M&A Vocabulary – Experts explain: GAAP

Despite convergence projects between IFRS and U.S. GAAP, and German GAAP (“HGB”) reforms (most recent reforms in 2015: German Accounting Directive Implementation Act (“BilRUG”) and 2009: German Accounting Law Modernization Act (“BilMoG”)), certain differences remain which include lease accounting, the treatment of goodwill and the different impairment approaches, LIFO accounting, R&D expense treatment.

The standard scope for cross-border deals may not include a detailed analysis of the differences between local GAAP and the Buyer’s applied GAAP, which is mostly performed upon request. Since the opening balance sheet of the newly acquired subsidiary within the Buyer’s group accounting is converted to the Buyer’s GAAP, post-Transaction surprises for pre-Transaction GAAP differences are eliminated. Nevertheless, ongoing differences need to be identified and addressed as part of the group reporting exercise.

Target companies sometimes maintain their books in ways that deviate from local GAAP, for example, by following cash or modified tax basis accounting. In the U.S., privately held companies are not obligated to prepare or present financials according to U.S. GAAP. Instead, the accounting function serves as the basis for accurate tax return declarations in accordance with the rules and regulations set by the various taxation authorities in the U.S. The IRS allows cash accounting for companies if group revenue is less than $25 million in revenue.

In that case, the goal of the financial due diligence should be to identify major differences between applied accounting policies and local GAAP as part of the Quality of Earnings. However, a full conversion to GAAP-compliant is not a regular exercise of a financial due diligence.

One of the major goals for GAAP is to present comparable period-over-period results, i.e. the cut-off for the revenue and cost recognition is of paramount importance, which may not occur in the case of non-GAAP compliant financials. We often see that several years of EBITDA results (as an average) are the foundation for the (multiple-based) business valuation, which became more popular in post-COVID transactions due to the various business impacts that have been difficult to fully quantify and isolate as part of the Quality of Earnings since 2020. Examples of these impacts include production shut-downs, labor shortages, logistical challenges, post-COVID revenue catch-up effects and commodity price inflation.

Most transactions in the U.S. are structured to include closing accounts, i.e. that the final purchase price is adjusted for working capital and net debt positions in the target company’s closing balance sheet. This varies from the locked-box mechanism which is popular in Europe. As such, it is crucial for Seller and Buyer to agree on the accounting principles that will govern the preparation of the closing balance sheet.

There is a recent trend to follow the target company’s past accounting practice (which may be different than accrual-based GAAP) rather than strict GAAP adherence for purchase price adjustment purposes. If the past accounting practice-method is referenced in the purchase agreement, surprises may be limited as the closing balance sheet follows the same non-GAAP adherence which was also the basis for calculating the working capital peg (typically the average of the last 12 months of working capital). Sellers may assert that this approach is fair to both sides. However, past accounting practice needs to be clearly identifiable, e.g., the non-recognition of certain liabilities, which should be recorded according to GAAP, could give rise to disagreements as to why these liabilities were in fact never recognized in the past. As such, detailed due diligence based on both annual and monthly financials is important to mitigate disagreements related to ambiguous past accounting practice definitions.

While GAAP serves as a cornerstone for financial reporting, nuances between local GAAPs and deviations from standards may present challenges in transactions. Effective navigation of these challenges requires comprehensive due diligence, appropriate determination of accounting principles in the Purchase Agreement and strategic planning for post-acquisition integration. By addressing these complexities proactively, Buyer and Seller can enhance transparency, mitigate risks and, ultimately, achieve a smoother closing of the deal.