Completion Accounts in acquisitions – what does ‘Accounting policies adopted in the Accounts’ mean? (Accountants out there may be surprised at this)

April 2015

Rating system:

Reading time (1-10 minutes): 3

Sophistication level (1 (idiot) – 10 (expert)): 7

Entertainment value (1 (turgid) – 10 (side-splitting)): 4

Background:

Many share and asset sale deals require a price adjustment to be made based on a set of completion accounts which needs to be drawn up. As everyone knows, a set of accounts will usually tell you what the company and its accountants want to tell you. So it’s important for both sides to set out as clearly as possible in the sale agreement how the completion accounts should be prepared and how any adjustments to the price should be worked out. The adjustment is often based on a company’s net assets, or a component part such as working capital, cash and/or debt, and will measure the actual positions at completion against an earlier set of the target’s accounts.

Since the seller and its accountants have been in control of the business and know how its accounts have been prepared it is usually the buyer and its accountants who have to try harder to understand how the past accounts have been prepared and to set out any specific requirements as to how the completion accounts should be prepared.

Most agreements have a provision along the lines that the completion accounts should be put together in the following order of priority, ie if there is any conflict the lower number is applied:

1/ applying specifically agreed policies and practices, or agreed values in respect of certain items;
2/ applying accounting principles and practices adopted by the company in compiling its previous accounts; and
3/ applying generally accepted accounting principles and practices under the accounting regime to which the company is subject (such as U.K. GAAP or IFRS).

Case:

In this case the seller and buyer were each 50% shareholders in the company (a dental practice). The sale agreement had standard priority provisions as above.

The problem here was that the company held lots of equipment under leases. But although the previous accounts had wording stating that they were prepared on the basis of the Financial Reporting Standard for Smaller Entities (which meant that the leases should have been treated as finance leases), that statement was wrong because in fact the accounts had been prepared treating the leases as operating leases. The agreement itself didn’t have any other provisions saying how they should be treated. So should the completion accounts treat them as finance leases or operating leases? If they were treated as operating leases the seller would receive a lot more money.

The parties and their accountants couldn’t agree the completion accounts, so as provided by the agreement they went to an independent accountant to decide as an expert. The independent expert said that as the figures in the previous accounts were all on the basis that the leases were operating leases, then the completion accounts should be prepared on the same basis. The seller was happy with this. But the buyer wasn’t so it went to court, and both the High Court and then the Court of Appeal ruled that…

Decision:

…the completion accounts should be prepared based on the policies which the previous accounts said would be adopted – not on the basis of the different policies which were actually applied in the previous accounts. So they needed to treat the leases as finance leases. So the seller was not happy.

This case surprised a lot of accountants, who would have read things the same way the independent expert did. Most businesspeople would think that if nothing much has changed from one date to another and they’ve been looking at a particular set of figures then the figures they are talking about will be similar. So were both parties surprised by this decision? Or did the buyer and his accountants spot a possible loophole and take a chance on it, knowing that if they had asked for the agreement to spell out that the leases should be treated as finance leases the seller would have wanted to negotiate a different price?! The case doesn’t say…

Advice:

Parties and their accountants should be very careful when they are agreeing how completion accounts should be prepared. They should check that reference accounts have actually been prepared in accordance with the policies which they are stated to have adopted. If they want the policies actually applied in the reference accounts to apply to the completion accounts even if they were wrongly applied, the ‘priority’ provisions in the agreement should be worded to say so. If in any doubt, specific policies to apply to the completion accounts should be set out in the agreement.

And it’s very important for solicitors to work with their clients’ accountants when they are drafting financial provisions in corporate deals. Otherwise, you can easily end up with disputes.

Case: Shafi v Rutherford [2014] EWCA Civ 1186