Case Study 1: Accounting Standards in Consolidated Financial Statements
Case Study 2: Challenges in Carve-Out Transactions and Financial Disclosures
A multinational group headquartered in Germany typically prepares separate financial statements for each group company and a consolidated financial statement in accordance with local GAAP (Generally Accepted Accounting Principles). To present the group to potential international buyers, a Financial Fact Book (FFB) with consolidated figures according to IFRS is often created. The IFRS figures presented in the FFB are also warranted in the purchase agreement.
Local GAAP may significantly differ from IFRS in several areas. While the buyer’s or seller’s financial advisors may make certain adjustments in their reports to align the figures with IFRS, these adjustments are often made at the group level only, without fully adjusting the figures of local subsidiaries consolidated into the group’s financial statements to IFRS. Moreover, local GAAP reflects the laws and practices of a specific country, meaning it varies from one country to another.
For example, revenue recognition can differ considerably. Under some local GAAP, a subsidiary may recognise revenue when the product is shipped, whereas under IFRS, revenue is recognised only when control is transferred to the customer. Differences often arise in lease accounting as well; under local GAAP, operating leases may not have been recognised on the balance sheet, while under IFRS, most leases must be capitalised according to IFRS 16. Adjustments can also be overlooked in the treatment of deferred taxes, as some local GAAP do not recognize deferred taxes for certain temporary differences.
These local considerations are not always known to the FFB preparer and may lead to overvaluation of revenue and assets and undervaluation of liabilities under IFRS. Such discrepancies are often only identified post-closing, when the new shareholder reviews each subsidiary more closely through an IFRS lens.
Therefore, it is crucial to consider the inherent adjustment risks of local GAAP figures during due diligence when consolidated or IFRS figures are used in an FFB. If time does not permit a thorough due diligence of these adjustments, the parties should discuss the risk beforehand and agree on risk allocation.
When a company decides to divest certain business areas that were not previously operated as separate entities, the seller typically prepares an FFB showing the figures of the carve-out business. The purchase agreement then includes a warranty for the income statement and balance sheet of the carve-out business as presented in the FFB.
While this principle may seem straightforward, it is actually highly complex in practice. Often, the exact scope of the carve-out is not clear at the time of signing the purchase agreement and represents a moving target. Expenses also frequently arise at a different group level and may not easily be allocated to a particular business unit. For example, if a global marketing campaign, restructuring, or corporate functional costs are incurred, allocating these costs to a single business unit requires certain subjective judgments, assumptions, and estimates. These inherent limitations are addressed in the FFB’s Basis of Preparation but often become points of contention post-closing.
It is advisable to clarify these inherent limitations in the wording of the warranty or in the Basis of Preparation referenced by the warranty. For example, it could clarify that:
the income statement and balance sheet of the carve-out business were prepared in accordance with the stated Basis of Preparation;
the income statement and balance sheet do not represent expenses (a) that would have been incurred if the carve-out business had been conducted on a standalone basis or (b) that the carve-out business will incur post-closing.
This underscores the importance of clear communication and agreement on the basis for cost allocation and disclosure, as well as the potential complications if the carve-out scope changes during the process.
A financial statement warranty without a knowledge qualification (eg, “to the seller’s (best) knowledge...”) does not mean it contains no subjective element. After all, financial statements themselves contain subjective elements.
If a company provides services to a client during the 2023 financial year, and the client has not paid by the financial statement reference date (31 December 2023), the company would typically recognise the receivable in its statements under local GAAP. If, later in financial year 2024, it becomes apparent that the client was already insolvent as of 31 December 2023, and unable to pay, requiring the receivable to be written off, this does not necessarily imply that the 2023 financial statement was erroneous if the client’s insolvency was not known or reasonably could have been known to the management while preparing the 2023 financial statements.
Buyers may frequently claim a breach of the financial statement warranty in such cases, despite the warranty (as agreed upon between buyer and seller) specifying that it is not to be interpreted as a strict financial statement warranty. The financial statement can still be compliant with, for example German GAAP, as the warranty pertains to adherence to an accounting standard rather than to the absolute collectability of the receivable.
To establish a breach of such a financial statement warranty, a party would need to demonstrate not only an objective violation of a statutory requirement but also that a diligent businessman could have recognised the violation with the knowledge available at the balance sheet date. Although this second element may seem somewhat subjective, the applicable standard is that of a generally diligent businessman rather than the specific businessman in question. The principle behind this normative-subjective element is to equally protect the businessman, the company, and its stakeholders. A businessman who is overly risk-averse may not fulfil his role effectively, and the company may not thrive. If the businessman acts prudently and can justify his decision under the given circumstances, he has fulfilled his statutory duty.
Case Study 3: Ex-Post Accuracy