Thank you to our colleagues Michael Smith and Nick Andrews in BDO UK.
When you are buying or selling a business, the two most common mechanisms for settling on the final price to pay are completion accounts and locked box. The process for establishing the price for the business can be complex and significantly affect the final outcome.
This article examines the optimal process for completion accounts where that process has been selected, and highlights some of the issues that can make the process longer and more difficult.
What are completion accounts?
When using a completion accounts mechanism, the parties agree a base amount payable by the buyer to the seller at completion, known as the ‘headline offer price’ and which represents the ‘enterprise value’. This can also be thought of as the initial unadjusted purchase consideration. The buyer typically calculates the headline offer price assuming that the target will be cash and debt free and have a normal level of working capital.
Post completion, a purchase price adjustment is then made to take account of the actual cash, debt and working capital of the business as at the completion date, to arrive at the final purchase price (known as the ‘equity value’). This is achieved through the creation of bespoke “completion accounts”. You will find an illustrative example of this below.
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Enterprise Value
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A
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£400 million
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Plus: Cash
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B
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£10 million
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Less: Debt
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C
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£30 million
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Net debt adjustment
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D = B - C
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(£20 million)
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Plus: reported working capital
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E
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£50 million
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Less: normal working capital
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F
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£65 million
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Working capital adjustment
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G = E - F
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(£15 million)
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Equity Value
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H = A + D + G
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£365 million
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How do completion accounts work?
The purchase price adjustment is based on the assets and liabilities actually acquired upon completion and relative to pre-completion assessments or estimates in the case of working capital. Additionally, where the offer references an assumed level of net debt, an adjustment to the Equity Value is made where the actual net debt differs. The purchase price adjustment can be significant and result in monies becoming due to either the buyer or the seller, i.e. it can result in the initial unadjusted purchase consideration being either increased or decreased.
To determine the required purchase price adjustment, and thus ultimately the final purchase price, a bespoke set of “completion accounts” are drawn up post completion, which show the net assets of the company acquired as at the date of completion. Completion accounts can be prepared by either the buyer or the seller, and are then reviewed by the other party. Completion accounts include a balance sheet and often contain separate statements for net debt, working capital and non‑current net assets.
What is the typical basis for preparation of completion accounts?
Given the importance of completion accounts it is critical that both the seller and buyer agree how the completion accounts should be prepared and that this is clearly set out within the Sale and Purchase Agreement (SPA).
It is not enough to agree that the completion accounts will be prepared under Generally Accepted Accounting Principles (GAAP), such as International Financial Reporting Standards (IFRS), UK GAAP or US GAAP. This is because a degree of discretion often exists under GAAP which means a range of accounting treatments can all be deemed appropriate and in-line with GAAP. The result of this is that two accountants, even when presented with the same facts, could come to two quite different views on the same issue. One view may be more cautious / prudent, and one may be less so, but both views could still be in compliance with GAAP.
What is the SPA hierarchy?
The most common approach for the basis of preparing completion accounts is a hierarchy with three limbs as follows:
- First limb: specific accounting policies set out within the SPA
- Second limb: consistency with past practice, i.e. the policies, procedures, practices, principles, treatments, methodologies and/or categorisations applied in preparing the last set of audited accounts of the target company (often referred to as consistency with past practice to the referenced accounts)
- Third limb: GAAP (e.g. IFRS, UK GAAP, etc.)
In the case of any conflict between the limbs, the treatment per the first limb prevails over the second and third limbs, and the second limb prevails over the third limb.
The second most common approach is:
- First, specific accounting policies set out within the SPA
- Second, consistency with past practice, to the extent past practice is in compliance with the accounting treatment under a specified GAAP
- Third, GAAP
Based on the first-mentioned hierarchy above, to determine how an item is to be accounted for in the completion accounts, the preparer would first have regard to any specific accounting policies in the SPA. If there are no specific rules covering the accounting treatment for a particular item, the preparer would then go to the second limb of the hierarchy: consistency with past practice. If the item or category of items was new and was not included in the last set of audited accounts, the preparer would then go to the third limb and apply the relevant GAAP as specified in the SPA.
As one goes down the hierarchy, there is more potential for the preparer to apply judgement in determining how an item is treated and so more potential for disputes between the parties.
Specific accounting policies for completion accounts
Specific policies can be agreed between the two parties and can range from stating a rule for a category of items (for example, specifying that the value of all inventory which is over one year old as at completion is written down to zero in the completion accounts) to stating a figure to be adopted for a specific item as at completion (for example, the value of a particular specific provision).
These specific policies aim to give a high degree of certainty to both parties regarding the figures to be recorded in the completion accounts.
It is not practical to have specific policies covering all items within the completion accounts. However, specific policies are often included where the item relates to a subjective accounting estimate or the item did not exist in the previous accounts, particularly where these items form a significant part of the target’s business.
The specific policies do not have to follow GAAP or the past practice applied in the last set of accounts for the target company, although they may do. This is part of the overall negotiation of the purchase price between the parties.
Consistency with past practice
Where there is a set of audited financial statements for the target company prior to completion, the policies, procedures and practices applied in preparing those accounts are often referenced as the consistent basis for preparing the completion accounts. The SPA may also specify that past practice is to include consistent application of management judgement.
By applying the same practice as used in the past, it protects the buyer or the seller from the completion accounts being prepared based on a different level of prudence than used historically (i.e. either more or less conservative) so as to affect the purchase price adjustment in favour of the preparer.
GAAP
For those items which are not covered by the first or second limbs of the hierarchy, the parties need to agree which relevant GAAP should then be applied. This is normally the GAAP that was applied in preparing the last set of audited accounts of the target, but it can differ. If this is the case, both parties should consider any impact on balances purely due to changing GAAP.
The three most common pitfalls of completion accounts
There are three common issues that can result in disagreement when it comes to preparing completion accounts.
Unclear and ambiguous wording
Wording which is unclear and ambiguous can lead to issues and disputes between the parties. You should ensure that language is as clear and definitive as possible, avoiding wording which is convoluted or lacks specificity.
It is crucial that the SPA has clear and unambiguous wording in defining specific policies or rules and to which items they apply. For example, stating that the pensions figure is “To be calculated based on the methodology agreed between the Parties, plus taking into account the risks on pensions as mentioned in the Vendor Due Diligence Report” is vague and open to interpretation, and can lead to disagreements between the parties.
The SPA should also clearly set out which accounts and for which entity in which year form the basis for “consistency with past practice”. Merely stating there should be “consistency with past practice” is not sufficient, as whose past practice and when?
When specifying which GAAP to apply, it is also necessary to state the effective date of that GAAP as accounting standards are often amended and occasionally replaced entirely, sometimes with quite significant impacts to the accounting treatment.
If the hierarchy wording in the SPA is ambiguous and results in differing views regarding the correct order of priority, this can lead to lengthy and costly disputes between the parties.
Depending on which limb of the hierarchy is applied, the treatment of an item can be very different. For instance, a specific policy relating to trade debtors (monies due from customers) could be that all trade debtors are written down to zero 12 months after an invoice has been issued to a customer. In contrast, the practice applied in preparing the last set of accounts could have been to write down all trade debtors by 50% after 12 months and then 100% after 18 months. IFRS is broader and instead states that an entity must assess at the end of each reporting period whether there is any objective evidence that a trade debtor is impaired, and the extent if so. The potential for disputes is clear.
It should be clearly understandable from the SPA in exactly which order the hierarchy is to be applied, and which limb takes precedence where there is any conflict between the limbs.
Errors in previous accounts
Although the usual order of priority is that consistency with past practice takes precedence over GAAP, one exception to this is where there are errors in the historical accounts. Errors in the historical accounts can lead to large and unexpected adjustments, either in favour of the seller or the buyer depending on the nature of the error.
In the expert determination case of Shafi vs. Rutherford, the SPA contained the usual three limb hierarchy, and for the purposes of the second limb (consistency with past practice), defined the target’s last accounts as being prepared in accordance with GAAP.
However, an error in the historical accounts was identified, post completion, whereby the accounting treatment of certain equipment leases in the reference accounts was incorrect under GAAP.
In the case of historical errors, courts are likely to order that the previous incorrect past practice, that also contravened the stated accounting policy and applicable GAAP in the reference accounts, should not be perpetuated and that the completion accounts should be prepared based on the correct accounting treatment per GAAP and the stated accounting policy.
Post balance sheet events
A potential area of dispute arises where the SPA is silent regarding the cut-off date for the admissibility of information that can be considered when preparing the completion accounts.
We have seen a range of cut-off dates used in practice, including:
- the completion date of the deal
- the date on which the preparer of the draft completion accounts submits them to the other party
- the date of the objection notice from the recipient of the draft completion accounts
- the date of agreeing the completion accounts or the determination of the completion accounts
Accounting standard IAS 10 ‘Events After the Reporting Period’ specifies that only those events after the reporting period which provide evidence of conditions that existed at the end of the reporting period, known as ‘adjusting events’, should be adjusted for in the financial statements. Those events, which are indicative of conditions that only arose after the reporting period, ‘non‑adjusting events’, should not be adjusted for in the financial statements.
Conclusion
The application of a completion accounts mechanism can lead to a significant post-completion price adjustment. This means all the parties must understand and agree the basis for the preparation of the completion accounts and set this out unambiguously in the SPA.
Getting it wrong can lead to a significant loss of value, not only due to an adverse purchase price adjustment, but also through management time spent resolving complex and lengthy disputes between the parties. A seemingly good deal can easily become a prolonged headache.
Even with the best of intentions and despite following advice, an M&A transaction can result in a dispute post-Completion. Each transaction is unique and any issues which arise on a particular transaction will need to be considered in the context of that specific case. Our Forensic M&A Services team has a wealth of experience and offers a range of specialist services both to reduce risk exposure pre-deal and to assist with any issues that arise post-deal.