Effects of inflation, interest rates, credit risk and geopolitical events

Economic uncertainty has been a hallmark of 2023, in large part due to geopolitical events and the impact of central banks increasing interest rates to combat inflation. Although some economists believe the likelihood of an imminent U.S. recession has become less likely in recent months,[1] inflation forecasts, future interest rates and the U.S. economy’s ability to maintain growth and low levels of unemployment remain unclear.

Such macroeconomic factors may impact accounting judgments and estimates used to prepare financial statements under generally accepted accounting principles (GAAP). Because merger and acquisition (M&A) transactions often include provisions in which the price the buyer pays to acquire a business is adjusted based on accounting calculations (e.g., net working capital or earnout adjustments), these macroeconomic factors may impact how parties calculate such purchase price adjustments.

Below, we discuss examples of how inflation, interest rates, credit risk and geopolitical events may impact purchase price calculations in M&A transactions and lead to purchase price disputes, if parties fail to consider the relevant factors when drafting purchase agreements.

Inflation

U.S. inflation — as measured by the seasonally adjusted annual change in the consumer price index (CPI) — began substantially increasing in the spring of 2021 and peaked in June 2022, reaching approximately 9 percent.[2] Although inflation has since eased, it remains elevated compared to the prior decade of low inflation (particularly when volatile food and energy prices are excluded from the CPI).

Pursuant to GAAP, many assets are recorded on a company’s balance sheet at the historical price the company paid to acquire the asset, and many liabilities are recorded at the price the company will pay to extinguish the liability in the future. As such, changes in prices may significantly affect a company’s balance sheet over time and any resulting calculation of net working capital as of an acquisition date.[3]

For example, inflationary pressure may be particularly relevant with respect to accounting for inventory balances. GAAP requires that inventory costs be determined under a recognized basis, such as first-in first-out (FIFO), average cost, or last-in first-out (LIFO). However, companies often record inventory at “standard costs.” GAAP permits using such standards costs to the extent they are “adjusted at reasonable intervals to reflect current conditions so that at the balance-sheet date standard costs reasonably approximate costs computed under one of the recognized bases.”[4]

During periods of inflation, an entity may determine the standard costs it previously established no longer reasonably approximate actual costs. In calculating closing net working capital, a buyer and seller may disagree whether inventory should be valued at the historical standard costs per unit used within the company’s pre-closing financial statements or whether such standard costs must be adjusted at closing to more precisely approximate actual costs. Disputes may arise if a purchase agreement’s accounting principles are ambiguous with respect to inventory costing, or if differences between standard and actual costs were not addressed when the target working capital was established.

Inflation may also have a significant impact on post-closing income statement amounts. As such, buyers and sellers may consider the potential effects of inflation on transactions when drafting earnout provisions. For example, an earnout based on achieving a specified dollar value of gross revenue may be more easily achieved in periods of high inflation (due to higher sales prices), even if the company does not generate incremental profit (due to the company simultaneously incurring higher input costs). To avoid such scenarios, a buyer might insist the purchase agreement include a provision that adjusts the earnout’s target revenue amount for inflation (e.g., an adjustment to the target revenue amount based on changes in the CPI from closing through the end of the earnout period).

Interest Rates

In response to inflationary pressures, several central banks have raised interest rates throughout 2022 and 2023.[5] Changes in interest rates can have a direct impact on balance sheet accounts that are reported at future expected cash flow values discounted by interest rates.

For example, under Accounting Standards Codification (ASC) 842 (Leases), lease liabilities are initially measured by the lessee using the discounted value of future lease payments at the lease commencement date.[6] Moreover, lease classification (i.e., operating or finance) at the commencement date is also impacted by the discounted value of future lease payments under ASC 842. If leases commence or are amended after the execution of a purchase agreement but prior to the closing of the deal, changes in interest rates during this period may significantly impact the accounting for such leases. Given that some purchase agreements require a reduction of the purchase price for certain types of lease liabilities, the discount rate used to classify and record these liabilities may be critical, and disputes may occur as to the appropriate lease discount rate.

Projected benefit obligations (PBOs) for a defined benefit pension plan are another accounting element directly impacted by interest rates. PBOs represent the actuarial present value of future benefits payable for employee service as of the balance sheet date and are calculated using discount rates. ASC 715 (Compensation – Retirement Benefits) requires the funded status of a pension plan to be recognized on an entity’s balance sheet, which is the difference between the fair value of the plan’s assets and the liabilities for the plan’s PBOs. Because some purchase agreements require the final purchase price be reduced for any unfunded pension plans (i.e., the amount by which PBOs exceed the fair value of the plan’s assets), the parties may dispute discount rates used to measure PBOs, particularly because GAAP requires discount rates be reevaluated at each measurement date.

Credit Risk

More corporate defaults occurred in the first half of 2023 than in the entire year of 2022,[7] and some economists expect defaults to continue rising throughout 2024.[8] With respect to purchase price adjustments, credit risk has implications for how companies account for amounts due from customers.

ASC 326 (Financial Instruments – Credit Losses) requires entities to record an allowance for current expected credit losses (CECL) over the lifetime of their financial assets, including accounts receivable. In determining a CECL allowance, entities consider past events, current conditions and forecasts for future events. Differences in interpreting current risks as of a balance sheet and projections of future credit risk may lead to disputes over whether entities’ receivables are accurately reserved. Moreover, parties often dispute whether post-closing events, such as late customer payments, short payments, payment refusal or a customer’s bankruptcy, should be considered in determining the required allowance as of the closing date.

Not only might heightened credit risk impact an assessment of previously recorded receivables under ASC 326, but such risks may affect an entity’s revenue recognition under GAAP for new revenue (and related receivables). Under ASC 606 (Revenue From Contracts With Customers), an entity may only recognize revenue if it is probable the entity will collect substantially all of the consideration to which it will be entitled for the goods or services that will be transferred to the customer. As such, accounting disputes concerning revenue recognition may arise from parties’ different assessments of a customer’s ability and intention to pay amounts owed under a contract.

Geopolitical Events and the Impact on M&A Transactions and Purchase Price Disputes

The global economy remains impacted by supply chain disruptions and business operation stoppages that began with the COVID-19 pandemic and were amplified by the war in Ukraine. Although obviously significant to the macroeconomy, the impacts of these disruptions may have unexpected accounting implications for M&A transactions.

The application of earnout provisions may be particularly challenging as significant geopolitical events unfold. Parties often agree to earnout provisions that contain bespoke non-GAAP accounting methodologies and adjustments that may be particularly challenging to apply when unforeseen events unfold. For example, a purchase agreement may require that the impact of “nonrecurring” events be excluded from the earnout calculation. Parties may disagree as to what it means for an item to be nonrecurring, how to quantify such items and how such classifications may change over time.

For instance, in mid-2020, both a buyer and seller may have agreed that certain new, temporary business costs (and/or offsetting government stimulus receipts) resulting from the COVID-19 pandemic may be classified as nonrecurring, and adjustments should be made to exclude the impact of those items. However, even if the parties agreed an adjustment was required, it is likely they would disagree as to how to quantify the adjustment. Moreover, by 2021 (after it had become clear the economic impacts of the pandemic would not rapidly vanish), parties may disagree as to whether ongoing effects of the COVID-19 pandemic were properly classified as nonrecurring.

Similarly, parties may disagree as to whether losses resulting from the war in Ukraine (e.g., losses on a contract with a Ukrainian, Russian or Belarusian customer) should be considered nonrecurring. The likelihood of such losses recurring in the future may be dependent on the resolution of the military conflict, sanctions or other governmental actions. Accounting for such uncertain issues may naturally lead to disagreements between buyers and sellers.

Conclusion

Unexpected events and changes in macroeconomic trends can impact accounting calculations that are used to adjust the purchase price for M&A transactions. The examples throughout this article provide a small sample of potential areas for disputes arising from economic changes out of a theoretically unlimited population of such issues.

It is not reasonable to expect buyers and sellers to accurately forecast all such future events or to provide specific language within purchase agreements to address each individually. However, when drafting purchase agreements, parties should be conscious of the fact that unforeseen events can — and likely will — unfold. To minimize disputes, parties should consider the major economic circumstances that underpin their deal and how (if at all) the parties will account for changes in those circumstances.

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