How to Minimize Post-Closing Surprises

Mergers and acquisitions in Texas reflect the state’s business success. With energy companies leading the way, almost $60 billion of deals were announced during the first half of 2013, with a slightly larger amount during the same period of 2012, according to Mergermarket.

By Jeff Compton
November 04, 2013
Originally published in Texas Lawyer.

Mergers and acquisitions in Texas reflect the state’s business success. With energy companies leading the way, almost $60 billion of deals were announced during the first half of 2013, with a slightly larger amount during the same period of 2012, according to Mergermarket.

Almost every merger requires post-closing settlement between buyer and seller. That’s due to variances between the values of various accounts as estimated by the seller at the time of closing versus those experienced by the buyer after closing. Some practical accounting guidance can help in-house counsel draft agreements in a way that minimizes post-closing surprises.

Value estimates that go into the purchase price inevitably must be “trued up,” or adjusted, after closing.

Disagreements arise because the seller estimates certain important balances before closing, then the buyer revises those estimates after closing. Well-prepared legal departments can help minimize disagreements between buyers and sellers and the cost to resolve them. In-house counsel should seek to maximize understanding of the basis for estimates between the seller and the acquirer by facilitating communication between the buyer and the seller from the beginning of the due diligence process through closing.

Generally accepted accounting principles (GAAP) are just that—principles.

GAAP always remain subject to interpretation. Equally correct answers can exist, based upon different reasoning applied to the same principles and facts. Most experienced sellers limit the potential disagreement over the application of GAAP by specifying that the seller’s GAAP, as applied by the seller’s auditors in the seller’s historical financial statements, will control.

If the seller’s auditors performed an audit immediately after the closing, there would be less potential for misunderstanding, but that’s not reality. In practice, the buyer will take exception to the seller’s treatment of transactions during the period since the last audit and through closing.

Accordingly, the buyer’s corporate accounting staff, at times supplemented by outside accountants, should perform careful due diligence on all of the seller’s accounts before and after the closing to understand just how the seller’s accountants interpreted and applied GAAP.

Due diligence is challenging in light of ongoing business realities.

The buyer’s due diligence includes detailed inquiries as to how the seller estimated key components of the current assets and liabilities and how the seller has tested estimates historically. To complicate the situation, these accounts change constantly, due to the business’ day-to-day operations.

No one fully can vet those accounts before closing. In addition to reducing potential misunderstanding, careful due diligence allows for establishment of accurate escrow balances, securing the payment of any allowed exceptions to the seller’s estimates.

An exhibit requires an explanation.

Just before closing, the seller supplies a simple exhibit to the purchase agreement listing the current assets and liabilities. But, given the nature of GAAP, the seller must estimate these balances, because the accounting with regard to all the balances is not completed at the date of closing.

In other words, GAAP accounting is a series of estimates. For example, while accountants can determine exactly the amount of cash a seller holds, the net amount of accounts receivable and accounts payable requires estimates at a given date as to how much the seller ultimately will collect or pay.

Before closing, the buyer’s counsel can improve the seller’s estimates and reduce potential misunderstandings by asking the seller for more detail on the purchase-agreement exhibit listing these estimates. For example, footnotes can explain the seller’s method for preparing each estimate. The more detailed the seller’s estimates, the easier it will be for the buyer to understand them and resolve disagreements.

Know what’s prospective and what’s retrospective.

After the closing, the buyer’s actions can increase the potential for misunderstanding. For example, the buyer may change the method of estimating items, such as ultimate collections of accounts receivable. There is nothing wrong with the buyer bringing its own estimation method to the acquired company’s estimate after purchase.

However, a change in estimate after closing should not prompt a change in the closing date’s estimates and balances. This is because, under GAAP, changes in estimates are prospective, not retroactive, in application.

In contrast, if the buyer determines the estimate was in error and the seller knew of the error as of the closing date, then the correction should be applied to the closing date. Clearly identifying and acknowledging whether a change in estimate or an error has occurred will reduce potential misunderstanding.

Limit the time frame for disputes.

Another way to reduce disagreement is to stick with the agreed period for the buyer to dispute any balances. It’s typically 90 days after closing. This is because facts change over time, while accountants must base estimates required GAAP accounting on information they know at the time they make the estimates. Going beyond the agreed period for allowing the buyer to propose adjustments introduces complications as to what adjustments are proper.

To reduce the potential for disagreement after closing, the buyer’s due diligence can focus on accounting methods the seller uses, especially with regard to estimates of current assets and liabilities. This also provides for more accurate escrow amounts to protect the buyer. Better disclosures in the purchase agreement’s working capital exhibit likewise will improve the process. Finally, avoiding changes in estimate methods during the period when the seller can take exception to those estimates—and not extending that period—benefits both the buyer and seller.

Jeff Compton is a shareholder in Houston CPA firm Compton & Wendler. His work involves identifying and valuing assets in the resolution of post-closing adjustments and other transactions. He is also accredited in business valuation by the American Institute of CPAs and is a certified fraud examiner.