M&A Vocabulary – Understanding Experts: “GAAP”

In M&A transactions, Financial Due Diligence is crucial for assessing the financial position and risks of the target company. It enables informed investment decisions and potentially more favorable negotiation outcomes. A key aspect examined closely during this process is the target company’s compliance with accounting standards, such as International Financial Reporting Standards (IFRS) or local Generally Accepted Accounting Principles (GAAP). These standards ensure consistency, transparency, reliability, and comparability across companies.

However, the analysis of “Quality of Earnings” (one of the core elements of almost every Financial Due Diligence) does not strictly follow GAAP rules. Instead, the focus is on presenting results from an economic and sustainable perspective as a basis for creating a business plan and for EBITDA-based business valuations. Certain business transactions recorded under GAAP may be excluded from EBITDA-based considerations, particularly if they are non-recurring or extraordinary in nature. The following explanations illustrate the potential consequences arising from deviations from local GAAP and differences from the buyer’s GAAP.

Differences between local GAAP in the target company’s country and the GAAP applied by the buyer (particularly relevant in cross-border deals)

Despite convergence projects for IFRS and U.S. GAAP and reforms to German GAAP (“HGB”) (the most recent reforms in 2015 through the Accounting Directive Implementation Act (BilRUG) and in 2009 through the Accounting Law Modernization Act (BilMoG)), certain differences remain, such as in lease accounting, the treatment of goodwill and different approaches to impairment testing, the LIFO method, and the treatment of R costs.

The standard scope of due diligence in cross-border transactions does not necessarily include a detailed analysis of differences between local GAAP and the GAAP applied by the buyer and is therefore usually performed upon request. Since the opening balance sheet of the newly acquired subsidiary is converted to the buyer’s GAAP as part of the buyer’s consolidated accounting, post-transaction surprises for pre-transaction GAAP differences are generally eliminated. Nevertheless, permanent differences must be identified and addressed in the context of consolidated reporting.

Deviations from local GAAP

Target companies sometimes maintain their books in a manner that deviates from local GAAP, for example by using cash-basis accounting or modified tax accounting. In the U.S., private companies are not required to prepare or publish financial statements in accordance with U.S. GAAP. Instead, accounting serves as the basis for correct tax returns in accordance with rules established by the various tax authorities in the U.S. The U.S. tax authority (IRS) allows companies to prepare cash-basis accounts if consolidated revenue is less than $25 million.

In this case, the goal of due diligence should be to identify major differences between the applied accounting principles and local GAAP when analyzing Quality of Earnings. However, a complete reconciliation of monthly and annual financial statements to GAAP-compliant figures is typically not the objective of Financial Due Diligence.

One of the main objectives of GAAP is to present comparable period results, meaning the timing of revenue and expense recognition is of utmost importance, which may not be correctly reflected in non-GAAP-compliant financial reports. Experience shows that EBITDA results from multiple years (as an average) are often used as the basis for (multiple-based) business valuation; this trend became more popular in post-COVID transactions, as it has been difficult since 2020 to fully quantify and isolate the various COVID impacts on the business within the Quality of Earnings analysis. Examples of these impacts include production shutdowns, labor shortages, logistical challenges, post-COVID pandemic revenue catch-up effects, and inflation in raw material prices.

GAAP and past practice

Most transactions in the U.S. are structured to include closing accounts, meaning the final purchase price is adjusted based on the target company’s closing balance sheet at closing with respect to working capital and net financial debt. In contrast, there is the locked box mechanism popular in Europe. Therefore, it is of utmost importance for sellers and buyers to agree on the accounting principles to be applied in preparing the closing balance sheet.

Recently, there has been a tendency to apply the target company’s past accounting practice for purchase price adjustment purposes instead of strict GAAP compliance (which may differ from accrual-based GAAP). Referencing the previously applied accounting practice method in the purchase agreement can help limit the risk of surprises, as the closing balance sheet follows the same non-GAAP principles used in calculating the working capital reference value (working capital peg) (typically the average working capital value of the last 12 months). Sellers argue that this approach is fair to both sides. However, the previously applied accounting practice must be clearly identifiable. For example, the non-recognition of certain liabilities that should be recognized under GAAP could give rise to disagreements as to why these liabilities were de facto never recognized in the past. Therefore, a detailed due diligence review of both annual and monthly figures is important to mitigate misunderstandings regarding ambiguous definitions in past accounting practice.

Conclusion

GAAP are the cornerstones of financial reporting. Nuances between local GAAP and deviations from the standards can present challenges in transactions. Efficient management of these challenges requires comprehensive due diligence, adequate definition of accounting principles in the purchase agreement, and strategic post-acquisition integration planning. By proactively addressing these complex issues, buyers and sellers can improve transparency, minimize risks, and ultimately ensure a smoother transaction closing.

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