BUSINESS CASE: Angela Kellett, Barrister and Solicitor

CASE 3: Angela Kellett, Barrister and Solicitor

Role: • An accounting advisor engaged by a lawyer to help with concerns about an earnout arrangement (payment for the purchase of a business based on performance after the sale has closed).
Key users: • Ms. Kellett and Mr. Jones are the only relevant users. Ms. Kellett will use the report to assist her in assessing the earnout agreement.
Key facts: • Earnout arrangement being proposed for sale of company.
• Selling price will depend on earnings after the sale closes and buyer (role is working for the seller) will prepare the financial statements.
• Ms. Kellett and Mr. Jones are unsophisticated financial statement users.
• Financial statements have a number of “soft spots” that could lead to Mr. Jones being disadvantaged by the earnout arrangement.
Constraints: • The purchaser has suggested the earnout state that the financial statements be prepared using GAAP consistently applied. A clean audit opinion would also be required. Tighter constraints are required because GAAP still provides significant leeway to the new owners that will allow them to disadvantage Mr. Jones.
Objectives: • Identify soft spots in the financial statements and propose ways to protect Mr. Jones from not receiving fair compensation for his business
Issues: • Possible non-arm’s length transactions.
• Inuvik will be a major supplier to other companies that the buyer owns.
• This is a reasonable strategy for the buyer but it creates risks for Mr. Jones because transactions between Inuvik and the other companies are not at arm’s length and the selling price used in the transactions may not be at market value.
• The new owner could require sales to occur at below market value, which would lower Inuvik’s net income and lower the payment to Mr. Jones. Doing this would be beneficial to the new owner.
• Contract should specify that sales to related parties should be at fair value and that independent verification be allowed if requested by Mr. Jones.
• Inventory valuation and write offs/downs.
• The contract protects Mr. Jones from changes in the accounting policies used for inventory because GAAP must be consistently applied.
• However, by its nature specific identification allows for manipulation because the managers can choose the actual items sold (if they are identical).
• Also a significant problem is that Inuvik has a supply of old inventory (that is still used).
• The new owner could decide that this old inventory is obsolete and write it down. This would reduce net income and the payment to Mr. Jones.
• The timing and amount of write downs is often arbitrary and with old, seldom used inventory a reasonable case could probably be made for a write down (with the auditor’s agreement).
• Mr. Jones and the buyer should determine which inventory is still useable and the earnout agreement should specify that that inventory should not be written down or off.
• New equipment purchase and accounting treatment of old equipment.
• New equipment could be amortized using a different amortization policy than the old.
• For example, the old equipment might be amortized using straight-line amortization while the new could have an accelerated method. This would not be a change in accounting policy so it would be allowable.
• Accelerated amortization would result in higher expenses in the first years compared with straight line, which would reduce the payment to Mr. Jones.
• The new owner could also choose a short amortization period.
• Mr. Jones and the buyer should agree on the amortization method that would be used on new equipment and the useful life and salvage value.
• If new equipment is purchased it result in the old equipment to be written down or written off.
• The information provided by Mr. Jones suggests that the old equipment would only be used on a limited basis if new equipment was purchased, which suggests the need for a write down.
• The amount and timing of write downs are subject to considerable judgement by the preparers of the financial statements.
• Mr. Jones and the buyer should agree to how possible write downs of the existing equipment should be dealt with in the earnout arrangement.
• Revenue recognition, returns, and bad debts.
• Inuvik should not be able to change its method of revenue recognition since the contract states that the financial statements must adhere to GAAP consistently applied.
• Change in revenue recognition policy would only be possible if the terms of transactions changed.
• There could be a problem with sales of components made using the new technology because the cost of the warranty may not be measurable (see the warranty issue).
• Otherwise there may be flexibility in setting the amount of bad debts.
• The earnout arrangement should specify the acceptable amount of provision for bad debts.
• Development costs.
• Development costs must have future benefits to be classified as assets (there are detailed rules for determining whether an expenditure can be capitalized as a development cost but students are not expected to know these rules).
• Judgement is required to determine whether they should be written down or off in a period.
• The new owner could elect to write the development costs down or off during the period on the basis that they are impaired.
• The new owner could also shorten the amortization period of the development costs.
• Both of the above two points would reduce net income and the amount of the payout to Mr. Jones.
• Mr. Jones and the buyer should agree on the status of the development costs at the time the sale closes. At that time the development costs should either be written down or off or the parties agree to no changes in how they are accounted for over the earnout period.
• Warranty costs
• Warranty costs should be expensed at the time the associated revenue is recognized (matching).
• Because the actual warranty costs will be incurred in the future it is necessary to estimate them at the time the sale is made.
• For existing products there appears to be a reasonable track record on warranty costs. Mr. Jones and the buyer should agree on the basis for determining the warranty provision (percentage of revenue that should be expensed).
• Without an agreement the buyer could increase the amount of the provision (probably by a small amount on a percentage basis).
• For the new product the issue is more serious.
• It is uncertain what the warranty costs will be for the new products and so the buyer may have significant flexibility in determining the provision.
• Revenue recognition rules allow for deferral of revenue recognition if it is not possible to make a reasonable estimate of the amount of the warranty provision.
• Mr. Jones and the buyer need to lay out the terms for the warranty on the new product. Some agreeable basis for determining the amount is necessary to avoid surprises described above.
• Goodwill
• Goodwill is not amortized but must be evaluated regularly to determine if it is impaired. If impaired the goodwill should be written down.
• Goodwill is a residual representing the amount of the purchase price of an entity that cannot be attributed to identifiable assets and liabilities. As a result what exactly goodwill is is not known.
• Because of its nature management could decide that a write down of goodwill is required. (The CICA Handbook provides rules for determining whether goodwill is impaired but students are not required to know these rules. However, because of its nature there is considerable judgement and subjectivity in the assessment).
• Management could argue that some or all of the goodwill is impaired with the impact that net income would be reduced and the payment to Mr. Jones decreased.
• Mr. Jones and the buyer should agree on the status of the goodwill at the time the sale closes. At that time the goodwill should either be written down or off or the parties agree to no changes in how it accounted for.
• Manager compensation
• The new manager of Inuvik will be the son of the new owner.
• Compensation will be a related party transaction and may not be at all related to the market value of the work the son does.
• Son could be significantly overpaid to reduce income and reduce the amount that would have to be paid to Mr. Jones.
• Earnout agreement should specify an appropriate wage for the manager, or not include manager compensation in the earnout calculation