You are in the early phase of a sales process and just received the first draft of a purchase agreement from the buyer, who knows that the financial statements of the business are not audited.  You ask your controller or bookkeeper to read the financial statement representations and warranties and wonder why that person just turned green in the face.

The  bookkeeper or controller just read that portion of that representation and warranty that said, in sum and substance, that the accounting books and records are maintained in accordance with historical accounting practices and that except as set forth in an attached schedule, the financial statements conform to generally accepted accounting principles (“GAAP”).

Your controller or bookkeeper tells you that they can only confirm that accounting books and records, and the resulting financial statements conform to QuickBooks.  Your business does not have a manual that sets forth the accounting practices that should be followed.  Additionally, your bank and everyone else who asked for financial statements were satisfied and never inquired as to whether they deviate from GAAP apart from the perfectly obvious – – the financial statements do not have footnotes.

You tell your lawyer that seller will not make that representation and warranty and if that is so important to the buyer, it can speak with seller’s accountant and figure this out themselves.

Your lawyer told you that there is no way that the buyer will agree to this and while this may seem like a small technical point to you, this can potentially crater the deal.  The reliability of the financial statements are now at issue and either the buyer will just pass or price this risk into the purchase price.

None of the lawyers on the deal can see a solution that is relatively balanced and works for both seller and buyer.  However, there is one.  I first need to set the predicate for illuminating that solution.

Historical Accounting Practices – Explained

Historical practices in the context of financial statements refer to the consistent methods and procedures a business has used over time to prepare its financials. This includes how the company records revenues and expenses, values inventory, accounts for liabilities, and applies other accounting principles. Historical practices generally reflect the accounting policies and routines that have been followed from year to year, which helps ensure comparability across different financial periods.

For example, if a company has historically used a specific method of depreciating its assets, or if it has consistently recorded revenue when goods are shipped (rather than when cash is received), these would be part of its historical practices. Deviating from these established methods without proper disclosure could lead to inconsistencies in financial statements.

For an operating business that sells products or services, several major accounting practices are applicable. These practices ensure that financial transactions are recorded accurately, consistently, and in compliance with GAAP or International Financial Reporting Standards (IFRS). Below are the key areas:

1. Revenue Recognition

• For product sales: Revenue is typically recognized when the product is delivered to the customer, and ownership has transferred (this follows the accrual basis of accounting). In some cases, businesses may recognize revenue when the sale is made, or when payment is received, depending on the terms of the sale.
• For services: Revenue is recognized when the service is performed or as the service is delivered. If the service is ongoing, revenue may be recognized based on the percentage of completion.

2. Cost of Goods Sold (COGS)

• This refers to the direct costs attributable to the production of goods sold by the business, including raw materials, labor costs, and overhead related to production. For a service-based business, the cost may involve labor directly involved in delivering the service. Accurate tracking of COGS is essential for determining gross profit.

3. Inventory Valuation

• For product-based businesses: Inventory accounting involves tracking the costs of goods that remain unsold at the end of an accounting period. Common inventory valuation methods include:

· First-In, First-Out (FIFO): Assumes the oldest inventory is sold first.

· Last-In, First-Out (LIFO): Assumes the most recent inventory is sold first.

· Weighted Average Cost: Averages out the cost of inventory for valuation purposes.

• Inventory valuation affects both the balance sheet (through current assets) and the income statement (through COGS).

4. Depreciation and Amortization

• Depreciation applies to tangible assets (e.g., buildings, machinery, vehicles) and allocates the cost of an asset over its useful life.
• Amortization applies to intangible assets (e.g., patents, goodwill) and similarly spreads the cost over the asset’s useful life. The method used (straight-line, declining balance, etc.) affects financial reporting.

5. Expense Recognition

• Accrual accounting: Expenses are recognized when incurred, not necessarily when payment is made. Common expenses include rent, salaries, utilities, marketing, and office supplies.
• Businesses must match expenses to the corresponding revenue they help generate (matching principle), which is especially important for long-term projects or service contracts.

6. Accounts Receivable and Accounts Payable

• Accounts Receivable (AR): This records revenue earned but not yet collected. AR represents money owed to the business by its customers.
• Accounts Payable (AP): Represents obligations the company has to pay for goods or services received but not yet paid for. Timely tracking of both AR and AP is critical for managing cash flow.

7. Capitalization of Costs

• Certain expenses related to long-term assets (e.g., machinery or improvements) are capitalized and recognized as assets on the balance sheet. These capitalized costs are expensed over time through depreciation or amortization, rather than being deducted as an expense in the year incurred.

8. Leases (ASC 842 or IFRS 16)

• For businesses with long-term lease obligations, lease accounting requires distinguishing between operating and finance leases. Finance leases are capitalized on the balance sheet, while operating leases typically only appear in the footnotes unless their treatment is changed by updated accounting standards.

9. Employee Compensation and Benefits

• Includes salaries, wages, and other benefits (e.g., retirement contributions, health insurance). Employee bonuses and stock options (for more complex businesses) must also be accounted for and accrued if applicable to the accounting period.

10. Taxes and Deferred Taxes

• Businesses must account for income taxes, sales taxes, payroll taxes, and other applicable local taxes. They may also need to record deferred tax assets or liabilities, which arise when tax obligations differ from accounting profits due to timing differences (e.g., depreciation).

11. Bad Debt Reserves

• For companies offering credit to customers, there may be situations where they cannot collect all outstanding receivables. Businesses typically set up a reserve for bad debts, allowing them to estimate and expense uncollectible accounts receivable.

12. Cash Flow Management

• This practice involves tracking the inflows and outflows of cash to ensure liquidity. Cash flow statements categorize cash flow into three types: operating activities, investing activities, and financing activities. Proper cash flow management is critical for ensuring the company can meet its obligations.

13. Foreign Currency Transactions (if applicable)

• If the business operates internationally, transactions in foreign currencies must be converted into the reporting currency. Any gains or losses resulting from currency fluctuations need to be recognized.

14. Provisions and Contingencies

• Businesses need to account for potential liabilities, such as legal claims, warranties, or other future obligations. These are recognized as provisions if they are likely and can be reasonably estimated. If the outcome is uncertain, they are disclosed as contingencies.

15. Operating Expenses (OPEX)

• Includes day-to-day costs necessary to run the business but not directly tied to the production of goods or services, such as marketing, rent, utilities, and administrative salaries. Properly categorizing these expenses is key for determining operating profit.

Core Principles of GAAP – Explained

The following is a simple, practical overview of the core GAAP concepts:

1. Accrual Basis of Accounting

• GAAP requires accrual accounting, which means recognizing revenue when it is earned (not necessarily when cash is received) and recording expenses when they are incurred (not necessarily when they are paid).
• Example: If you provide services in December but don’t get paid until January, GAAP says you still record that revenue in December, the month you earned it.

2. Revenue Recognition

• Under GAAP, you recognize revenue when the performance obligations are met. This means revenue is recorded when a product is delivered or a service is provided, not necessarily when you receive payment.
• Example: If you ship a product to a customer in November, you recognize the revenue in November, even if the customer doesn’t pay until December. If you’re offering a service, the revenue is recognized as the service is delivered or performed.

3. Matching Principle

• GAAP requires that expenses be matched with the revenue they help generate. This means you need to record expenses in the same period as the related revenue.
• Example: If you incur costs in October to deliver a service in November, those costs should be recorded in November, because that’s when the related revenue is recognized.

4. Consistency

• GAAP requires consistent application of accounting methods from period to period. This means you should stick with the same methods of accounting for inventory, depreciation, or other financial areas unless there’s a valid reason to change.
• Example: If you’ve always used the “First-In, First-Out” (FIFO) method for inventory, you should keep using it unless you can justify why switching to another method, like LIFO, would be appropriate.

5. Materiality

• GAAP allows some flexibility for small, insignificant deviations from the standards, as long as they are not material, meaning they wouldn’t affect the decision-making of someone relying on the financial statements.
• Example: Minor bookkeeping errors that don’t affect the overall accuracy of your financials might be acceptable, but failing to properly record a major liability could be a material issue that violates GAAP.

6. Conservatism

• GAAP encourages conservatism, meaning you should err on the side of caution when recording uncertain events or potential losses. If there’s a potential for a loss, you should record it when it’s probable and estimable, but gains are only recorded when they are realized.
• Example: If you’re facing a lawsuit, and it’s likely you’ll lose, GAAP would have you record the potential liability. But if you expect a large payment from a customer, you wouldn’t recognize that as income until you’re certain to receive it.

7. Full Disclosure

• GAAP requires transparent reporting of all material information that might affect users of the financial statements. This means including footnotes or schedules to explain any significant accounting policies, uncertainties, or deviations from the norm.
• Example: If you use a non-standard method for calculating a specific financial metric, that needs to be clearly disclosed in the notes to the financial statements.

8. Objectivity and Reliability

• GAAP requires that financial statements be based on objective, verifiable information. This means that estimates, assumptions, and judgments should be supported by factual data whenever possible.
• Example: When valuing assets like inventory or equipment, you should base the valuation on actual market data or past sales, not on optimistic projections.

9. Going Concern Principle

• GAAP assumes that the business is a going concern, meaning it will continue operating for the foreseeable future. If your business is at risk of shutting down, you need to reflect that in the financials.
• Example: If your business is facing financial difficulties that threaten its survival that needs to be disclosed in the financial statements.

10. Consistency in Reporting Periods

• Under GAAP, financials must cover consistent reporting periods, usually a fiscal year or quarter. The same period is used year after year unless there’s a significant change.
• Example: If you’ve been reporting on a calendar year basis (January to December), you should continue doing so unless you have a good reason to change.

Solution to the Historical Practices / Conformance with GAAP Rep & Warranty Stalemate

The suggested solution is a representation and warranty stating that seller’s financial statements have been prepared from the books and records of the target company that have been maintained in accordance with  the “Accounting Practices and Principles”, as defined in the applicable Disclosure Schedules.  The applicable schedule would contain all of the above historical practices and GAAP principles that seller’s bookkeeper / controller specifically states that he or she knowingly follows – – whether its labeled as a “historical accounting practice” or a “GAAP Principle,” becomes irrelevant.    Is it a perfect solution?  Probably not.  But is it good enough to keep a deal from cratering – – maybe so.

THIS POST IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSTITUTE LEGAL ADVICE.

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