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Completion accounts clauses that are a contradiction in terms
There have been a number of recent judgments dealing with the jurisdiction of experts appointed in the context of expert determinations *. As a forensic accountant, I have been involved with many expert determinations arising from business sale and purchase agreements (SPAs). In my experience, the most common jurisdictional issue where proceedings are issued is in relation to the accounting hierarchy to be adopted in preparing the completion accounts.
A typical construction states that the completion accounts should be prepared in accordance with: 1) specific accounting policies; 2) the treatment adopted in the preparation of the reference accounts; and 3) generally accepted accounting principles (GAAP) **. Item 1 takes priority over items 2 and 3, and item 2 takes priority over item 3. The aim of the accounting hierarchy is to provide a clear and unambiguous set of criteria to be adopted in preparing the completion accounts.
Unfortunately, this does not always happen in practice. I have seen many SPAs where items 2 and 3 are combined, requiring the completion accounts to be prepared in accordance with GAAP as applied in the reference accounts. On first glance, this looks like a neat simplification of the more lengthy hierarchy outlined above. However, it is far more complex and causes untold difficulties for the expert accountant.
The issue arises where the accounting treatment adopted in the reference accounts was not GAAP compliant. Believe it or not, this is often the case, even where the reference accounts have been audited and received a clean audit opinion.
For example, consider a large manufacturing company which, for many years, had a disused warehouse on one of its sites. The warehouse had been valued at cost in the statutory accounts. Three years ago it was demolished but, because of an oversight, the value of the warehouse was not written off in the statutory accounts. This error was not picked up by the auditors at the year end and was carried forward and included within subsequent sets of audited accounts.
So, how should the warehouse be treated in the completion accounts?
Under the ‘simplified’ hierarchy we are faced with a dilemma. What was GAAP as applied in the reference accounts? The accounting treatment applied was to include the warehouse as an asset in the reference accounts. This suggests that the warehouse should be included in the completion accounts. However, under no circumstances could keeping the value of a significant yet non-existent asset in the balance sheet be considered to be GAAP compliant.
The ‘simplified’ hierarchy is a contradiction in terms. There are two possible accounting treatments which could be applied by the expert. They could determine that the warehouse should be included as an asset in the balance sheet (and thereby be consistent with the prior treatment) or that it should not (and thereby apply GAAP). Neither treatment complies fully with the requirements of the accounting hierarchy.
At this point the expert has three choices. They can make their own decision as to the interpretation of the agreement (and run the risk of making a manifest error), ask the parties for their submissions on this point or request independent legal advice. Whichever route is chosen, it will most likely be more time consuming (and costly) for the parties.
I have been involved in expert determinations where the expert’s jurisdiction to interpret the ‘simplified’ accounting hierarchy has been taken to arbitration by the parties. In cases where it has been decided that the expert can determine their own jurisdiction, counsel has been instructed to advise on the meaning of the ‘simplified’ hierarchy.
Under the typical three-point hierarchy set out above, the accounting treatment for the warehouse is more straightforward. Assuming there are no relevant specific policies, the seller’s formulation shown above results in the warehouse being included in the balance sheet (it is required to be ‘consistently wrong’). Under the alternative purchaser’s formulation, where items 2 and 3 in the above hierarchy are reversed, the warehouse will not be shown in the balance sheet because it would not be GAAP-compliant to do so.
The different results achieved under the seller’s and purchaser’s formulations illustrate why parties often agree to the ‘simplified’ hierarchy. As written it appears to be a compromise between the two approaches, but its operation in practice is anything but a compromise. As an expert accountant operating under the terms of the SPA, one cannot simply split the difference or make a determination on an equitable basis. The expert’s decision will be all or nothing – the ‘simplified hierarchy’ will be determined to require either GAAP or consistency to take precedence.
One question I am often asked about this scenario is whether it means that the audited accounts were not in accordance with GAAP. Should the purchaser be bringing a warranty claim under the relevant accounts warranty? And here’s the rub. The audited accounts included the non-existent warehouse yet were in accordance with GAAP. The reason? The value of the warehouse was not material to the accounts as a whole. GAAP are only required to be applied to material items. Of course, the value of the warehouse may be material to the completion accounts if a pound-for-pound purchase price adjustment is based on the value of the net assets of the business. But this does not necessarily mean that there has been a breach of warranty.
In any event, even if there has been a breach of warranty it is likely to be difficult to show that the purchaser has suffered a loss. Loss in a warranty claim is calculated as the difference between the value of the business had the warranty been true, and the value of the business in light of the breach of warranty. Where the price for a business has been calculated on the basis of the net asset value shown in the balance sheet, there is likely to be a loss, but net asset value is rarely the method used by purchasers to value businesses operating as a going concern. Where the business has been valued based on expected future profits or cashflows, the purchaser is likely to struggle to demonstrate that it has suffered a loss unless it can demonstrate in its valuation model that specific cashflows were expected to be generated from its use of the warehouse.
So what’s the solution? The less you leave to other people to decide or determine, the more certain your own position will be.
Getting it right in the SPA has to be a priority, but all agreements are of course the product of negotiations between the parties. I have advised clients on the wording in the SPA where the commercial decision has been taken to sign an agreement containing a ‘simplified’ hierarchy. It hasn’t always resulted in a protracted completion accounts process but there have of course been occasions where it has been very painful.
It may be possible to agree on the parties’ interpretation of the hierarchy before the completion accounts process kicks off, assuming you can persuade your counterparty to agree to your preferred interpretation. But just because you are, say, a seller, do not assume that the seller’s formulation will be best for you – your preferred interpretation will be dependent upon the circumstances specific to the deal.
Kate Hart is director of forensic services at Roffe Swayne
*Barclays Bank PLC v Nylon Capital LLP  EWCA Civ 82, Wilky Property Holdings PLC v London & Surrey Investments Ltd  EWHC 2888 (Ch) and Persimmon Homes Limited v Woodford Land Limited  EWHC 3109 (Ch).
**Note that items 2 and 3 can be reversed. The format shown is typically considered to be the seller’s formulation; the reverse is the purchaser’s formulation.
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