Preventing expensive surprises with post-closing adjustments.by Birdzell, Luther E., III
The price paid for a business is often subject to adjustment. The adjustment is based on a financial result, or combination of financial results, determined as of, or through the closing date. Because there is a time lag between the closing date and the date financial results are available, these adjustments must be determined after the closing. Unfortunately, these purchase price adjustments frequently are very large, and unanticipated by at least one party to the transaction. By carefully managing the process, you can help prevent these unexpected and expensive surprises.
Purpose and Form
These post-closing adjustments are generally intended to increase or decrease the price based on what was acquired. Perhaps the most common adjustment is based on closing net worth.
For example, the purchase price may be $75 million plus or minus the difference between the actual net worth of the business on the closing date, and a predetermined amount specified in the purchase and sale agreement. Assume the specified, or base amount is $62 million, which would have been negotiated by the parties and might have been based on the projected net worth on the closing date. If the actual closing net worth is $65 million, the buyer would owe the seller an additional $3 million ($65 million less $62 million), making the final purchase price $78 million. If, on the other hand, the actual closing net worth is $58 million, the purchase price would be adjusted downward by $4 million to $71 million.
In a variation on the closing net worth concept, the purchase price may be adjusted based on selected actual account balances on the closing date. For example, the purchase price might be adjusted based on the actual amount of inventory on hand or total net working capital on the closing date.
Most post-closing adjustments are based on balance-sheet measures. But post-closing adjustments based on some earnings or cash-flow measure, for a period through the closing date, are also used. Earnings or cash- flow adjustments are especially appealing in transactions in which the purchase price was based on a multiple of earnings or cash flow. For example, a subsidiary sold for $120 million based on an assumption that the business will generate $20 million of operating cash flow in the twelve-month period before the closing, resulting in an operating cash- flow multiple of six (six multiplied by $20 million of cash flow equals the $120 million purchase price). The purchase price might be adjusted based on six times the difference between $20 million and the actual operating cash flow for the twelve-month period ending on the closing date.
Of course it is possible to combine balance sheet and cash-flow and/or earnings measures to form multiple adjustments.
The Purchase and Sale
The purchase and sale agreement is usually the document that controls the post-closing adjustment. Too often, the contractual language is agreed on without sufficient input from the accountants who will have to compute the adjustment. In extreme cases, this lack of accounting input results in contracts that require computations that either cannot be made or that have totally unintended results.
For example, an agreement specified that the purchase price would be adjusted based on the amount by which inventory on the closing date differed from a specified amount, wit at the closing date to be based on the lower of cost or market value, determined on an item-by-item basis. The specified amount was provided by the seller.
Although the agreement made no reference to the source of the information, the specified amount was the inventory amount as of the previous year end for the subsidiary being sold, and was taken directly from the seller's final consolidated financial statements. The contract required that "market" was to be based on the prices at which the inventory had been sold to unrelated third-party customers in the sixty- day period preceding the closing.
The inventory in question included a large dollar amount of spare parts used in the manufacturing plants being sold. These spare parts were not and were never intended to be sold to unrelated third-party customers. However, legitimate questions existed whether the carrying value of the spare parts was higher than that permitted by generally accepted accounting principles. Some of the parts were "safety spares" that would be used only if unexpected breakage occurred. Also, the quantity listed for certain other parts represented several years of usage. However, it would have been very difficult to obtain these parts if the company ran out due to the nature of the equipment involved.
The seller maintained the spare parts should be included in the closing inventory based on their cost. The buyer took the position the parts should not have been included in inventory at all for purposes of comparing the actual closing inventory to the specified amount.
The dispute went to arbitration, and the buyer prevailed. The buyer successfully argued the language defining market made it clear only inventory held for sale to third parties was to be included in the comparison to the specified amount. The buyer said if the seller intended to include spare parts in the comparison, appropriate language governing their valuation would have been written into the contract. The seller suffered a large, unanticipated loss. The seller's position-that spare parts were included in the specified amount so that they must also be included in the final closing inventory - was rejected.
This unfortunate example (for the seller) illustrates two very important aspects of post-closing adjustments. First, input from the accountants, who will have to make the calculations, is often vital to ensure the calculations will have the intended results. Second, establishing the specified base amount and ensuring the contract requires the actual closing amount be computed in the same way as the base can require considerable care and work. If the base and the actual closing amount are not computed the same way, changes in the method of computation will change the purchase price, a result rarely intended by both parties. In the above example, including the spare parts in the specified amount but not in the final closing date inventory - non- comparable measurements - had a severe negative effect on the seller.
Accounting Principles To Establish
the Specified Amount
The accounting principles to be used to determine the specified amount and the actual closing amount are the first consideration. Using different accounting principles to determine the specified amount and the closing amount will result in a purchase price adjustment from changing accounting principles.
Generally accepted accounting principles, consistently applied, are generally used. However, GAAP is rarely sufficient, and in many cases may be undesirable. GAAP as applied to interim dates is frequently not the same as GAAP applied at a year end. Interim reporting may involve "smoothing" or "leveling" practices.
It is usually desirable to keep interim reporting practices out of the post-closing adjustment process. Many interim reporting practices are not GAAP, but are used based on immateriality. What is immaterial for general financial reporting purposes, however, may be very material to a buyer and seller when the effect is real cash. Many interim reporting practices that are GAAP are very subjective, and can lead to disputes between the buyer and seller because of their subjectivity. If interim reporting practices are to be used, I suggest the way in which they are to be used be very carefully specified in the purchase and sale agreement. Furthermore, test calculations of the specified amount and the closing amount may be helpful.
Consider a company that performs extensive maintenance during an August vacation close-down, and levels the related $2,400,000 expense over the year by charging income $200,000 a month. On July 31, there will be a $1,400,000 deferred maintenance liability ($200,000 multiplied by 7 months). On August 31, there will be an $800,000 "prepaid" maintenance asset recorded ($2,400,000 of actual maintenance performed during August less eight months of expense at $200,000 a month). At year end the $800,000 will have been amortized to zero.
Do the buyer and seller really intend the purchase price to change by $2,200,000, depending on whether the closing takes place on July 31 or August 31? If the actual cost is $3,400,000 and the $1,000,000 excess of the actual amount over the budget is spread over the last four months of the year, should the purchase price be increased by $1,000,000? Is deferring the $1,000,000 over the last 4 months consistent with GAAP? Is smoothing maintenance costs over a year consistent with GAAP?
If interim reporting practices are not used, the contract should specify that GAAP used at a fiscal year end are to be employed.
Many financial statements have multiple, immaterial GAAP departures. These departures can become highly contentious when they result in real dollar purchase-price adjustments. if the specified amount is calculated based on normal reporting practices that include the GAAP departures, and the actual amount is calculated using GAAP, rigidly applied to everything, the change of accounting principles, not the economics of the transaction, will change the purchase price. GAAP departures of this type may be especially prevalent in relatively small divisions or subsidiaries of large companies. Areas with frequently found immaterial GAAP departures include:
* Vacation pay accruals. SFAS 43 requires an approach that is frequently not followed and usually increases the liability.
* Operating leases. Many leases are accounted for as operating leases, although they are capital leases under the SFAS 13 tests. The effect is difficult to predict because a capital lease creates both an asset and a liability.
* Accruals for services. Many companies account for services on a cash or invoice received basis rather than on a full accrual basis.
* Reserves for excess and obsolete inventory and doubtful accounts. Many companies "true up" these reserves annually, especially if the impact is expected to be small.
* Inventory shrinkage. Many companies slightly over-provide for inventory shrinkage so as not to be "surprised" by the results of the annual physical inventory.
In many cases, the immaterial GAAP departures are used for calculation of both the specified amount and the closing amount. In such cases, the purchase and sale agreement must carefully specify which departures are acceptable and what accounting principles are to be used.
Try to avoid any "cash basis" accounting. It is too easy for the seller to manipulate cash basis accounting - by not paying bills, for example - to the buyer's disadvantage.
Foreign Currency and
Another area in which accounting principles need to be carefully evaluated involves foreign exchange and foreign currency statements. When a multi-national enterprise is involved, balance sheets are typically translated using the exchange rates in effect on the balance sheet date (a partial exception exists for entities in countries with high inflation rates). If the exchange rates used to calculate the specified amount and the closing actual amount are different, the purchase price will have changed due to the exchange rate changes. As a result, many purchase and sale agreements specify both calculations will be made using the same foreign exchange rates.
Considerable diversity exists with respect to accounting for foreign currency hedging, and disagreement exists with respect to GAAP. Because this area is not well defined, the accounting for foreign exchange transactions, including contracts and hedging, should be agreed upon by the parties and incorporated into the purchase and sale agreement.
LIFO is frequently very difficult to predict and is, unfortunately, subject to considerable manipulation. Interim LIFO calculations are especially difficult because the "real" calculation can be performed only at year end. If a company used LIFO to cost all, or a portion, of its inventories, any purchase price adjustments should be computed using some other method, such as FIFO or average cost.
What Accounts Are Subject to
Once the accounting principles to be used have been agreed upon, the next step is to decide which financial statement elements will be subject to the post-closing adjustment process. Even when the parties agree that a "closing net worth" concept is appropriate from a business perspective, it may be desirable to exclude many assets and liabilities because resolution of their amount, and the effect of that resolution on the purchase price, is better handled by means other than the accounting post-closing adjustment. Examples of items frequently excluded, and the way in which they are resolved, are as follows:
* Environmental liabilities. These obligations are frequently excluded because their amounts are extremely difficult to determine and can be large. A seller indemnification is frequently relied upon to hold the buyer harmless from pre-acquisition problems.
* Post-retirement health care, and other post-employment benefits including dental, life insurance, and pensions. These liabilities can be very subjective, involving multiple assumptions including assumptions as to discount rates, future medical inflation rates, and, in the case of funded plans, rates of return on plan assets. The effect of these obligations on the purchase price can be settled through actuarial calculations, using assumptions previously agreed to by both the buyer and seller.
* Workers'compensation. These liabilities are very subjective due to the long time frame over which payments may be required on difficult cases. Again, actuarial calculations using assumptions previously agreed to by the parties can be used to resolve these issues.
* Taxes, including Federal, state, and local income taxes, and other taxes, including sales taxes. The result of tax audits is extremely difficult to predict, especially when complex and/or unusual transactions are involved. Establishing the total liability for taxes involves estimating the outcome of tax audits, a series of estimates not likely to be agreed upon easily by buyer and seller. Seller indemnification of the buyer for tax audits is one approach to removing this area from the post closing adjustment process.
Another approach is to escrow an amount for many post-closing contingencies, including taxes. Because of the long time required to resolve tax audits, no approach is likely to be entirely satisfactory. The buyer and seller may not trust each other's long-term financial prospects, making indemnifications - or promises by the buyer to repay amounts by which recorded liabilities for tax audits exceeded the results - difficult to negotiate.
* Litigation reserves, including product liability and other amounts that may be covered by insurance. These amounts can be agreed upon outside the accounting process.
Once the parties agree on which accounting principles and financial statement elements will be included, the final step is to attempt to prevent unnecessary disputes over judgmental areas. Taxes and workers' compensation were discussed above. Other difficult, judgmental areas may include: * Allowance for doubtful accounts; * Reserves for sales returns and allowances; * Inventory excess, obsolescence, and lower of cost or market reserves; * Warranty accruals for claims against the company; * Warranty claims against vendors; and * Loss reserves, especially loss contract reserves.
GAAP is reasonably clear about the requirements for each of the above areas. However, the calculations, can be highly judgmental. Many companies use formulas to calculate receivable, inventory, and warranty reserves. The buyer and seller may not agree on the appropriate formulas.
Disputes can be minimized if the approach to be taken in judgmental areas is clearly set forth in the purchase and sale agreement after negotiation by the parties. Leaving judgmental areas to the post-closing dispute resolution process leads to disputes to resolve. How can you prevent this? The accountants who will have to negotiate any disputes after the fact must instead spend a small fraction of that time agreeing on the approach to judgmental areas before the purchase and sale agreement is finalized. That way, they can prevent many disputes.
Because the outcome of such disputes is very hard to predict, buyers and sellers should negotiate the purchase price when the contract is being prepared. Don't leave the process to the accountants after the closing via the post-closing adjustment. Approaches to judgmental areas that can be agreed upon in advance include - * Reserve formulas for doubtful accounts, sales returns and allowances, inventory, and warranty costs; * The market prices to be used for inventory lower of cost or market calculations, or the method to be used to determine market prices; and * The labor and overhead rates, and cost of materials to be used in calculating loss contract reserves. Because the actual losses on loss contracts will depend on future costs, the rates and costs to be used depend on forecasts.
Comparison of the Specified and
Before comparing the specified and actual amounts, the actual amount must be determined. Because the buyer usually has control of the books and records after the closing, the buyer is a logical candidate to prepare the closing statements. This approach also gives the buyer the opportunity to go through the closing statement in great detail. That may serve to offset any advantage the seller may have had in establishing the specified amount because of the seller's greater knowledge of the business prior to the sale.
Questions frequently arise whether the closing statement should be audited. In many cases, the buyer and seller have the accounting staffs and time to complete the post-closing adjustment process without audit. However, in other situations an audit can bring a degree of objectivity to the closing statement, and a level of time, that will be cost- effective in the post-closing dispute resolution process.
If an audit is to be performed, the next question is usually whether it should be performed by the buyer's or the seller's auditor. Third party auditors are rarely used because they have no familiarity with the situation, and it is usually not cost-effective for them to obtain that familiarity for a single audit. if the buyer prepares the closing statement, there is a balance of knowledge that can be obtained by having the seller's auditor examine it. In addition, the seller's auditor may be more familiar with the entity to be audited as a result of experience with it before the sale. in many cases, the buyer's auditor will have to perform an audit to satisfy the buyer's reporting requirements. In those cases, having a full audit performed by the seller's independent accountants may be duplicative.
After the closing statement has been prepared, the other side is usually given a specified amount of time to review it and specify any disagreements. Assuming the buyer prepared the closing statement, the seller's review will usually go much smoother if the documentation supporting the closing statement is well prepared and easy to follow. In many cases, the closing statement is prepared without clear, written support. As a result, the seller has a very difficult time understanding what was done by the buyer, a situation that almost inevitably creates disputes. Furthermore, the effort by the seller to create the documentation tends to duplicate work the buyer has already performed. This is a highly inefficient process.
Many potential disputes can be resolved during the seller's review before the seller specifies a formal disagreement. If the buyer's position is correct, the buyer should be able to convince the seller before the seller formally specifies that a dispute exists, and vice versa.
Even with careful planning, some disputes are likely to occur. Most can be resolved through negotiation. Frequently, clear documentation is the key to success in these negotiations. "Back of the envelope" calculations are rarely effective.
If negotiations are not successful, many purchase and sale agreements provide for arbitration by an accounting firm. The agreement should make clear what is subject to accounting arbitration and what is not. Generally, accounting issues are subject to arbitration, whereas legal issues are subject to a different arbitration process or litigation.
Often the line between accounting issues and legal issues is not clear. For example, a purchase and sale agreement specified that reserves for "taxes to be paid by the seller" would be excluded from the closing statement, thereby effectively increasing the purchase price by increasing closing net worth. A dispute arose whether a particular tax reserve should be excluded, because it was doubtful whether the seller would ever be required to pay the tax in question. Is the issue here a matter of contract interpretation subject to litigation or an accounting matter subject to accounting arbitration? To avoid having to choose between accounting arbitration and legal resolution of disputes, the contractual language should be very specific. For example, the contract might say: All disputes related to the preparation and content of the closing statement and the application of the provisions of the section of the agreement related to the preparation of the closing statement, shall be subject to accounting arbitration except for those specified matters that the parties wish to exclude." Close coordination between the accountants and the attorney drafting the purchase and sale agreement is necessary.
Another helpful contractual provision related to arbitration is a clause limiting the arbitration award to an amount at or between the positions taken by the parties. In a recent arbitration related to inventory reserves, the buyer maintained the reserve should be $700,000, whereas the seller maintained the reserve should be $200,000. The arbitrator determined that the-reserve should be $1,200,000, thereby awarding the buyer $500,000 more than the buyer asked for!
Preventing Expensive Surprises
Post-closing adjustments can effectively serve the interests of both the buyer and seller of a business. To achieve the intended results, the actual amount at closing must be calculated in the same way as the specified amount used to determine the adjustment. Carefully-worded descriptions of the way specified and actual amounts must be calculated are key to avoiding unintended and expensive purchase-price adjustments.
Luther E. Birdzell, III, CPA, is an audit partner with Arthur Andersen & Co. and has been extensively involved with his firm's corporate finance consulting practice, specializing in mergers, acquisitions, and restructurings. He was chairman of the NYSSCPA'S Financial Accounting Standards Committee. This article is based with permission on an article titled, "Preventing Expensive Surprises with Post-Closing Adjustments," by Mr. Birdzell which appeared in the Winter 1992/93 Journal of Corporate Accounting and Finance.
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