Page 33 - M & A Disputes

the year-end financial statements are subject to a longer closing period (for example, a process that em-
ploys more detailed year-end analyses and adjustments, reclassifications, physical inventory counts,
payables being held open longer, and so on). Some transaction parties may believe that the balance
sheet(s) used to determine the target working capital should be audited to establish its (their) conformity
with generally accepted accounting principles (GAAP) or other accounting principles mutually agreed to
by the parties, which could mitigate the possibility of any interim versus year-end accounting differ-
ences. If interim statements are audited, the buyer should consider inserting a clause into the agreement
to review the interim audit working papers as part of the due diligence procedures. Practitioners need to
be aware of whether the interim financial statements were audited, reviewed, compiled, or none of the
above.

If the target or interim balance sheet does not reflect normal year-end adjustments, then the closing bal-
ance sheet should be prepared consistent with the target, so that only true economic changes, not chang-
es due to accounting, are reflected. If the target or interim financial statements were not prepared under
GAAP in a consistent manner with prior year-end accounting practices, there could be an inconsistency
between the target balance sheet and the closing balance sheet. Such an inconsistency could result in an
unintended windfall to one of the parties.

As one means of mitigating M&A disputes, the practitioner should consider in advance the potential dif-
ferences between accounts per the target balance sheet and accounts per the closing balance sheet. The
transaction parties should attempt to address those differences in the acquisition agreement (for example,
accounting for income taxes is only trued up at year-end and, therefore, not adjusted in the target or in-
terim balance sheet).

The practitioner should also consider whether any items on (or omissions from) the target balance sheet
that are based on errors of fact or mathematical errors will be retained for purposes of calculating the
closing date working capital balance.

Preparation of the Closing Balance Sheet

Most postclosing disputes arising out of acquisitions and divestitures that involve accounting and finan-
cial reporting issues result from the buyer’s changes to the seller’s historical accounting practices or an
audit of the closing balance sheet. The buyer typically claims that the seller’s practices were not in ac-
cordance with GAAP. After closing, the buyer has an increased opportunity to change the accounting
practice because the buyer now controls and operates the target company. This allows the buyer access
to information that it may not have had before the closing. In addition, the buyer has access to company
personnel who are familiar with the accounting systems, practices, and procedures. The buyer may use
this information to lower the working capital or net asset value on the closing balance sheet, and this
will have the effect of reducing the purchase price. Often, practitioners can assist the buyer with the
preparation of the closing balance sheet.

Objection Notice

Although the seller may prepare an estimated closing-date balance sheet prior to closing, it is generally
the case that the buyer prepares the final closing-date balance sheet because the buyer, at this point in
time, controls the books and records and supervises the employees of the business. The final closing bal-
ance sheet is then submitted to the seller. Under most acquisition agreements, the seller has a specified
period — often 15–90 days — during which it can object to items in the buyer’s closing balance sheet. If
the seller has objections, it files an objection notice within the time frame set in the agreement. Howev-
er, it is common that the time deadlines set in the agreement are extended. Typical contract language

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