Survey Results of Merger & Acquisition Damage Claims

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1 Survey Results of Merger & Acquisition Damage Claims One of the significant practice areas at is addressing damage claims related to merger and acquisition transactions. Generally, the damages being alleged is an adjustment to the purchase price paid for alleged misrepresentations made by the seller as to the accuracy of the selling company s balance sheet. The standard asset purchase agreements and stock purchase agreements generally contain certain seller representations that require that the historical financial statements of the selling company conform in all material respects to Generally Accepted Accounting Principles ( GAAP ). The Financial Accounting Standards Board ( FASB ) promulgates the GAAP accounting standards used within the US. 1 The disputes that often arise after the closing of the purchase transaction can cover multiple accounting areas. To highlight the various areas of potential dispute and to identify the most common areas that give rise to litigation in merger and acquisition transactions, conducted a review and survey covering the past five years of litigation involving damage claims arising from merger and acquisition transactions. Our survey covered more than 200 transactions. Our survey covered primarily transactions involving privately held companies and indicated that there is a common theme and specific accounting areas that give rise to most GAAP accounting damage claims. Approximately 71% of all post-closing GAAP accounting disputes relate to four areas of accounting from the selling company s financial statements: Ø Failure to Record Contingent Liabilities 22% Ø Account Receivable Valuation/Collectability 20% Ø Unrecorded Liabilities 18% Ø Inventory Valuation/Obsolescence 11% 1 For publicly traded companies, GAAP accounting standards may also be promulgated by the Securities and Exchange Commission.

2 Survey Results of Most Common Area of GAAP Accoun7ng Disputes 4% 1% 8% 1% 20% Account Receivable Valuation/Collectability Contingent Liabilities 22% 11% Inventory Valuation/ Obsolescence 5% 18% Unrecorded Liabilities 6% 4% Account Receivable Valuation/Collectability Valuation of Intellectual Property Investments in Unconsolidated Joint Ventures/Businesses Contingent Liabilities Accounting for Employee Compensation/Incentive Plans Other Inventory Valuation/Obsolescence Fixed Assets Valuation/Obsolescence/Depreciation Unrecorded Liabilities Material Adverse Change in Business Operations Product Pricing/Costing Impact on Gross Margin Contingent Liabilities A contingency is defined by the FASB as an existing condition, situation, or set of circumstances involving uncertainty as to possible gain (gain contingency) or loss (loss contingency) to an entity that will ultimately be resolved when one or more future events occur or fail to occur. With respect to contingent liabilities that exist as of the date of the balance sheet provided by a seller there is a GAAP requirement to record such contingent liabilities if they meet the guidance set forth within the accounting standards, or at a minimum, be disclosed in the financial statement footnotes. Accounting Standard Codification ("ASC") 450 promulgates the accounting standard for the recognition of contingent liabilities. ASC 450 states, "an estimated loss from a loss contingency shall be accrued by a charge to income if both of the following conditions are met: 2

3 a. Information available before the financial statements are issued or are available to be issued indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. Date of the financial statements means the end of the most recent accounting period for which financial statements are being presented. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss. b. The amount of loss can be reasonably estimated. 2 [Emphasis Added] Examples of both probable and estimable contingent liabilities commonly left off the balance sheets of the selling entity are related to: Ø Warranties on product and services; Ø Pending and threatened litigation claims; Ø Under insured losses for damage to assets and property; Ø Guarantees of third-party indebtedness; and Ø Income taxes under IRS audit or related to aggressive tax positions previously taken. The financial impact of unrecorded contingent liabilities may result in the purchaser over paying for the assets and/or stock of the selling company. In a former matter that we advised, the unrecorded product warranty liability discovered during the litigation process amounted to $1.2 billion! Account Receivable Valuation/Collectability Under GAAP, accounts receivables are to be reported on the balance sheet at their net realizable value. Accordingly, the invoiced amount of any receivable should be offset for financial statement purposes for an estimated allowance for doubtful accounts. An allowance for doubtful account is considered a contingency under ASC 450 as previously discussed. If it is both probable and estimable that a loss exists on the face value of the receivable as of the balance sheet date, it must be accrued to record an allowance for lack of collectability. 2 Accounting Standard Code

4 Under GAAP, a company is required to implement accounting policies and procedures for estimating the uncollectibility of accounts receivables. This can be accomplished by either adopting a specific identification process of individual accounts receivables that may be deemed as impaired or completely uncollectable or through historical experience of collections and bad debt write-off. The specific methodology is the responsibility of company management. Overstated accounts receivables and/or failure to record a proper allowance for doubtful accounts under GAAP may result in the purchaser overpaying for the selling company s assets or stock. Unrecorded Liabilities In many purchase transactions, the selling company may have liabilities that existed at the balance sheet date that were just not recorded through either intentional omission or through deficiencies in accounting policies and procedures to properly identify liabilities on a timely basis. To a certain extent, accounting for liabilities may require company management to rely on certain assumptions to properly account for liabilities. Examples of common unrecorded liabilities identified during our survey included the following: Ø Payroll taxes; Ø Income taxes; Ø Litigation damages; Ø Executive compensation; Ø Employee bonuses; Ø Liabilities triggered by a buy/sell provisions for key employees and management; Ø Pension and employee benefits; and Ø Unrecorded inventory purchases. 4

5 The Financial Accounting Standards Board ("FASB") in Statement of Financial Accounting Concepts No. 6 Elements of Financial Statements 3 defines a liability as follows: A liability has three essential characteristics: (a) it embodies a present duty or responsibility to one or more other entities that entails settlement by probable future transfer or use of assets at a specified or determinable date, on occurrence of a specified event, or on demand, (b) the duty or responsibility obligates a particular entity, leaving it little or no discretion to avoid the future sacrifice, and (c) the transaction or other event obligating the entity has already happened. 4 [Emphasis Added] Unrecorded liabilities may result in the purchaser overpaying for the net assets or stock of the selling company. Inventory Valuation/Obsolescence Like accounts receivables, inventory is to be reported on the balance sheet at net realizable value. Accordingly company management of the seller must implement adequate accounting policies and procedures to properly reflect the value of inventory at the lower of cost or market, including any reserves (allowances) for inventory obsolescence or slow moving and overstocked inventory. Generally inventory observations are made on a regular basis to properly account for both the quantity of inventory on hand and to address inventory valuation and obsolescence issues. 3 The FASB is currently engaged in an ongoing update of the Conceptual Framework- Elements and Recognition. As of March 15, 2010, the FASB has tentatively adopted the following working definition of a liability, subject to final approval of a forthcoming Exposure Draft Document and Final Standard: A liability of an entity is a present economic obligation for which the entity is the obligor. Present means that on the date of the financial statements both the economic obligation exists and the entity is the obligor. An economic obligation is an unconditional promise or other requi rement to provide or forgo economic resources, includi ng through risk protection. An entity is the obligor if the entity is required to bear the economic obligation and its requirement to bear the economic obligation is enforceable by legal or equi valent means. 4 Statement of Financial Accounting Concept No. 6 Elements of Financial Statements. Para

6 The issue of inventory accounting may become more complex in those cases where the selling company uses a standard cost inventory system whereby inventory purchases, manufacturing costs and overhead are capitalized to inventory by using standard cost accounting methods. Under a standard cost accounting system, the company management is also required to establish accounting policies and procedures to adequately adjust inventory costs and valuations for the actual variances that may exist between the standard cost and the actual costs being incurred for purchased materials, labor and overhead involved in the manufacturing process. Examples of common issues that we identified in our survey that resulted in accounting disputes related to the following: Ø Failure to conduct inventory observations to adjust balance sheet inventory balances to actual inventory counts on hand; Ø Changes in accounting methodology of inventory costing from first-in-first-out (FIFO) to last-in-last-out (LIFO) to report higher value inventory balances; Ø Failure to adjust standard cost inventory balances reported for current variances; Ø Failure to establish inventory obsolescence reserves for old, slow moving and overstocked inventory; and Ø Failure to eliminate intercompany profit recorded in inventory balances for transfers between corporate subsidiaries and affiliates for consolidated balance sheet purposes. Among the most difficult accounting areas where assets can be over valued in a merger and acquisition transaction is related to inventory. Depending upon the complexity of the inventory accounting systems (for example standard cost accounting in manufacturing processes), the identification of potential post-closing purchase price adjustments may require specific accounting expertise. Settle Up Options on the Purchase Price Paid A common provision within most asset purchase and stock purchase agreements is the ability to adjust the purchase price for changes in working capital that may transpire between the date the purchase closed and a subsequent date to re-evaluate the value of the working capital and 6

7 assets acquired. This provision provides a basis for the purchaser to adjust the purchase price for changes in the estimated value of assets and liabilities based on pre-closing date balance sheets. In the end, the accounting disputes are generally reviewed by accounting experts to reach a compromise between the selling and purchasing parties. The extensive overview of our survey is helpful to highlight those areas that disputes may arise and provide a basis to establish parameters to address disputes as early as possible. 7