's Role

Purchase agreements should include a cost-effective method for resolving any dispute that might arise. An accounting arbitration is an excellent alternative to litigation.

In an accounting arbitration, the parties identify an expert who has an in-depth understanding of GAAP, knowledge of the arbitration process, and an understanding of the business purpose and economics of transactions. One of the first steps of an arbitration occurs when the arbitrator arranges a meeting between the parties and their representatives to explain the process. At such a meeting, the ground rules are established, and both parties are provided an opportunity to express any reservations about the fairness of the process. The parties also review a timetable for the conduct of the arbitration. This step is especially important if the purchase agreement provides an unrealistic period of time for completing the arbitration, as is often true. CPAs can help establish a timetable that will enable the parties to set forth their position in a comprehensive, concise manner and allow for resolution of the dispute in an expedient fashion.

The arbitrator prepares an engagement letter which summarizes the process agreed to by the parties including the respective roles and responsibilities of all involved. By reducing the process to writing, each party has an opportunity to raise a recorded objection if they believe any aspect of the process is inappropriate or unfair. An engagement letter serves as a written record of the understandings reached and minimizes the possibility of overturning the arbitrator's final decision due to an unfair process. The engagement letter is often a key document in determining which types of issues are to be resolved by the arbitrator. Only accounting and financial matters (not matters of law) should be made subject to the accounting arbitration. The timing and conduct of the arbitration should be set forth in reasonable detail and be attainable.

Identify the Matters in Dispute. The obvious initial step in an arbitration can be surprisingly difficult. The parties need to agree on what issues and related amounts are in dispute and subject to the arbitration. CPAs representing both sides often play an important role in identifying the issues and the related strengths and weaknesses of each of the positions taken by the parties. Certain differences may be excluded from the arbitration. For example, a party has conceded an item, the difference is due to a reclassification that does not affect the purchase-price adjustment, or the parties find the amount too insignificant to warrant the expense of receiving an arbitrator's ruling.

Prepare Formal Position Papers. The next action required in the arbitration generally is the preparation of formal position papers by each party with respect to the disputed items. Formal position papers require the parties to distill their understandings of the relevant facts and provide support for the merits of their positions. The paper should summarize the form and the substance of any related transactions or other accounting events; specify what documents or other forms of evidence can be used to support the understanding; and identify the related accounting position, including the relevant accounting literature. A CPA's knowledge of GAAP, the issues being arbitrated, and his or her experience both with the theoretical and practical applications of GAAP as it applies to those issues make CPAs good candidates for advocating the positions of the parties in drafting position papers.

Develop a Response. After having gained a better understanding of the other side's position through a review of their position paper, a CPA frequently assists in developing a response, which serves as an opportunity to state the position more clearly, to elaborate on a position which had been stated in more general terms in the initial paper, and to refute statements in the other party's position paper.

Clarify and Identify the Essence of the Issues. Frequently, the arbitrator and the parties may find it beneficial to meet and discuss the respective positions to clarify points raised and expeditiously identify the essence of the differences. CPAs should attend these meetings both to help support the GAAP positions set forth and to give advice during the process.

Hear Oral Testimony. When the parties' positions cannot be supported or refuted through the reading of the parties' position papers and supporting documentation, the arbitrator may find it necessary to hear oral testimony at a formal or informal hearing. Witnesses can be especially helpful in resolving disputes relating to accruals of future contingent liabilities such as potential losses due to lawsuits or losses on long-term contracts and the write-down of assets, such as obsolete inventories or impaired buildings and machinery. CPAs, sometimes in conjunction with attorneys, often play a lead or participative role in these hearings due to their strong knowledge of GAAP and the issues.

Position papers and subsequent rebuttals and meetings with the arbitrator provide a basis for the parties to talk to each other in specific terms. An understanding of the process is critical for a CPA advising a party on the strength of its position and the arbitrator's likely thought process and outcome--factors which are critical to a decision to either proceed or attempt to reach a settlement.

Reach a Determination. The final determination of the arbitrator is generally communicated to the parties in a written report which includes a brief summary of the key factors considered by the arbitrator in making the decision. To ensure that the arbitrator's ruling is not based on incomplete or misunderstood facts, CPAs should recommend that the arbitration process provide for each party to first receive a draft copy of the report prior to its final issuance. This process allows each party an opportunity to bring to the arbitrator's attention any apparent errors in the arbitrator's understanding of relevant facts.

Plan Ahead

The CPA can advise parties to a dispute on the advantages and strategies of an accounting arbitration before it begins and during the arbitration process. The key to a cost-effective, timely, and fair arbitration of a purchase-price adjustment is to plan ahead. There are significant advantages to resolving disputes through accounting arbitration. First, the accounting arbitration process generally leads to a quicker resolution of a dispute as compared with litigation. The arbitration timetable typically spans from one or two months to six months. This enables the parties to have their differences resolved quickly so that they can devote their full attention to successfully operating their ongoing businesses. Also, because of the shortened timeframe, an accounting arbitration is generally more cost-effective than litigation.

Many arbitrations over a purchase-price adjustment can be completed with little consultation with legal counsel, which, when combined with the shorter timeframe, results in significantly lower costs for the parties. In some instances, a CPA's assistance may suffice for a proper presentation of a company's position without requiring further outside help.

A third advantage of utilizing an accounting arbitration is that ultimate resolution of the issues will be determined by a CPA arbitrator who understands the relevant accounting and business issues in dispute. The likelihood of a CPA arbitrator reaching the fairest resolution is often greater than leaving the resolution to a judge or jury who may lack a fundamental understanding of GAAP, the accounting process and the related business issues.

Generally, the parties can facilitate a prompt resolution by providing for an arbitration of such differences in the purchase agreement. That provision might specifically provide for the method of selecting an arbitrator (such as selection through an organization such as the Center for Public Resources or the American Arbitration Association) or specifically identify an arbitrator (such as an accounting firm or an individual CPA). The individual or firm selected should be experienced in the arbitration process. An experienced arbitrator who understands both the process and the underlying accounting issues can be the most effective individual to resolve differences in a purchase price dispute. By selecting a mutually acceptable arbitrator in the purchase agreement, the parties may avoid a lengthy selection process during a later period when they may be less inclined to be cooperative.

Caution and Understanding are the Key

While many disputes over purchase-price adjustments may be avoided through careful drafting of purchase agreements to reflect the complexities of accounting and the parties' intent, some disputes inevitably arise. To be prepared for the possibility of such a dispute, CPAs can recommend that acquisition contracts include a provision for an accounting arbitration. CPAs can be instrumental in reaching a timely, cost-effective, and fair resolution by understanding and guiding a party through the arbitration process.

George R. Zuber, CPA, is an audit partner and David C. Schector, CPA, is a senior audit manager with Deloitte & Touche. Both are active in providing litigation consulting services to clients. Mr. Zuber and Mr. Schector are members of the AICPA and NYSSCPA.

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