The tenth deal commandment

Avoiding accounting and auditing delays, hence higher costs, for newly acquired portfolio companies can be acheived in four steps.

Thomas Bonney is founder and managing director of CMF Associates, a financial and managment advisory firm to private equity, middle market and international companies. He can be reached at tbonney@cmfassociates.com.

Most of us can recite the moral code laid out in the Ten Commandments in the Bible. Similarly, private equity chief financial officers are well-versed in the specialized set of deal commandments which, if consistently followed, ensure a strong start for a newly acquired portfolio company.

In particular, middle market CFOs understand the critical nature of what we call the ?tenth deal commandment:? thou shalt avoid technical accounting and auditing ?purgatory.? This type of limbo can delay closure of the deal or post-transaction financial reporting matters ? and ultimately distract management from focusing on delivering the growth potential of the investment.

In light of today's increased investment prices and leverage, undue time in accounting and auditing purgatory can become costly. And, the damaging effects can linger well beyond the close of the deal. According to a recent report in The McKinsey Quarterly titled ?Where Mergers Go Wrong,? ?? unless synergies are realized within? the first full budget year after consolidation, they might be overtaken by subsequent events and wholly fail to materialize.?

With the significant consequences of breaking the tenth deal commandment in mind, private equity CFOs can consistently stay out of purgatory by maintaining awareness of potential technical accounting and auditing issues that cause delays. The key is not necessarily having the precise answer, but understanding where the tax or audit professional might have issues with the underlying design or implementation of a deal.

So let's not solely rely on hope and prayer. Here are four crucial aspects of technical accounting and auditing for CFOs to keep out of purgatory during an acquisition. Ensuring best practices in each of these areas is vital to keeping the deal, and the management team's attention, on the right track.

Controlling the audit process and auditors
Problem: In circumstances where there is a transfer of ownership, auditors are assigning higher levels of inherent risk to engagements, resulting in multiple local office reviews of key documentation, supplemented by National Office reviews.

Furthermore, there are further challenges in completing the acquisition accounting and opening balance sheet audit: higher levels of complexity due to innovative deal structures, ever-changing regulations, auditor independence rules, and concurrent tax and accounting-related counsel needs.

Under-resolved accounting issues and lengthy audits can become expensive, but more importantly, they detract management's attention from running the business.

Solution: Incorporate three processes into your finance operation to minimize the prospect of audit purgatory. First, to ease the audit process, read the draft agreements with an eye on technical accounting treatment, or have a knowledgeable resource review them prior to signing. Line up your accounting and auditing team before the close to ensure you are positioned to resolve issues quickly and focus on delivering on the growth projections. In practice, firms should run the ?audit? bid processes for clients in advance of the formal close of the deal, and ask audit firms to provide interpretation on potentially complex matters.

Secondly, make sure your internal finance team is prepared for the rigors of a financial audit: complete any other ?open projects,? bring in additional senior accounting resources if necessary, leave adequate time to review workpapers prior to submission to auditors, and conduct a thorough review for unrecorded liabilities.

Thirdly, in areas where you must take an aggressive position or interpret conflicting or ?gray? technical guidance, prepare a white paper that specifically sets out your point of view using the following headings: transaction fact set, relevant guidance or literature, and analysis and conclusion.

This format allows your local audit partner to quickly comment on your analysis and therefore avoid uncomfortable independence issues. It also facilitates the National Office's comfort level with the competency of the analysis (and therefore management), particularly given that they may not have any personal contact with you.

Recording basis for the acquired entity in stock transactions
Problem: The basic ?basis? questions are:

  • 1. Do you write up 100 percent of the acquired entity to fair value or just the percentage you acquired?
  • 2. Does the retained interest of the seller include what they hold immediately or equity they can earn through performance based incentives in the future?
  • 3. How does one deal with debt-related instruments that have equity-related attributes?
  • The accounting industry's interpretation of the technical guidance in this area of deal-making used to be fairly straightforward: if less than 19.9 percent interest is retained, write up 100 percent of the deal to fair value. The increasing frequency of less than 100 percent transfer of interest, combined with incentive-based performance arrangements for the seller/operator and the seller's inclusion or exclusion from the acquiring company's control group have added gray areas that create the potential for the under-informed to get caught in purgatory.

    In addition, accounting firms increasingly look at this question on an ?individual facts and circumstances basis,? which is code for ?I've got to involve my national office.? Improper preparation can lead to discussions and negotiations with the sometimes intractable national office about narrow accounting questions that ultimately have limited business or cash flow implications. Because the issues in this section often involve the auditor's national office, escape can be difficult, and could potentially require your team to waste significant time and dollars.

    Solution: Familiarization with key technical literature can help, including EITF 88-16, Basis in Leveraged Buyout Transactions and SFAS No. 141, Business Combinations. However, certain criteria must be followed to be able to write up 100 percent of the purchase, requiring the appropriate expert in this area on your team.

    Be prepared! Ensure that your research is done up front and the auditors are consulted as early as possible. If needed, bring in an expert. By doing this, you can answer the auditor, have a better chance of obtaining your desired treatment, and most importantly, save time and money.

    Allocating the purchase price
    Problem: You've paid $100 million for a business and the accountant's next question is, ?How do we allocate the purchase price?? Allocation purgatory can manifest itself in several ways:

  • 1. Auditors that are not fully comfortable with your tangible/in-tangible valuation firm.
  • 2. Internal staff that is unfamiliar with the nuances of intangible asset valuations, and does not appreciate how management of this process can have real after-tax cash flow implications.
  • 3. Internal staff that is unfamiliar with the rules and process of valuing opening inventory balances in a transaction.
  • Solution: Have someone on your internal team who is familiar with the nuances of intangible and tangible asset valuation. Ensure that you and your auditors consult early and often with third party providers that are computing the tangible and intangible valuations. This becomes even more important if the transaction has been structured as a purchase of assets or a stock deal where a 338-h10 tax election has been made. In these cases there are real dollars at stake.

    Intangible assets that are created as part of the transaction are amortized over 15 years for tax purposes. However, certain fixed assets can be amortized in as few as five years. The more value ascribed to these shorter-lived assets, the more cash there will be to fuel growth through current tax bill savings. The company's active involvement in a managed valuation process will help keep you out of allocation purgatory, and should also bring the added value of enhanced, after-tax cash flow that can be used to pay down debt.

    Disagreements over purchase price adjustments
    Problem: Most deals incorporate some type of mechanism for adjusting the purchase price through a GAAP-based working capital adjustment, ultimately computed as of the close date. The buyer is looking for areas to push down working capital (and therefore retain escrow dollars), while the seller is looking to maintain working capital. This often leads the internal finance/accounting staff to get caught in the middle ? put in a situation where they must provide bad news to either the previous owner (frequently still the CEO) or the new private equity ownership.

    Significant working capital adjustments create questions of integrity, intent, and competency that can push these relationships into difficult territory. Furthermore, trust between the buyer and the CEO seller can be seriously damaged, putting the successful implementation of growth plans in this now highly leveraged company at risk.

    Solution: While your auditors may provide some mediation help (and ultimately will help with the technical side of these adjustments), by the time they get involved, it may be too late to resolve the potentially longer-term issue of broken trust and bad feelings. These three steps should keep everyone fully informed and all eyes wide open:

  • 1. In advance, look at typical areas or situations where adjustments might be probable:
    a. Reserves for AR and inventory
    b. Accruals for vacation, bonus, warranty
    c. Deferred revenues and deferred taxes
    d. Arms-length nature of related party transactions
    e. Small local, long-time auditing firm involved
  • 2. Prepare clear, auditable, and highly professional workpapers citing technical references if necessary for each adjustment.
  • 3. Talk through each proposed adjustment with the seller and the buyer separately so they have complete knowledge of the facts when negotiations begin.
  • Conclusion
    In accordance with following the tenth deal commandment, a heightened awareness of the aforementioned issues can prevent problems, but at times, despite the best intentions, a portfolio company can languish in accounting and auditing purgatory, burning cash and producing limited value.

    Prevention lies in proactive planning and control of accounting and auditing processes. However, as outlined, today's operationally focused CFOs may need to dust off technical accounting skills developed in the early years with the ?Big Eight? to efficiently solve the issues and move on to running the business.