United States: Wearing Blinders To Avoid The Use Of Hindsight Post-Closing

Last Updated: July 10 2019
Article by Frank A. Lazzara

Hindsight, which rarely makes it to the top-ten list of our desired superpowers is nonetheless, a pretty useful tool to have handy despite competing with the much more sought after and potentially lucrative ability to accurately forecast the future.  Accountants or auditors in particular, are the benefactors of this privilege and get to put it to use every time they are engaged to opine on a company's financial statements.  Namely, that period from the date of the financial statements (i.e., the traditional calendar year-end) through the date of issuance, which coincides with the date of the auditor's report (or opinion), is that slice of time where an auditor has the corroborative benefit of hindsight.
  
For the days from the end-date of the subject financial statements until the company issues their Form 10-K, which range from 60 to 90 days from the period-end of the annual financial statements for a public filer, the auditor gets to consider all the information known or knowable about conditions that exist at the balance sheet date of 60 to 90 days prior.

By way of example, a December 31 set of financial statements for a large accelerated filer (i.e., the most stringent time window) will afford the auditor the period through March 2 (i.e., 60 days later) for vetting those required balance sheet estimates, such as collectability reserves for accounts receivable and loss contingencies established as current liabilities.  Effectively, this is an opportunity to deploy hindsight regarding those forward-looking estimates representing the state of a balance sheet, dated 60-days in the past.

GAAP and IFRS

More than a privilege or opportunity, this information window is actually a requirement of Generally Accepted Accounting Principles ("GAAP") in the US and International Financial Reporting Standards ("IFRS"), everywhere else.  To those professionals who work within the start-up environment, 60 days seems almost impossible, but the good news is that for non-public filers, that window may only constrained by their funding or equity investor's requirements.

So, why is this relevant to M&A deal closings?  Well, as most deals include a "basis of preparation" condition that requires either GAAP or IFRS adherence, those transaction parties have agreed that any financial statements exchanged between them, especially those prepared in the quest to initially estimate and thereafter, true-up closing working capital, must comply with this tenet.  The concept is referred to as "subsequent Events" and as to US GAAP, can be found in Accounting Standards Codification ("ASC") 855-10.

A corollary US GAAP standard that is relevant to information learned about financial statement estimates is ASC 250 – Accounting Changes and Error Corrections.  ASC 250 defines the various accounting changes as:  a change in accounting principle; an accounting estimate; or, the reporting entity.  A change in an accounting estimate is fundamentally what is being proposed by one of the parties in a working capital dispute that utilize hindsight learned, post-closing often, many months or in excess of a year, after the transaction closing.  ASC 250 instructs:  "A change in accounting estimate shall not be accounted for by restating or retrospectively adjusting amounts reported in financial statements of prior periods or by reporting pro forma amounts for prior periods."

Accounting is part historical reporting and part foretelling the fate of current assets and liabilities and accordingly, the ongoing recognition of changes in estimates to reported financial data would give rise to a never-ending cycle of restating prior estimates and previously issued financial statements.  As the results of previously recorded estimates became known and to the extent they varied from their corresponding accrual-based estimates, the never-ending fine-tuning would convert best-estimates into actual experience.
 
ASC 855-10 is therefore applied to identify the post-closing time period for which information can be considered in the preparation of the financial statements that are used for calculating closing working capital.  The Implementation Guidance within ASC 855-10-25-1 addresses subsequent events that are to be recognized in the subject financial statements (i.e., "Type I Subsequent Events") and provides examples (i.e., in ASC 855-10-55-1) that illustrate the requirement to use all available information to derive balance sheet estimates about conditions that existed at the balance sheet date.

Why is This Not Universally Applied? 

Although practitioners who regularly serve as neutrals and party advisors in this type of arbitration and venue will generally apply this guidance, which can also be found within the AICPA Forensic and Valuation Services Section practice aid on Mergers and Acquisition Disputes (the "M&A Practice Aid"), our experience routinely indicates that the consideration of evidence learned in hindsight and introduced into closing working capital arbitration proceedings by the parties is a common occurrence.  While this is a surprise to us and should also be unexpected to those who practice this specialty, it may prove instructive to party advisors.

GAAP and IFRS require the consideration of all available information regarding events that affect conditions existing at the relevant financial statement dates through either their issuance, or delivery to the respective party.  ASC 855 is the guidance that defines information that is "in-play" for the preparation of the balance sheet used to derive the final working capital figure and requires the preparer to consider all information available through the date of preparation, or the date financial statements are "available to be issued."

In our experience, we find that parties regularly make reference to information learned after the date of the preparation of the "final balance sheet," a tactic that is intended to appeal to the independent accountant's sense of equitability.  Working capital disputes will linger and if they proceed to arbitration, will be aired from 12 to 24 months or longer after the preparation of the subject balance sheet.  Inevitably, parties will become aware of information that developed during this time period and may refute estimates used in the working capital calculation, such as liability estimates for loss contingencies, obsolescence adjustments for inventory and contra-asset calculations for potentially uncollectible customer accounts.

Considerations

Merger and acquisition activity continue at a healthy pace and we think it prudent for advisors who are faced with a dispute that is heading to an arbitration to carefully select the independent accountant and to strategically consider the strength of their claims within the light of the Subsequent Events guidance.

For example, if the subject company is not equipped with the financial reporting rigor that will enable it prepare the necessary financial statements estimates, the relevant party (i.e., Seller or Buyer) should seek to negotiate for additional time gather the data and prepare the necessary estimates.

Of course, if you're on the opposite side of the party that requires an extensive amount of additional time to derive reliable accounting estimates, then seek to limit the extent of time permitted for financial statement preparation, try to "collar" the variation from an agreed-to target component of working capital, or negotiate some type of favorable concession.

If you're amenable to providing additional time to your counter-party, be mindful of the window of developing information and endeavor to limit the use of subsequent events information and be specific about the date through which relevant information will be permitted to impact the judgement surrounding accounting estimates.

Conclusion

In applying GAAP or IFRS, we adhere to the Subsequent Events guidance that limits the extent of hindsight data that can be used in a purchase price dispute.  However each arbitration is unique and the selected arbitrator's level of experience with adjudicating accounting disputes is not universal thereby necessitating a thorough assessment of the facts and parties in each matter to maximize your chances of prevailing in a working capital purchase price dispute arbitration.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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