[author: Frank Lazzara]
Introduction
Accountants (or auditors in particular) are the benefactors of hindsight and get to put it to use every time they are engaged to opine on a company’s financial statements. Namely, that period from the date of the financial statements (i.e., the traditional calendar year-end) through the date of issuance, which coincides with the date of the auditor’s report (or opinion), is that slice of time where an auditor has the corroborative benefit of hindsight.
For the days from the end-date of the subject financial statements until the company issues its Form 10-K, which range from 60 to 90 days from the period-end of the annual financial statements for a public filer, the auditor gets to consider all the information known or knowable about conditions that exist at the balance sheet date of 60 to 90 days prior.
By way of example, a December 31st set of financial statements for a large, accelerated filer (i.e., the most stringent time window) will afford the auditor the period through March 2nd (i.e., 60 days later) for vetting those required balance sheet estimates, such as collectability reserves for accounts receivable and loss contingencies established as current liabilities. Effectively, this is an opportunity to deploy hindsight regarding those forward-looking estimates representing the state of a balance sheet, dated 60-days in the past.
GAAP and IFRS
More than a privilege or opportunity, this information window is actually a requirement of Generally Accepted Accounting Principles (“GAAP”) in the U.S., and International Financial Reporting Standards (“IFRS”) everywhere else. To those professionals who work within the start-up environment, 60 days seems almost impossible, but the good news is that for non-public filers, that window may only be constrained by their level of funding or equity investor’s requirements.
So, why is this relevant to mergers and acquisitions (“M&A”) deal closings? As most deals include a “basis of preparation” condition that requires either GAAP or IFRS adherence, those transacting parties have agreed that any financial statements exchanged between them, especially those prepared in the quest to initially estimate and thereafter true-up closing working capital, must comply with this tenet. The concept is referred to as “Subsequent Events” and as to U.S. GAAP, it can be found in Accounting Standards Codification (“ASC”) 855-10.
A corollary U.S. GAAP standard that is relevant to information learned about financial statement estimates is ASC 250 – Accounting Changes and Error Corrections. ASC 250 defines the various accounting changes as:
“A change in accounting principle; an accounting estimate; or, the reporting entity.”
A change in an accounting estimate is fundamentally what is being proposed by one of the parties in a working capital dispute that seeks to utilize hindsight learned (often post-Closing) many months—or in excess of a year—after the transaction closing. ASC 250 instructs:
“A change in accounting estimate shall not be accounted for by restating or retrospectively adjusting amounts reported in financial statements of prior periods or by reporting pro forma amounts for prior periods.”
Accounting is part historical reporting and part foretelling the fate of current assets and liabilities. Additionally, it is the ongoing recognition of changes in estimates to reported financial data giving rise to a never-ending cycle of restating prior estimates and previously issued financial statements. As the results of previously recorded estimates became known and to the extent they varied from their corresponding accrual-based estimates, the never-ending fine-tuning would convert best-estimates into actual experience.
ASC 855-10 is therefore applied to identify the post-closing time period for which information can be considered in the preparation of the financial statements that are used for calculating closing working capital. The Implementation Guidance within ASC 855-10-25-1 addresses subsequent events that are to be recognized in the subject financial statements (i.e., “Type I Subsequent Events”) and provides examples within ASC 855-10-55-1 that illustrate the requirement to use all available information to derive balance sheet estimates about conditions that existed at the balance sheet date.
Why Is ASC Guidance Not Universally Applied?
Although practitioners who regularly serve as neutrals and party advisors in this type of arbitration and venue will generally apply this guidance, which can also be found within the AICPA Forensic and Valuation Services Section practice aid on Mergers and Acquisition Disputes (the “M&A Practice Aid”), the consideration of evidence learned in hindsight and introduced into closing working capital arbitration proceedings by the parties is a common occurrence and may prove instructive to party advisors.
GAAP and IFRS require the consideration of all available information regarding events that affect conditions existing at the relevant financial statement dates through either their issuance or delivery to the respective party. ASC 855 is the guidance that defines information that is “in-play” for the preparation of the balance sheet used to derive the final working capital figure and requires the preparer to consider all information available through the date of preparation or the date financial statements are “available to be issued.”
Parties often make reference to information learned after the date of the preparation of the “final balance sheet,” a tactic that is intended to appeal to the independent accountant’s sense of equitability. Working capital disputes will linger, and if they proceed to arbitration, will often be aired from 12 to 24 months or longer after the preparation of the subject balance sheet. Inevitably, parties will become aware of information that developed during this time period and may refute estimates used in the working capital calculation, such as liability estimates for loss contingencies, obsolescence adjustments for inventory, and contra-asset calculations for potentially uncollectible customer accounts.
Considerations
Merger and acquisition activity continues at a healthy pace, and it is prudent for advisors who are faced with a dispute that is heading to an arbitration to carefully select the independent accountant and to strategically consider the strength of their claims within the light of the Subsequent Events guidance.
For example, if the subject company is not equipped with the financial reporting rigor that will enable it to prepare the necessary financial statement estimates, the relevant party (i.e., Seller or Buyer) should seek to negotiate for additional time to gather the data and prepare the necessary estimates.
Of course, if you’re on the opposite side of the party that requires an extensive amount of additional time to produce reliable accounting estimates, you might seek to limit the extent of time permitted for financial statement preparation, try to “collar” the variation from an agreed-to target component of working capital, or negotiate some type of favorable concession.
If you’re amenable to providing additional time to your counterparty, be mindful of the window for developing information and endeavor to limit the use of subsequent events information, being specific about the date through which relevant information will be permitted to impact the judgment surrounding accounting estimates.
Conclusion
In applying GAAP or IFRS, professionals should adhere to the Subsequent Events guidance that limits the extent of hindsight data that can be used in a purchase price dispute. However, each arbitration is unique and the selected arbitrator’s level of experience with adjudicating accounting disputes is not universal, thereby necessitating a thorough assessment of the facts and parties in each matter to maximize chances of prevailing in a working capital purchase price dispute arbitration.
Acknowledgments
We would like to thank Frank Lazzara for providing insight and expertise that greatly assisted this research.
