Minimizing your risk of GAAP-related post-close disputes
The close date for a transaction can be the beginning of a complicated and potentially contentious post-close process between buyers and sellers. Post-close disputes often originate from disagreements between each party over the calculation of working capital adjustments to the purchase price, or an earnout payment. One of the most common disputes relates to the interpretation and application of the following wording: “ … in accordance with generally accepted accounting principles (GAAP) applied in a manner consistent with past practices.”
Contention can arise when components of this provision are interpreted differently…
The inclusion of this provision, worded in this manner, inevitably invites disagreement between the parties to a deal. Contention can arise when components of this provision are interpreted differently, and when:
- There is a disagreement over the specific past practices which comprise the historical financial statements.
- A financial statement error is discovered after the agreement is executed.
- Determining whether the practices used to prepare the historical financial statements are consistent with GAAP.
- To the extent the past practices used to prepare the company’s historical financial statements aren’t in accordance with GAAP, which methodology should be used to account for an item if there is more than one acceptable methodology under GAAP.
Any, and or all, of these disagreements can arise when buyers or sellers calculate the working capital amount or the earnout payments in the post-close period.
More specificity in the wording of this provision would minimize the various interpretations and reduce the likelihood of a post-close dispute.
Buyers and sellers should consider incorporating the following modifications to the GAAP provision:
- If the parties are concerned their risk past practices weren’t consistent with GAAP, particularly if those concerns relate to material financial reporting areas, such as inventory, revenue recognition, etc., modify the provision to restrict the calculation of these post-close amounts to only the past practices of the company. If the parties believe the post-close calculation is intended to only adjust for events between execution and the closing of the deal, the parties are likely to favor consistency and, therefore, the use of past practices.
- When accounting items related to any post-close calculations, or for which it’s known prior to the close date are more likely to lead to disagreement over the determination of past practice, the parties should consider describing the specific past practices for each of these accounting areas. Specific to any earnout calculations, which are always forward looking after the close date, parties should clarify the use of any new accounting pronouncement that becomes effective during the earnout period, and is relevant to the calculation.
For example, if a deal involving a private company closed in 2018, the historical revenue recognition practices this company would be required to adhere to would be ASC 605; for any earnout period running through 2019, the revenue recognition criteria of the company would change with the implementation of ASC 606. Without any clarification provided in the purchase agreement regarding which ASC is applicable to the earnout period calculation, the parties to this calculation could end up in a dispute over which ASC is applicable, — especially if the difference in the application of the standards to the earnout calculation amount is significant.
- If the parties want to safeguard post-close calculation consistency with GAAP, consider changing the language for this type of provision to read, “Working Capital shall be calculated in accordance with GAAP applied consistently with the company’s past practices, solely to the extent such practices are in accordance with GAAP.” If the parties believe the purchase agreement is intended to guarantee the financial condition of the company at closing, the parties are more likely to favor language that articulates the need for any post-close calculations to be prepared in accordance with GAAP.
- Agreements should clearly define what accounts are included in the working capital calculation. To the extent there are some accounting items that may be included in the working capital calculation that a party might claim are noncurrent, the parties should explicitly state how those items will be treated in the calculation of working capital.
- If the purchase agreement includes a schedule showing the calculation of working capital, the parties should confirm the definition of working capital is consistent with the schedule, including any language in the schedule that may describe the accounting methodologies or treatments used to calculate working capital.
Including these modifications in a purchase agreement post-closing calculation provision may not completely eliminate post-close disputes between parties, but they certainly can minimize the risk of disputes. If a dispute does happen from the post-close calculation, the implementation of these modifications can also enhance the strength of a party’s position if they were to enter the arbitration process, depending on a party’s perspective and whether it intended for the company’s past accounting practices or GAAP to be applied to any post-closing amount calculations.
If you would like to discuss potential post-close disputes, please reach out to our team today.