Working capital adjustments

12.9.1 Description and example

It is very common for a business acquisition agreement to provide for adjustments to the purchase price for a business based on the finalization of the target’s working capital balances as of the acquisition date. For example, assume that the buyer and seller agree to sell the target to the buyer for $10,000,000 on December 31, 20X1. One of the elements that was considered by the parties when negotiating the purchase price was the amount of working capital the target had on December 31, 20X1. While this amount could be estimated on the acquisition date, the parties acknowledged that the final amount of working capital on the acquisition date could be different than this estimate. As such, the parties agreed to allow for an adjustment to the purchase price to reflect any difference between the estimated amount of the target’s working capital on the acquisition date and the actual amount of the target’s working capital on the acquisition date. The parties agree that the amount of any adjustment to the purchase price will be determined by March 31, 20X2. Assume both parties agree, based on the terms of the business acquisition agreement, that the estimated amount of the target’s working capital on the acquisition date (and the amount reflected in the $10,000,000 purchase price) was $2,500,000 and the buyer issued its financial statements on February 28, 20X2, which reflected consideration transferred of $10,000,000 in the accounting for the business combination. Further, assume that on March 31, 20X2 the parties agree, based on the terms of the business acquisition agreement, that the final amount of the target’s working capital on the acquisition date was $3,000,000. As a result, there is a $500,000 working capital adjustment that results in the buyer paying the seller an additional $500,000 of consideration.

The business acquisition agreement typically defines working capital, explains how the working capital adjustment is determined and provides a date by which the working capital adjustment must be finalized. In addition, the business acquisition agreement may provide a mechanism by which disputes related to the working capital adjustment may be resolved (e.g., use of a pre-selected mediator). Disputes about the working capital adjustment may arise due to ambiguities in the business acquisition agreement. The terms in the business acquisition agreement pertaining to working capital adjustments are an integral component of the accounting for the consideration transferred and working capital adjustment within the accounting for the business combination.

12.9.2 accounting guidance

The buyer in a business combination must determine whether a working capital adjustment represents a measurement period adjustment (which would be retroactively reflected in the accounting for the business combination [see Section 12.7.1]). Continuing with the example introduced earlier in Section 12.9.1, the buyer must determine whether the $500,000 working capital adjustment represents a measurement period adjustment. Making this determination in that relatively simple fact pattern is fairly straight-forward because the buyer and the seller agreed on the estimated and actual amounts of working capital as of the acquisition date.

The $500,000 working capital adjustment would be treated as a measurement period adjustment because:

y The working capital adjustment is based on the buyer obtaining additional information about the amount of working capital that existed as of the acquisition date;

y If the buyer had known the actual amount of working capital on the acquisition date (instead of just an estimate of the amount of working capital), the buyer would have reflected that actual amount in the accounting for the business combination; and

y The working capital adjustment was finalized before the close of the measurement period.

It is key in this situation that the buyer: (a) identifies as of the acquisition date the potential for a working capital adjustment to result in a measurement period adjustment and (b) makes the appropriate disclosures regarding its initial accounting for the business combination not being complete in its December 31, 20X1 financial statements. In making these disclosures, the buyer would need to indicate that the amount of consideration transferred included in the accounting for the business combination was based on an estimate of working capital that had not been finalized at the time its December 31, 20X1 financial statements were issued. Keep in mind that there may be more measurement period adjustments resulting from the working capital adjustment. To the extent the account balances included in the target’s working capital calculation were not final in the initial accounting for the business combination reflected in the December 31, 20X1 financial statements (which is what gave rise to the working capital adjustment), measurement period adjustments may also be necessary to record the final fair values for these account balances. For example, assume the $500,000 working capital adjustment discussed earlier was necessary because the initial estimate of accounts receivable on the acquisition date was

$1,400,000 (which was included in the initial estimate of working capital of $2,500,000) and the final amount of accounts receivable was $1,900,000 (which was included in the final amount of working capital of $3,000,000). In this situation, it would be reasonable to expect that the measurement period adjustment to reflect the $500,000 working capital adjustment would also reflect an adjustment to accounts receivable.

It is often helpful to consider whether there is a clear and direct link between the working capital adjustment and the consideration transferred (i.e., the accounting for the business combination) when determining whether the adjustment possesses the characteristics of a measurement period adjustment. In the relatively simple example introduced earlier in Section 12.9.1 and this section, there is a clear and direct link between the working capital adjustment and the consideration transferred. In other situations, this link may not be as clear or as direct. These situations require a complete understanding and analysis of all of the facts and circumstances.

One factor the buyer would consider in this regard is whether an arbitrator was involved in determining the working capital adjustment. If an arbitrator was involved, the buyer would need to further consider whether the arbitrator is rendering a decision as to the facts of the working capital adjustment or whether the arbitrator is acting in the capacity of a mediator between the buyer and seller. The arbitrator rendering a decision as to the facts of the working capital adjustment would likely be indicative of a clear and direct link between the working capital adjustment and the consideration transferred. Another factor the buyer would consider is whether disagreements about other representations and warranties in the acquisition agreement are being settled as part of a compromise on the working capital adjustment. If this were the case, it would be indicative that there is not a clear and direct link between at least part of the working capital adjustment and the consideration transferred.

Taking into consideration whether there is a clear and direct link between the working capital adjustment and the consideration transferred when determining whether the working capital adjustment should affect the accounting for the business combination (i.e., be treated as a measurement period adjustment) is consistent with a position taken by SEC staff member Randolph P. Green in a speech he gave at the 2003 Thirty-First AICPA National Conference on Current SEC Developments. In this speech, the following observations were made by Mr. Green:

y “In order to reflect some or all of the settlement of such a claim as an adjustment of the purchase price of the acquired business, the acquirer should be able to persuasively demonstrate that all or a specifically identified portion of the mixed claim is clearly and directly linked to the purchase price.”

y “Similarly, claims that assert one party misled the other or that a provision of the agreement is unclear are not unique to business combination agreements and do not generally establish a clear and direct link to the purchase price and, therefore, should be reflected in the income statement.”

While this speech was given prior to the issuance of Statement 141R, the same conceptual issue existed under the predecessor guidance. We believe the thought process used to address the conceptual issue under the predecessor guidance continues to be relevant in addressing the same conceptual issue that exists today.

A situation in which at least a portion of a working capital adjustment would not be considered a measurement period adjustment involves a situation in which it is one year after the acquisition date and the buyer and seller cannot agree on the amount of the working capital adjustment. At the close of the measurement period (i.e., one year after the acquisition date), the buyer must make its best estimate of the acquisition-date fair value of the consideration transferred, which includes the working capital adjustment. Assume further that another year passes before the buyer and seller reach a compromise on the amount of the working capital adjustment. The accounting effects of the working capital adjustments made at the close of the measurement period and upon the buyer’s and seller’s compromise are different from one another:

y The effects of the working capital adjustment at the close of the measurement period should be reflected in the accounting for the business combination provided the adjustment possesses the characteristics of a measurement period adjustment. How the accounting for the business combination is affected by the working capital adjustment depends on a number of factors. For example, if the dispute between the buyer and seller was over what accounts should be included in the “working capital” definition in the business acquisition agreement, then it is likely that only goodwill would be affected by the adjustment to consideration transferred. However, if the dispute between the buyer and seller was over the amount within the working capital accounts as of the acquisition date, then it is likely that the acquisition-date fair values of the working capital accounts themselves (e.g., accounts receivable, accounts payable) would also be the subject of a measurement period adjustment (as discussed earlier in this section).

y The effects of the working capital adjustment upon the buyer’s and seller’s compromise would be accounted for outside of the business combination with the effects likely reflected in the income

statement. The amount of the final working capital adjustment would be the difference between the best estimate of the acquisition-date working capital adjustment made at the close of the measurement period and the compromised amount of the working capital adjustment.