Prior to acquiring a business, a buyer often performs due diligence and analyzes the company’s historical financial results. Following the closing of the deal, the company’s reported performance (e.g., revenue, gross profit, net income, EBITDA, etc.) may not live up to the buyer’s expectations. When this occurs, the buyer typically attempts to identify what changed and how it may respond. In this edition of Raising the Bar, we discuss considerations a buyer may have in evaluating these types of situations and how accounting advisors may assist.

Identifying the Cause of the Drop-Off

Changes in Economic Results vs. Accounting Differences

The first step in analyzing a decline in performance often is to confirm whether the reported deterioration is primarily due to differences in accounting (i.e., changes in how the company measures its financial results) or due to changes in the actual economic performance of the acquired company.

To begin this assessment, accountants may perform analyses of the acquired company’s financial statements and underlying accounting documentation. These could include analytical procedures to identify key trends and/or detailed transactional testing to isolate specific general ledger account variances.

For example, if post-closing reported revenues are significantly below expectations, accountants may compare revenues by customer and/or contract to identify the specific decline. Alternatively, if profit margins are lower than expected, accountants may analyze transactions within individual expense accounts to identify any unusual items causing the higher reported costs. Sometimes the primary drivers can be quickly identified or are readily known by the company’s management. However, it is not uncommon for significant impacts to be obscured by “noise” in financial data, particularly if there is a large quantity of relatively small value transactions. Such instances often require multiple analyses to isolate the critical elements.

Once the key items driving the change in reported performance have been identified, the buyer will typically attempt to determine why those elements changed. To make such a determination, it is first necessary to understand whether the change resulted from different accounting practices or from a change in actual economic circumstances. Using the prior example concerning a drop-off in revenue reported for a customer, a buyer will likely want to understand whether the acquired company actually began generating less revenue from that customer (e.g., the customer began placing fewer purchase orders) or, alternatively, whether the company’s revenue recognition accounting practices changed with respect to that customer (e.g., the company began deferring the recognition of revenue or reversing previously recognized revenue for the customer).

If a difference in accounting is driving the change, it is often important to distinguish whether that difference results from accounting errors in the acquired company’s historical financial statements or, instead, whether the difference results from a post-closing change in accounting practice.

Accounting Differences: Correction of an Error vs. Accounting Change

Accountants distinguish between the correction of an accounting error and a change in accounting practices (e.g., from the application of one accepted accounting principle to a different accepted accounting principle). Specifically, pursuant to generally accepted accounting principles (GAAP), an “accounting change” is a “change in an accounting principle, an accounting estimate, or the reporting entity. The correction of an error in previously issued financial statements is not an accounting change.”[1]

Accounting changes may occur for a variety of reasons following a buyer’s acquisition of a company. In some instances, the buyer may require that the acquired company implement the accounting principles and estimation methodologies utilized by the buyer’s other subsidiaries, even if such accounting treatments differ from the acquired company’s historical practices. For example, an acquired entity may adopt the buyer’s methodology for determining credit losses for its trade receivables.[2] If a target company were to use one method to develop its allowance prior to closing (e.g., using an accounts receivable aging schedule) and it switches to a different method after closing (e.g., using discounted cash flows), the new method can produce different results, despite both approaches potentially being GAAP-compliant.

If the results of a new accounting methodology differ significantly from the results of the prior methodology, a buyer may conclude that the prior methodology was inappropriate despite the seller’s belief that the historical methodology complied with GAAP. While GAAP may permit a variety of methodologies to determine individual accounting amounts, a methodology may violate GAAP if it overlooks or misuses pertinent facts. As such, determining whether the difference from applying a new methodology represents the correction of an error or an accounting change is dependent on the facts and circumstances concerning the accounting balance.

Responding to Identified Accounting or Economic Issues

Once a buyer has identified the cause for the change in reported performance, it may then respond to the issue. The buyer’s response will likely depend on whether the issue relates to (1) a change in actual economic performance, (2) a change in accounting practices, or (3) the correction of an accounting error.

Changes in Economic Circumstances

Sometimes an acquired business’s decline in performance may simply be the result of unfortunate macroeconomic or microeconomic events that occurred after the closing of the transaction. In such instances, the buyer may coordinate with the acquired company’s management to determine the best way to respond to such events, but the buyer may not have a direct way to recover from any third party for the downturn.

Conversely, if the event occurred prior to closing but the event’s effects caused the company’s post-closing performance to deteriorate, then the buyer may consider whether it can recover under a mechanism provided for by the purchase agreement or related transaction documents. For example, assume a purchase agreement contains a representation that no customers had indicated they would decrease their purchases from the company, but—shortly before closing—one of the company’s major customers did inform the company it would no longer make purchases. In such an instance, the company may be able to recover losses resulting from the inaccuracy of the representation.[3]

Determining whether an economic event occurred prior to closing may not always be straightforward. In some situations, a pre-closing event may only become apparent following the closing date. As such, in evaluating whether economic circumstances existed as of the closing date, accountants may need to consider events that occur subsequent to closing. For example, ASC 855 (Subsequent Events) states, “An entity shall recognize in the financial statements the effects of all subsequent events that provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing financial statements.”[4]

Accounting Changes

If the decline in the company’s post-closing reported results is a result of an accounting change (e.g., a change from one generally accepted accounting methodology to another generally accepted methodology), then the buyer will likely want to quantify the impact of such change so that it can analyze comparable period-over-period results.

One area in which this commonly occurs is with respect to the acquired company’s implementation of purchase accounting. ASC 805 (Business Combinations) generally requires entities to measure the identifiable assets acquired and liabilities assumed at their fair values on the acquisition date.[5] Those fair values may be quite different from the pre-closing book values. The change in the carrying value of those assets or liabilities will typically impact reported post-closing earnings as such assets and liabilities are consumed, depreciated/amortized, or extinguished.

Correction of Accounting Errors

Finally, if the company’s reported financial deterioration results from errors in the pre-closing financial statements, the buyer will likely want to identify the impact of those errors on the relevant accounting periods. For example, if the company recorded erroneous entries that inflated revenue or failed to record expense during the pre-closing period, the buyer will likely want to quantify the amount by which such historical financial statements were misstated, as such misstatement may have impacted the buyer’s valuation of the acquired company.

In such instances the buyer might be able to recover losses resulting from its reliance on the inaccurate information and may be able to recover based on a claim for breach of the financial statement representation in the purchase agreement. We’ve previously discussed such potential claims in our July 2019[6] and September 2020[7] editions of Raising the Bar.

In addition to seeking potential recoveries from third parties, a buyer may want to identify and quantify errors in the acquired company’s historical financial statements to prevent such errors from impacting future financial statements. The buyer and company may work with internal or external accountants to put in place controls that would prevent or detect such errors.

Conclusion

Sometimes a deal does not turn out how a buyer had hoped when it entered into a purchase agreement. However, experienced accounting advisors may: (1) help the buyer understand what went wrong, (2) assist in quantifying losses the buyer suffered in its pursuit of recovering such losses, and (3) support the buyer in creating a plan to respond to the ongoing financial impact of the issues and reduce their impact on future periods.

The views and opinions expressed in this article are those of the authors.

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