Address accounting on day one for post-acquisition value creation

This is one of seven private equity value creation strategies we have compiled into our new guidebook. Download the entire guidebook here.

We’ve identified three key areas where, in our experience, accounting issues can cause hiccups or misunderstandings between the buyer and seller.

Definition of terms

Every agreement is different, which is why both parties need to pay particular attention to how key terms are defined. A case in point is working capital. Many target organizations maintain their accounting on a cash basis as opposed to U.S. GAAP — the method that will be used for the new entity’s opening balance sheet. The closing agreement should clearly state the method of calculating the target’s working capital on the closing date, whether it is to be calculated based on past practices or in accordance with U.S. GAAP — otherwise, a discrepancy may occur. Even “normal” assets and liabilities such as accounts receivables, inventory, and cash should be defined to avoid misinterpretation.

The valuation process for intangibles can be time-consuming and is also subjective, so starting the process early is key.

For example: A seller may be motivated to leave old or bad inventory or receivables on the books unless the definition clearly states they’re excluded. In terms of cash, generally, there’s a minimum level of cash on hand. But, does that mean cash in the bank? Or the adjusted book value of cash? Are certain cash accounts included/excluded?

Valuation of intangibles

In preparing for the year-end audit, private equity firms need to account for all assets and liabilities acquired in the transaction on day one and assess the impact of any potential intangible assets that may arise from the transaction, including goodwill. The valuation process for intangibles can be time-consuming and is also subjective, so starting the process early is key.

While the Private Company Council alternative accounting method allows companies to include some categories of intangibles under goodwill, not all intangibles are covered by the alternative. It’s advisable to have a solid understanding of what intangibles are present at the target company.

Fair value and other balance sheet accounts

Some accounts will need to be revalued because opening balance sheet rules require different measurement than accounting for continuing entities. Two examples of items that are generally adjusted are deferred revenue and inventory. Companies sometimes overlook the complexities of these calculations, since they tend to be familiar with the concept of deferred revenue or inventory (unlike certain intangibles). However, they may not realize how these items are valued in the opening balance sheet under U.S. GAAP. Many target companies — on whom private equity firms rely to assist with valuation calculations — are under the misconception that whatever is on their books at the time of the closing date is what goes onto the opening balance sheet, but this is not the case.

For instance: Inventory that’s considered a work in process needs to be revalued to consider the margin markup, estimated costs to complete, and the related costs of disposition.

Clarity around these key accounting issues can avoid surprises, misunderstandings, and most importantly, post-acquisition disputes. By addressing these accounting issues, private equity firms will ensure a successfully road ahead for value creation.