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Ducking the cross fire: avoiding disputes in buy-sell agreements.


Among the many sources of disputes that embroil accountants, few seem as intractable as engagements to report on financial statements used to determine the price of a business transaction. Consider two examples.

1. The deal for Spin-Off, Inc. to sell a division to Buyer Corp. entitles Spin-Off to a final payment based on the division's audited net capital, reported on by Buyer's accountant, as of the closing date. How angry will Spin-Off be, after the deal is closed, when it learns that Buyer made a massive charge for inventory obsolescence because of redirected business plans for the division? And when Spin-Off sues Buyer over the impact of the charge on the final payment, can Buyer's accountants stay out of the firing line?

2. Mr. Patriarch finally retires and sells his family business to its young managers, who agree to a several-year stream of payments to the venerable founder based on the level of annual sales. But Patriarch had traditionally recorded all his revenues at the contract dates, while the managers - conservatively planning for the future - record revenue over the contract lives. Although the new accountants for the managers support their conservative policy, the CPAs become the targets for Patriarch's litigation.

The circumstances in either situation could easily have been reversed so the other party felt wronged, but the consequence would have been the same - disruptive litigation. Consider if Spin-Off had dressed up the division's balance sheet by retaining reserve provisions at the consolidated level, thereby bestowing on Buyer a nasty future surprise. Or the managers taking over from Patriarch could discover belatedly that the loss of his influence with life-long customers hurt the collection of receivables, leaving them with both the obligations to the old man and a large hole in their cash flow.

These types of transactions can take many forms. For this article, the generic term buy-sell agreements is used. It defines the sale of all or part of a company when the purchase price is subject to an adjustment based on the results of an audit as of the closing date and/or involves an escrow or a final payment tied to net worth as shown on the audited closing-date balance sheet.

Other possible variations include

* A provision requiring extra consideration if the audited net worth exceeds a stated amount, or a payback for a shortfall.

* An agreement that audited net worth (or working capital) below a defined level presents the buyer with the option to withdraw.

* An agreement between shareholders of a closely held corporation about the earn-out compensation of a senior executive, whose pay, bonus or retirement is tied to future earnings.

A buy-sell agreement might involve a complete set of financial statements, an incomplete financial statement or even a presentation of one or more single financial statement elements. Although a buy-sell agreement might require only that the accountant's report express negative assurance, more typically an accountant will be asked to provide a standard report based on an examination in accordance with generally accepted auditing standards. (If the agreement calls for specialized accounting other than generally accepted accounting principles, the provisions of Statement on Auditing Standards no. 62, Special Reports, would apply.)

Such transactions vary with the creativity of the participants, but they have one thing in common: When a disappointed party believes too much was paid or too little received, that party often will turn to litigation and cast the legal net over the reporting accountants. An accountant in these circumstances needs to be aware of techniques for managing the engagement's risks and offer ideas on how the principals can avoid or minimize their disputes. The collateral benefit is to spare the CPA involvement in an expensive, protracted and often avoidable lawsuit.

When there is dispute potential in a buy-sell agreement because audit outcomes can favor one party or put the other at a disadvantage, the accountants are under pressure. The immediate conflict is that the context differs from that of the ordinary audit under generally accepted auditing standards. A frequent source of frustration are the lawyers who draft the buy-sell agreement but do not fully address the parties' needs, opting out of responsibility by inserting a provision for an ostensibly binding GAAS audit. Should a careful CPA either accept or conduct an engagement within these contractual constraints: "An additional payment will be made by the purchaser within 30 days of the delivery of a closing date balance sheet, accompanied by the unqualified report of ABC Accounting Firm, which payment shall be equal to three times the amount by which net worth on the closing date balance sheet exceeds $1 million. The accountant's report shall state that the closing date balance sheet is expressed in accordance with generally accepted accounting principles and the accountant's report shall be final."

Despite references to a "binding" or "final" audit, a provision like this often only begins a dispute. Lawyers and their clients typically fail to appreciate the potential sources of difference of opinion between the buyer and the seller. An "expectations gap" that leads to litigation is created when the final financial statements differ significantly from the expectation of one party or the other. The fallacy of the initial assumption of finality is revealed. Parties to the sale who believe an audit will settle matters misapprehend the accountant's basic role: The issuer - whether buyer or seller - always has the underlying responsibility for the financial statements and the accounting principles used, with all the associated opportunities to affect the results. The role of the accountant is and must remain secondary.

Opportunities for dispute also may arise from innocently held differences between buyers and sellers, manipulations or hidden agendas. Given the issuer's wide range of flexibility in setting forth financial statements, the likelihood of dispute is high and, legitimately or not, the other party may feel manipulated.


Early CPA involvement in the negotiations of the buy-sell agreement is a major risk-mitigating technique, whether or not that CPA eventually will be the one to issue the contemplated report. At the least, the consulting accountant can bring to light potential areas of disagreement that may be resolved early in the negotiations. (For some warning signs to be alert to, see the sidebar on page 68.) A CPA can be involved in a number of ways.

* Identifying from the financial statements a preferred basis of presentation, such as the use of current rather than historical values for certain assets or liabilities or the choice of Fifo rather than Lifo inventory presentation. The parties' agreed preference can then be spelled out in the buy-sell agreement itself.

* Making both parties aware that one of the parties to the agreement may be motivated by considerations other than those revealed by a typical set of financial statements prepared according to GAAP, such as preserving family wealth or acquiring uniquely valued assets (real estate, patents or personnel, for example).

* Identifying a change in accounting required by new accounting standards published after the last available financial statements were issued.

Primarily, the accountant's early involvement should assist in identifying specific areas of potential dispute or, at least, areas that seem to be significant to one side or the other. For example, extra attention may need to be paid to the importance of accounting estimates or to the consistent application of GAAP. Such areas with the possibility of differing expectations can include the following:

* Possible misstatements for items inventoried that previously had been expensed.

* Items capitalized that previously had been charged to repairs and maintenance.

* Changes in burden rates.

* Application of revenue recognition policies.

* Purchase and sales cutoffs as of the balance sheet date.

* Unrecorded liabilities, particularly of an entity that previously had not prepared GAAP financial statements.

* Expenses not accrued at period end.

* Any bias toward overstatement or understatement of accounting estimates.

To expand one example, it is common for the buyer and seller to differ on litigation reserves - a problematic issue under the best of circumstances. The seller may have followed a "trench warfare" approach to a backlog of litigation, with the reasonable expectation that the passage of time and a tough attitude would minimize costs. A buyer seeking a fresh start and not wishing to have new management distracted by old matters might be willing to be more openhanded. These differences are ripe for discussion in negotiating the buy-sell agreement. The CPA's concern should focus on which party bears both the financial and the litigation resolution responsibility.



An issue frequently encountered in the buy-sell environment is the tension between GAAP and consistency. This matter arises because the direct financial impact on the parties causes heightened attention to issues that would not be material in a routine reporting context. What should be done, for example, regarding nonmaterial amounts on the seller's prior financial statements, which were clearly erroneous under GAAP or even reflected no discernible policy? Should the issuer perpetrate the error in the name of consistency or implement its choice of GAAP, along the way electing whatever accounting principles may be acceptable?

A real situation illustrates the dilemma: A seller with responsibility for issuing a closing date balance sheet had for many years carried goodwill arising out of a largely moribund prior transaction. The previous accountants tolerated this as not material, though GAAP clearly indicated a writeoff. As of the closing date, the seller remained consistent and declined to book the adjustment, to the dismay of the buyer whose purchase price was arguably inflated by a worthless goodwill item that, the buyer argued, GAAP should have eliminated. (The example can be shifted slightly to reverse the impact. Suppose the agreement gives the buyer responsibility for issuing the closing date balance sheet and the proceeds of the sale are to be reduced for a writeoff taken by the buyer.)

When the parties attempt to draft their own accounting rules for a particular subject, they often will fail to consider or anticipate the full range of possible outcomes. For example, an avoidable dispute arose in a management buyout when the parent selling a division and the acquiring managers both sought to eliminate from their transaction the results of inventory writedowns by explicitly placing on the buyers the effect of "writedowns actually taken" in the period just prior to the closing. The lawyers drafting the buy-sell agreement failed to understand that the writedowns submitted by division-level management were recorded only on approval at the parent level. In this situation, proposed adjustments were held up and not recorded at the level of the selling parent, which argued, perhaps unfairly, and the buyers certainly thought it unfair, that no credit should be given for writedowns that should have been made but in fact were not.

Another example is when the parties specify that a closing is contingent on the receipt of an unqualified auditor's report and require delivery of the report in a very short time. Reality intrudes when unresolved issues surface or unexpected delays occur. The parties may not have anticipated the length or extent of involvement by the accountants to complete a full GAAS engagement. Even when the CPAs are not directly a party, setbacks should be anticipated. The accountants should be wary of a contractual obligation to deliver a report either unsupported by sufficient underlying work or on an impractical timetable.

The early stage of negotiations is the right time to discuss whether a closing is contingent on an unqualified auditor's report and what form of report would or would not be acceptable to the principals.

It may not feel comfortable to raise this question directly with the parties, but the CPA should be mindful that, in a buy-sell situation, one side or the other might use the possibility of a dispute over the contemplated financial statements as a bargaining lever. It is not unheard of for one party to argue that release of funds held in escrow is not appropriate because the contemplated financial statements or auditor's report is not what was thought to be required under the buy-sell agreement. The accountant may not be in a position to identify such potential overreaching early in the process, but it would be naive not to recognize the possibility that such manipulation of financial or other business reporting does occur.



Posttransaction disagreements may emerge, despite the CPA's best efforts to anticipate areas of dispute. Identifying and addressing these disagreements before submitting the audit report is the way to avoid more serious disputes in the future.

A helpful and increasingly common technique for dispute resolution is for the issuer to submit preliminary drafts of the financial statements and the auditor's report for review by the other party and its advisers, at times including a review of the audit working papers. Differences emerging from such a review can then be the subject of direct negotiation between the parties, assisted by their respective advisers.

If the parties cannot resolve their differences, it is common to involve an arbitrator or other neutral third party. The efficiency of arbitration remains a matter of debate, especially given the legitimate scope of the issuer's choices under GAAP and the delay and expense of involving another participant. Some buy-sell agreements require the accounting firm doing the closing date audit to perform explicitly as the arbitrator or final decision maker and both parties to agree that its decisions are final. In such a situation, the accountant should obtain a hold-harmless provision from all parties. The recent decision in Coopers & Lybrand v. The Superior Court of Los Angeles County (12 Cal. App. 3d 524, 1989 Cal. App. LEXIS 756) holds that an agreement for an audit, binding as between the parties, may confer "arbitral immunity" on the auditor under that state's arbitration statute.



An accountant who becomes aware of a potential disputed financial statement item can direct inquiry to and seek representations from both sides as a way of promoting resolution of the dispute before the report is issued. In this event, the CPA should focus the attention of both sides on the possibility that, by failing to achieve resolution, they are requiring an audit report modification. The issues to be made clear are that there is a lack of sufficient corroborating evidence to support the issuer's representations or that the dispute makes uncertain the asset's ultimate realization.

It is possible that the side of the transaction not responsible for issuing the financial statements might resist responding to such inquiries. It can argue that it is not in a position to respond or should not take a position on statements for which it is not directly responsible. The CPA's response is that the inquiry, and the resulting dialogue and negotiation, provides the most expeditious and least costly avenue for resolution. Moreover, he should remember, and the parties should understand, that the CPA is the sole determinant of the scope of appropriate inquiries, in the exercise of professional judgment.

Nothing in the literature on evidential matter (AU section 326 of American Institute of CPAs Codification of Statements on Auditing Standards) suggests a CPA should be reluctant to solicit the views of both parties to a potentially disputed item. In fact, he is encouraged to inquire outside the entity under audit by the provision that "the amount and kinds of evidential matter required to support an informed opinion are matters for the auditor to determine in the exercise of his professional judgment" (AU section 326.20).

Both principals to the buy-sell agreement are thus legitimate sources of representations or any other audit evidence that is connected with an audit for this transaction.

When the buyer engages the CPA, the seller can argue that its responsibility for the financial statements has been superseded. But the seller has the historical background and perspective to know where the skeletons are buried. Conversely, the buyer also can assert that a new legal entity has been formed or that new management is not responsible for events and transactions occurring before the closing date. However, a buyer (or other successor) will have conducted a due diligence investigation in connection with the underlying transaction and may have acquired interim experience through managing the enterprise between the time of a preliminary agreement and the closing date. It could, therefore, possess information sufficient to have its own views on important subjects about which the CPA might inquire.

Also, the buyer has responsibility for financial statements and the conduct of the business for any subsequent postclosing period (including the period covered by the CPA's subsequent review). The buyer also might be expected, in the course of discharging its responsibilities, to have become aware of (or to be responsible for) matters affecting the financial statements as of the closing date.



There should be no reason for the accountant to allow one party or the other to retain an undisclosed "ace in the hole" that specific inquiry by the CPA might force onto the negotiating table. Informal inquiry to a party regarding the results of its investigation (including the results of work done by accountants, appraisers, lawyers and investment bankers) might be done orally with responses documented by memorandum. Depending on the level of formality involved, however, and because this is the party's last chance to raise an issue, written confirmation may be desirable. The representation might be as follows:

"In connection with your audit of XYZ Company's financial statements as of December 31, 19X1, based upon the responses of XYZ Company's management to our inquiries and the results of other procedures performed by us and our advisers (add, if appropriate, `except as described below,'), we are not aware of any matters that cause us to believe that the financial statements of XYZ Company as of December 31, 19X1, are misstated in any material respect."

When the buy-sell agreement and the engagement letter are prepared, it is a good idea to identify exactly what written representations the CPA will request from both parties. A typical provision in an engagement letter might say:

"As part of our audit, we will (a) make specific inquiries of ABC Company as to the results of its investigation of XYZ Company and (b) request written representations from ABC Company regarding its awareness of any matters that would cause it to believe that the balance sheet might be materially misstated."

By raising this matter early and clearly, the CPA can avoid either party's adverse reaction to being asked for a representation later in the process. Having asked for formal written representations from both sides, the accountant sets in motion a chain of events governed by professional standards. The failure of one party to respond ordinarily would preclude issuing an unqualified report.

In the buy-sell environment, identification of potential disputes and their early resolution is one of the CPA's central goals. The parties to a buy-sell agreement might be unhappy with the release of a report containing a scope qualification because of the refusal of one party to indicate agreement with the closing date financial statements. The prospect of this outcome should uncover any disputes that otherwise would lie dormant until emerging later in the form of a lawsuit.

JAMES R. PETERSON, JD, is a member of the legal department of Arthur Andersen & Co., Chicago. He is a member of the American Bar Association and the American Corporate Counsel Association.

The author gratefully acknowledges the assistance of Jerry Serlin, a principal in the auditing and procedures group of Arthur Andersen & Co. (C) Arthur Andersen & Co.
COPYRIGHT 1991 American Institute of CPA's
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Article Details
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Author:Peterson, James
Publication:Journal of Accountancy
Date:Jan 1, 1991
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