Just completed the sale of a business? Great, crack open the champagne.
Corporate solicitors, lenders, accountants, clients – all happy.
Now ring the litigators. “Why?” you cry, “everyone’s happy and the deal is watertight”. Well, it is for the first 20 days, month, or whatever period has been chosen for the buyer to prepare the completion accounts…
And then the problems start. The seller is reviewing the completion accounts and has a finite period in which to dispute them before they are deemed to have been agreed. The pressure is on. And that’s when everything starts to unravel.
We’ve been here before. Many times. And now we’re seeing it more frequently than we did five years ago.
But still no-one wants to invest time and money up front to prevent a completion accounts dispute arising. So this article looks at some of the common issues that arise in completion accounts disputes – forewarned is forearmed as they say. Completion accounts disputes have been cropping up since I started working as a forensic accountant 18 years ago – one of my first cases was a £100m+ completion accounts dispute involving many tens of items in dispute.
First a brief refresher. In a corporate transaction the sale and purchase agreement (SPA) typically includes a purchase price that is adjusted by reference to the net current assets (or working capital) of the company on the completion date. If the net current assets are greater than a negotiated target figure the seller receives a top up payment. If, however, the net assets on completion are less than the target the buyer gets a refund. The net assets of the company are set out in the completion accounts which are prepared and agreed (either voluntarily or by expert determination) between the parties.
Below are our top five issues arising in completion accounts disputes.
1) Accounting policy hierachy
The SPA needs to be specific about how items should be accounted for in the completion accounts. The most common issue arises when the accounting policy hierarchy requires the completion accounts to be prepared in accordance with generally accepted accounting practices (GAAP) on a basis consistent with the accounting policies applied within the company’s accounts in previous years.
The presumption here is that last year’s statutory accounts were prepared in accordance with GAAP. No doubt they were. But what wbout that stock of spares for the factory plant? No-one pays any attention year on year to items such as these because they’re not material (i.e. of any significance) to the accounts as a whole – it doesn’t usually matter to the users of the accounts. So, having established that the figure in the statutory accounts is in fact very out of date and incorrect, what do we do about the stock of spares? Under a GAAP as long as consistently applied accounts formulation we have the option to either continue as before – keep the value the same (be consistently wrong) or change to the correct valuation (act in accordance with GAAP but be inconsistent).
It’s a conundrum that the expert frequently has to deal with, but which could easily have been avoided by drafting the accounting policy hierarchy more carefully in the first place.
2) Inadequate definitions
Deals vary as to how much time the parties spend wrangling over the definitions but these are important to get right and can be crucial in a dispute. Where a working capital purchase price adjustment is used the definition of working capital is of paramount importance. Everyone thinks they know what working capital is but, unless it is defined precisely in the SPA there are grounds for disagreement, as the SPA definition trumps commonly accepted knowledge.
Working capital is subjective.
Working capital is not a number shown in a set of statutory accounts and its calculation is subjective. This is particularly the case with regard to debtors, which many companies treat as current assets irrespective of the period over which the debt is due to be collected. It can come as a shock to discover that a five year debt that has always been shown in current assets is considered by the buyer to be only one fifth current. And if the definitions don’t deal with this point and you have to fall back on a consistency accounting argument can you be consistently wrong here?
3) Specific policies that are not specific or too subjective
It is very difficult to draft a specific accounting policy telling the preparer of the completion accounts exactly how to treat individual items. However, where the policies are too vague a dispute is likely to arise. Here are some examples:
Stocks are to be valued at the lower of cost and net realisable value. Cost includes appropriate overheads. The biggest issue here is what level of overheads should be capitalised in the stock value? Who decides what ‘appropriate overheads’ are or how they should be calculated?
Is there an option? Who decides?
Plant should be depreciated over 5 or 10 years. Which is it then? Depreciate over five years or 10 years? Is there an option? If so, one party will inevitably choose five years and the other will choose 10 years, which could come out with very different answers depending on how significant the company’s plant is.
If the accounting policy hierarchy is carefully worded and requires accounting treatment to be consistent with that in previous years in priority to the application of GAAP this may not become an issue. However, specific accounting policies usually take precedence in an SPA accounting hierarchy so the inclusion of vague or ambiguous accounting policies is simply asking for trouble.
4) The ‘fairness’ argument
As an expert there are always some items where one of the parties protests that the proposed treatment is simply not fair or not in accordance with their intentions. In fact, sometimes it is quite clear to the expert that the treatment of an item according to the SPA is not fair and is not even commercial.
However, the expert’s role is to determine the completion accounts in accordance with what the SPA says and not what one of the parties thought it said or wanted it to say. So, whilst it pains us to do so, we sometimes have to make decisions which don’t always make sense but are what the parties specifically signed up to in the SPA.
5) Trying to get around the SPA
The party reviewing the completion accounts is inevitably under serious time pressure as, in accordance with the terms of the SPA, the completion accounts are deemed to be agreed by the parties if a dispute notice is not served within a set time period (which can often be relatively short). The dispute notice must set out in reasonable detail the nature and quantum of the items in dispute.
A common ploy to get around the strict accounting requirements set out in the SPA is for the preparer to include a ‘general provision’ in the completion accounts. The general provision is inevitably disputed by the reviewer and is subsequently re-allocated against specific items in the completion accounts after the preparer has had more time to consider these items, with the overall impact on the net assets in the completion accounts being the same. General provisions are not permissible under GAAP but it is very easy for the reviewer to willingly accept the ‘greater level of detail’ subsequently provided in reallocating the original general provision without recognising that, in effect, they have conceded an arguably strong point.
In a nutshell completion accounts disputes can be avoided (or the impact minimised) by some clear focus on the wording of the SPA. Whilst we have advised clients on this topic in advance, they are in the minority – few clients want to spend the time preventing an unknown dispute arising and prefer to wait and see if they have to invest in the (time consuming and expensive) cure at a later date.