Merger & acquisition transactions often include provisions in which the price the buyer pays to acquire a business is adjusted based on accounting calculations. These accounting calculations may measure amounts as of the closing date (e.g., balances of cash, net working capital, and indebtedness) or for post-closing periods (e.g., post-closing revenue or earnings to determine earn-out payments due to the seller).

In performing these calculations, disputes may arise regarding the proper application of accounting standards. Sometimes disputes occur because parties overlook anticipated changes in future accounting standards or differences between existing accounting standards. Below, we discuss situations when conflicting standards may arise and examples of disputes that might occur.

Newly Issued Accounting Standards

Organizations that establish accounting standards (e.g., the Financial Accounting Standards Board and the International Accounting Standards Board) periodically issue new standards, which may either establish new accounting requirements or supersede earlier guidance. Although there is typically significant time between when the governing organizations announce the intention to establish new standards and when those standards become effective, buyers and sellers may not contemplate the impact of the new standards on purchase price adjustments.

For example, one recent change in U.S. generally accepted accounting principles (GAAP) was the introduction of Accounting Standards Codification (ASC) 842 governing lease accounting, which supersedes ASC 840.[1]  Under ASC 840, lessees were required to classify leases as either “operating” or “capital.” Assets and liabilities for capital leases were recorded on the lessees’ balance sheets whereas operating leases were generally off-balance sheet arrangements. Pursuant to ASC 842, lessees must now classify leases as either “operating” or “finance,” and assets and liabilities are recorded on-balance sheets for many operating leases under ASC 842. 

Historically, many M&A deals contained provisions in which the purchase price for a business is to be reduced, dollar-for-dollar, for any “capital lease” balances owed as of the closing date (i.e., the capital lease balances are treated as indebtedness of the acquired business). If parties continue to use such “capital lease” terminology within their purchase agreements without considering the impact of ASC 842, disputes may arise as to what constitutes indebtedness. For example, the parties may disagree whether the classification criteria applicable for classifying “finance leases” within ASC 842 should be used or whether superseded criteria within ASC 840 for classifying “capital leases” still applies. Moreover, the parties may dispute whether liabilities for operating leases now recorded on-balance sheet under ASC 842 may be included within indebtedness.

Another recently issued accounting standard that may affect purchase price adjustments is ASC 326, which governs the recognition of current expected credit losses.[2] Prior to ASC 326, companies assessed the collectability of receivables under ASC 450 (concerning contingencies). Pursuant to ASC 326, entities will be required to record a reserve against receivables that includes a measure of expected risk of credit losses, even if the risk is remote. Conversely, under ASC 450 entities reserved for such losses only if the loss was determined to be probable. As such, in measuring the receivable balances to be included in closing net working capital, parties may reach different determinations if they are applying ASC 450 or ASC 326. Accordingly, disputes may arise if the parties fail to account for how a transition from ASC 450 to ASC 326 may impact the closing date net working capital calculations used for the purchase price adjustment.

Differing Accounting Standards

Setting aside that accounting standards change over time, parties may also fail to appreciate differences between existing accounting standards (e.g., U.S. GAAP, International Financial Reporting Standards (IFRS), income tax standards, etc.). Sometimes a target’s historical financial statements have been prepared using accounting standards that differ from the agreed-upon accounting standards to be used in determining the final purchase price under the purchase agreement. 

For instance, the parties to an M&A transaction may agree that the net working capital of the entity being sold must be determined at closing in accordance with GAAP, despite the entity having historically maintained its accounting records on a cash-basis. Under cash-basis accounting, an entity generally records its revenues and expenses when it receives or pays cash. This differs from accrual-basis accounting (e.g., GAAP and IFRS), in which many transactions are accrued prior to payment or receipt of cash. Accordingly, there may be significantly more assets and liabilities recorded on a company’s balance sheet when the company transitions from cash-basis to accrual accounting. If the parties fail to properly consider this impact in determining target net working capital and final net working capital, post-acquisition disputes may arise.

Parties also frequently encounter differences in accounting standards when deals cross jurisdictions. Take, for instance, a situation where a U.S. buyer that is familiar with U.S. GAAP acquires a business from a European seller that prepares financial statements under IFRS. The parties may not appreciate the differences between U.S. GAAP and IFRS that could relate to accounts within the final calculation of net working capital (e.g., differences in accounting standards governing inventory and provisions/contingencies). After the transaction closes, these differences may become more apparent when the buyer transitions the target entity to its financial reporting system. When this occurs, the parties may disagree on the proper application of accounting standards as of the closing date for the purchase price adjustment.

Different Application of the Same Accounting Standards 

Finally, disputes may arise due to applying the same accounting standards in a different manner. In fact, the most common types of disputes often arise when parties reach different accounting conclusions despite theoretically applying the same standards.[3]

For example, sometimes stand-alone financial statements for the business being sold may not exist because the entity’s financial results were previously reported as part of the consolidated financial statements prepared for a larger entity under GAAP. In applying GAAP to prepare carve-out financial statements for the target entity, certain differences may arise compared to the seller’s historical practices for consolidated reporting (e.g., due to different materiality thresholds or intercompany allocations). These differences may lead to disputes over how to calculate the purchase price (e.g., using the historical practices for consolidated reporting vs. carve-out practices for the target entity) even though both practices may comply with GAAP. 

Conclusion

Post-acquisition purchase price disputes relating to the issues above are often complex. Each dispute should be evaluated in light of its unique circumstances, including the specific language within the purchase agreement. To mitigate the risk of such disputes, buyers and sellers should work together with their legal and accounting advisers when drafting purchase agreements. Often, it is helpful to engage advisors that have specific expertise regarding such disputes prior to executing a purchase agreement. This enables the expert to advise on the applicable purchase agreement language to help avoid potential disputes and for the party to be prepared should a dispute ultimately arise.