Newburg | CPA Tax Brief (02/11/2022)
Newburg | CPA Staff Writer – David R. Natan, CPA, MST, CVA — February 4, 2022
During an acquisition, buyers need to be extra careful when reviewing interim internal accrual based financial statements for completeness and accuracy. Quite often the application of the more popular EBITDA (Earnings Before Interest, Taxes Depreciation and Amortization) multiples whether applied to an interim projected period or latest trailing twelve-month period may be distorted when dealing with interim financial periods. For privately held companies, interim period closings are often not as accurate and complete as those that align with the company’s natural calendar or fiscal year-end and can distort or overstate the purchase price if all liabilities are not captured. Applying a thorough ‘Search for Unrecorded Liabilities’ test, can often be an integral piece to successful due diligence. The understatement of liabilities can result in inflated EBITDA and purchase price figure for the buyer.
So how do we perform a proper ‘Search for Unrecorded Liabilities’ when reviewing interim financial statements?
- Obtain a detailed accounts payable aging and accrued expense detail that ties to the interim balance sheet period.
- Review banking activity and cash disbursement details for 30 to 60 days after the interim close period.
- Ensure you are making an adequate number of selections to get a sufficient amount of coverage over the testing.
- Target the larger payments and more common vendor names with the goal of obtaining 80% or more coverage of the payments selected.
- Request and review the selected payments with the supporting documents (e.g., suppliers or service provider invoices, credit card receipts, etc.) to determine whether the liabilities were incurred before or after the interim balance sheet date.
- If the service or supply period relates to a period prior to the balance sheet date, trace this back to the accounts payable aging detail or accrued expense detail.
- Inquire with the related personnel about any unrecorded invoices.
- Document and total any disbursements that related to the balance sheet period and were not recorded within accounts payable.
When you are dealing with an interim period cutoff, we would also recommend going back to the prior calendar or fiscal year period that matches the tax return and perform similar steps with transactions to provide additional comfort and ensure no understatement of liabilities.
The Search for Unrecorded Liabilities will often be a natural biproduct if you have a well-planned out Net Working Capital Peg as part of the transaction. During the Letter of Intent and due diligence periods, the Buyer should ensure that they have a protective Net Working Capital Peg that very specifically addresses the expectations of where they expect current assets over current liabilities to fall. Layering on the Search for Unrecorded Liability procedures to the Accounts Payable when reconciling the Net Working Capital Peg is an important step to ensure adequacy. Acquiring a business that may not have adequate working capital and potential hidden liabilities will only put strain on your newly acquired venture.
The Newburg | CPA due diligence team can help you navigate these complexities and avoid surprises relative to your acquisition. Visit www.newburg.com for more information.
Newburg | CPA Staff Writers
David R. Natan, CPA, MST, CVA — February 14, 2022
Avoiding surprises when acquiring a company should be tantamount in the eyes of the buyer. One of the keys to a successful acquisition is the integration of the Net Working Capital Peg not only to avoid surprises but also properly plan the transition. Net Working Capital is defined as the excess of current assets over current liabilities. Ultimately it is used to measure the short-term liquidity of a business. Net Working Capital is calculated as follows:
Cash and Cash Equivalents + Accounts Receivable + Inventory + Other Current Assets
LESS: Accounts Payable + Accrued Expenses + Deferred Revenue + Other Current Liabilities
As the buyer works through the decision to acquire a company, one of the more important provisions to put in the LOI (Letter of Intent) would the requirement for adequate working capital post acquisition as agreed upon by both the buyer and seller. When the transaction gets to the APA (Asset Purchase Agreement) or SPA (Stock Purchase Agreement) stage we typically strongly recommend the use of a formal referenced exhibit that details all current assets and liabilities showing explicitly each item of adjustment or addback to arrive at the final Net Working Capital Peg. Ultimately this Net Working Capital Peg would result in a potential increase or decrease to the purchase price of the deal. At closing, if the final calculations come in lower than the Peg, this would mean a reduction in the overall purchase price. A final calculation that comes in higher would mean an increase to the purchase price. Coming to a middle ground that is enough to support ongoing operations seamlessly is the objective.
While often transactions may be approached using a cash-free and debt-free basis it is important to note that depending on the timing of the closing date or overall approach to development of the purchase price, cash or debt can be included within the equation. As a buyer, it is important that you develop a comfort level with the Peg and perform historical analysis whether they be the last six- or twelve-month trailing averages or an even more recent or shorter picture depending on the industry or seasonality. Ideally, to avoid headaches and unforeseen cash flow issues, the buyer would like the final closing net working capital to come in closer to the Peg determined. It should also be noted that the purchase agreement should allow for the buyer’s internal accounting team or external accounting firm to review and reconcile the final net working capital figure derived at closing within 60 or 90 days after close.
As the buyer, developing a comfort level with your trend analysis and making sure that you fold in this working capital component to inherent trends of the business and your 12-month forecast will go a long way to the success of your acquisition. Working collaboratively with the seller to ensure you have a very detailed definition of what makes up this Net Working Capital Peg will be a healthy exercise. We have detailed examples of some of the types of the explicit adjustments or disclosures to apply to the detailed Net Working Capital Peg exhibit:
- Level of cash to be left at close (if any)
- Explicit removal of any current debt obligations that are not applicable
- How the use of the company’s existing line of credit will be handled or excluded if the same banking relationship is maintained
- Adjustments for aged accounts receivable that may be 60 or 90 days old
- Office/building security deposits assuming the landlord will want full reissuance and is not assigning over the lease
- Tax adjustments that are exclusive to the seller such as sales tax payable or accrued state level composite taxes owed (under an Asset Purchase Agreement)
- Potential ‘undeposited funds’ that may be separately stated due to accounting software timing issues
- Interim period cutoff issues and hidden accruals. Depending on the date of your close, if before month-end there may be more exposure to errors. Items such as accrued payroll adjustments depending on the last pay-period could be significant to the transaction.
- Adjusting or earmarking aged or obsolete inventory
- Work-in-process adjustments to ensure proper allocations between buyer and seller. Quite often a percentage completion approach to the more significant jobs that overlap the close period might help clarify or avoid surprises down the road (over/under billed calculations).
- Deferred revenue adjustments or considerations. This is often a highly contested item. As the buyer you want to ensure you are not left with the remaining work and liability to perform while the seller gets the cash. Careful attention and explicit examples should be considered when dealing with customer advances or advanced collections.
- Ensure you have planned out the payroll transition properly not only with your weekly or bi-weekly pay date cut-off issues but also potential PTO accruals, accrued bonuses for employees, etc.
Determining the Net Working Capital Peg may be one of the more conceptually difficult areas to grasp within the buyer due diligence process. Spending the time upfront to understand the calculation will educate the buyer as to the innerworkings of the business while also avoiding any short-term liquidity concerns.
The Newburg | CPA’s due diligence team can help you navigate these complexities and avoid surprises relative to your acquisition. We deliver a tailored approach to all our acquisition due diligence clients. Visit www.newburg.com for more information.
Newburg CPA, a Boston-based accounting firm can assist you. Contact us if you have questions.