All transaction participants need to be on the same page when it comes to the accounting rules that are applied to the preparation of financial information.
This article was published on June 22, 2017 on the Middle Market Growth, a weekly newsletter published by Association of Corporate Growth (ACG). It is reprinted here with permission.
Revenue recognition standards adopted by the Financial Accounting Standards Board (FASB) will become effective over the next two years. In light of the changes, it is a good time to remind ourselves that accounting terms in transaction documents need to be precisely drafted to suit the particular transaction and expectations of the parties. Using boilerplate accounting terms can lead to significant issues, especially as the new revenue recognition standards go into effect.
Accounting standards, such as generally accepted accounting principles (GAAP) and the International Financial Reporting Standards (IFRS), are not sets of unwavering requirements, but rather are flexible sets of principles and rules, resulting in a situation in which two companies applying the same standards can account for things very differently. This is generally not an issue. But when companies transact in such a way that all parties are relying on financial information prepared by one of the parties, all transaction participants need to be on the same page when it comes to the accounting rules that are applied to the preparation of the financial information.
For example, when the seller of a company will receive an earnout based on the achievement of revenue targets after closing, it needs to ensure that how the buyer will determine the achievement of these targets (i.e., how they will be accounted for) matches the seller’s method. Because of this, practitioners have developed a fairly typical set of provisions designed to ensure that all transaction participants (and others) understand the basis of accounting that will be applied to the preparation of financial statements and other financial information to be delivered or relied on in the future by the transaction parties. However, when the accounting standards undergo a significant change, such as with the new revenue recognition standards that will be going into effect over the next two years, accounting standards-related definitions should not be dropped into agreements as “boilerplate language,” but rather need to be examined closely and drafted with precision to ensure that all parties understand what accounting standards are to be applied and when.
It is integral to a successful deal that the parties to the transaction interact with the legal team to ensure that what is reflected in the agreement is the arrangement that the parties both understand and mutually intend. Nowhere is this confluence more prevalent than the definitions of the accounting standard and methodologies to be applied, which in just a few lines can spin parties’ expectations off track if done in an insufficiently precise way. You need to ensure that your service providers are aware of the rules of the road in accounting treatment, as no industry is immune to this issue.
So when the applicable accounting standard is “GAAP,”1 how do you define it precisely? The most basic formulation — “GAAP means U.S. generally accepted accounting principles” — implicitly references its own shortcomings, namely that GAAP is largely principles-based and allows companies to make judgments on certain accounting treatment. This basic formulation may be adequate for a representation that certain financial statements were prepared in accordance with GAAP, as this is backward-looking and simply confirms that the financial statements and the methodologies applied were within the confines of GAAP. But this formulation would provide poor guideposts to anyone looking toward the transaction agreement to determine how GAAP should be applied in the preparation of future financial statements or financial information.
A better approach is to use the basic formulation to define the standard (GAAP, in this case), but also to include a second defined term that identifies the particular methodologies used in applying GAAP. For example, “’company methodology’ means U.S. generally accepted accounting principles as applied by the target company in the preparation of its most recent audited financial statements.” This approach identifies the applicable accounting standard and how that particular accounting standard should be applied by referencing a specific set of financial statements that utilized those particular methodologies.
Although the application of particular accounting standards may be required in certain instances by a company’s regulators (notably the SEC with respect to publicly traded companies) or creditors, in general, companies are not required by law to follow any particular set of accounting standards and therefore may not apply the particular accounting standard to all of their accounts. Even when regulators or creditors require a company to use particular accounting standards, (i) there may be exceptions allowed for particular accounts; (ii) the regulators or creditors may not identify a single standard, but rather allow the company to choose from certain acceptable options;2 and (iii), for the most part, will not be so specific in their requirements as to mandate the methodologies to be used by the company in the application of the accounting standards. When there is a deviation in the methodologies from what GAAP would allow, this deviation can be identified within the “company methodology” definition or by reference to a separate schedule within the “company methodology” definition.
Don’t Fall Into the Consistent Application Trap
In many instances, the “company methodology” definition also includes a concept of the accounting standards and methodologies being “consistently applied.” As a technical matter, this is not necessary because GAAP and other accounting standards generally require consistent application of the standards and have specific principles to handle the unique instances when the standards change or when a company wants (or needs) to utilize a different approach. As such, most of the time, including the “consistently applied” concept will simply be redundant, but, with the implementation of the new revenue recognition standards, including ”consistently applied” may result in unintended consequences.
For deals closing now with earnouts, royalties or other provisions calling for future payments that rely on financial statements or information prepared after the implementation of the new revenue recognition standards, the inclusion of “consistently applied” would lead the parties to use the historical methodology. If that is the parties’ intention — to make an apples-to-apples comparison of historical and future revenue recognition — it would be appropriate. But if the buyer’s expectation is that the new revenue recognition rules should be used in preparing the financial statements or the information off of which the earnout, royalties or other future payments are determined, the buyer will be dissatisfied with the result. The new revenue recognition standards significantly change the timing of when a company may recognize revenue (generally, they will allow for earlier recognition of revenue), so earnout, royalty or other payments expected in a particular period by one of the parties may be delayed to future periods if the current, as opposed to new, revenue recognition standards are applied.
This issue is not just one of expectations or delayed gratification; it could have real economic impact to the seller expecting such payments. For example, when an earnout is tied to revenue and allows for payouts only in a defined period after the transaction has closed, revenue that the seller expects to be recognized within the earnout period may actually be recognized after the earnout period under the current standards, which may result in a particular target being missed altogether and no earnout payments being made, or revenue that is simply never factored into the earnout.
Our recommendation would be to ensure that the accounting terms properly account for the parties’ expectations, explicitly if needed. If the financial metrics truly should be determined consistently with the historical financials, then the inclusion of a “consistent application” concept is only a starting point. When a large change to the accounting standards is expected (such as the new revenue recognition standards), then we recommend that the particular change be explicitly carved out from the “consistent application” concept. If, however, the parties intentionally, and with full awareness of its effects, decide to factor in the new standards, then that also should be stated clearly.
Ensure All Parties Understand Whose Methodologies Are Being Applied
The identification of a particular set of methodologies in applying accounting standards necessitates the determination of “whose” methodologies are to be applied. In some situations, such as a working capital calculation, it may be appropriate to apply the seller’s methodologies. In other situations, such as the determination of a royalty payment, the buyer’s methodologies may be more appropriate. It may even be the case that a hybrid set of methodologies is needed for a particular situation. For instance, when a future payment, such as an earnout payment, is tied to net income of the target company while it is a subsidiary of the buyer, it may be appropriate to allow for the buyer’s methodologies to be used, but for certain things, such as the application of allocated overhead expenses (i.e., expenses that are applied to the target solely as a result of it now being a subsidiary of the buyer and that did not exist when the target was a standalone company) to be carved out of the calculation.
Regardless of the methodologies ultimately chosen to be applied to a particular situation, you need to ensure that your service providers reflect in the transaction agreement a call for the application of the chosen methodology to the particular situation (and one agreement may define multiple sets of methodologies as different situations may require the application of different methodologies). The transaction agreement should also reflect that the parties to the transaction understand the methodology or methodologies being applied and the implications thereof.
For example, when a working capital calculation requires the application of the seller’s methodologies, it is imperative that the working capital target was calculated using those same methodologies. As another example, when an earnout or royalty is to be determined based on the buyer’s methodologies, sellers should ensure they understand what those methodologies are, and not assume that they are the same or similar to their own, in determining the likelihood of payment.
Finally, you need to consider the basic practical implications of the standards being relied on. For example, when an earnout or royalty is to be determined using either a hybrid or modified version of the buyer’s methodologies or the seller’s methodologies, the buyer needs to make sure that its accounting department understands this and is capable of producing the information necessary for the calculations off of the buyer’s accounting system (which applies only the buyer’s methodologies in everyday practice). Even if producing the numbers based on the agreed-on methodology is possible, the buyer will want to ensure that the timeframes allowed for the calculations (i.e., the time between the end of a particular period and when the particular payment is to be made) are long enough to “translate” financial information from the buyer’s accounting system to the methodologies to be applied to the calculation. This example is less about determining the method to be used for the payment amount, but more about confirming that, once a set of methodologies is chosen, the party that will need to apply the methodologies is actually able to do so, either at all or within the confines of other provisions of the agreement, such as timing requirements.
Although the issue of whose methodologies to apply may not be directly impacted by the new revenue recognition standards, it should be noted that publicly traded companies are to adopt the new standards for periods beginning after December 15, 2017, while privately held companies can wait until their first period beginning after December 15, 2018. When determining whose methodologies to apply to future payments it is important to consider the nature of the party whose methodologies are used to decide whether or not the new revenue recognition standards will be an issue and by when. An alternative would be to address the new revenue recognition standards directly — regardless of the methodologies to be applied or when the parties adopt the new standards, explicitly stating whether the new or current revenue recognition standards should be applied to the calculation as part of the methodology definition.
This article is not intended to be an exhaustive review of all of the issues arising from the new revenue recognition standards or that surround accounting terms in transactions generally, but more as a reminder that what the transaction agreement says about the accounting to be applied can have a real and material impact on the parties’ expectations. Being precise when drafting these provisions, and confirming that all parties are on the same page with the choices made and that all parties (lawyers, accountants and CFOs) understand the implications of those choices, are key to ensuring no foreseeable issues arise from the transaction because of differences in how the parties account for the transaction.
Endnotes
1 GAAP is the accounting standard most utilized by companies in the United States, so the remainder of this article will reference GAAP as an applicable accounting standard. Note, however, that the discussion equally applies to other accounting standards, such as IFRS, Canadian GAAP, etc.
2 For instance, SEC reporting companies may use U.S. GAAP or IFRS in the preparation of their financial statements.
