Predecessor and Successor Financial Statements (#198)
/In this podcast episode, we discuss the best practices for predecessor and successor financials when a company is being bought out and you have to cut off the financials in the middle of the month. Key points made are noted below.
The Cutoff Problem
The owners of the acquiree may have negotiated an earnout provision. This means the performance of the acquiree has to continue to be tracked after the acquisition, and if it does better than a target level, then the owners get a bonus payment from the acquirer. This is a problem when the cutoff is in the middle of the month, because the former owners only get credit toward their bonus for the second half of the month, and that can cause squabbling over which revenue and expense items to include or exclude. The best practice is to include in the acquisition agreement a statement that, for the purposes of the earnout, that particular month is simply the entire month. That means the official reporting month may be split, but there should be a separate pro forma income statement for that month that combines the two.
Ownership of Working Capital
The next issue is in regard to the working capital that the acquisition agreement assumes will be on the books when the acquirer takes over the business, which is in the middle of the month. The agreement may state that it’s expected to be a certain amount, which is based on an average of what the working capital has been over the past few months. If the actual amount on hand is different from the average, then the amount paid to the owners of the acquiree gets adjusted. The problem is that the amount of working capital can rise and fall during the month, and the amount in the middle of the month could be different from the amount that’s usually there at the end of the month. For example, if a company does a lot of its billings at month-end, its working capital is a lot higher then, because of the extra accounts receivable. In this case, it makes sense to look back over the past couple of months and see if the working capital level has been different during mid-month. If it has, include that figure in the acquisition agreement, so that there won’t be any final adjustment to the acquisition price paid to the owners.
Use of Journal Entries
The income statement for each part of the month has to fairly represent what happened during that part of the month. Which means that there will be a lot of journal entries. For example, there’ll need to be separate depreciation entries, one for the first part and one for the second part of the month. And whenever there’s a supplier invoice that’s intended to cover the whole month, you’ll need to use an accrual to apportion the expense between the two parts of the month.
For payroll, this is like doing a month-end payroll accrual, except that it’s in the middle of the month. This means figuring out the hours that have been worked but not paid to employees as of the mid-month financials, and creating an accrual for that amount as of the mid-month financials. And the same goes for all of the expenses that you normally accrue at month-end.
Most accruals are set up as reversing entries, so that the accounting software automatically reverses them at the beginning of the next month. But in this case the automatic reversal doesn’t work, because the second income statement for the remainder of the month is still in the same calendar month. So instead, all of these mid-month accruals have to be manually reversed within the second half of the month.
If there are any billing situations where goods and services are supplied to customers all through the month and then they’re billed at the end of the month, then you have to create an accrual for the revenue earned through the first part of the month, and then immediately reverse it in the second part of the month.
Inventory Counts
If the inventory records are unreliable, then there has to be a mid-month physical inventory count and inventory valuation.
Required Documentation
The documentation level for this mid-month close needs to be similar to what you’d do for a year-end close. That means putting together account reconciliations for the contents of all balance sheet accounts as of the mid-month close, as well as putting together what is essentially the year-end book for the mid-month financials. The reason for this level of documentation is that there’s been a change in control of the company, and the new owner will want really good beginning records.