In a sale and purchase agreement, it is common for sellers to provide warranties or indemnities over the historical financial information relating to the target company. Superficially, these accounts warranties may appear simple and understandable. However, we are frequently involved in M&A disputes in which breaches of accounts warranties are alleged.
There is no standard accounts warranty – each will be tailored to the specifics of the particular transaction – but there are certain terms that will almost always be included. The purpose of this chapter is to explain some typical features of accounts warranties, providing an expert explanation of the meanings of terms that are frequently included and what it means from an accountant’s perspective to comply with those terms.
To provide context for this chapter, it is helpful to start with some example accounts warranties.
First, in relation to the financial statements of the target, a typical warranty provided by a seller might be as follows:
The financial statements for the year ending 31 December 20XX comply with the requirements of applicable laws and International Financial Reporting Standards as consistently applied by the Company and give a true and fair view of the financial state of affairs, assets, liabilities, financial conditions, financial performance and results of the Company as at the date the financial statements for the year ending 31 December 20XX were authorised for issue. The financial statements for the year ending 31 December 20XX . . . and have been audited by [an Audit Firm] who have issued an unmodified audit opinion.
Second, in relation to management accounts of the target, a warranty might be as follows:
The management accounts for the nine months ending 30 September 20XX have been prepared with due care on a basis consistent with the financial statements for the year ending 31 December 20XX and in accordance with the Company’s accounting policies.
Finally, an accounts warranty may refer to specific figures or performance measures of the target, along the lines of the following:
EBITDA [earnings before interest, tax, depreciation and amortisation] is reported in accordance with International Financial Reporting Standards with adjustment for non-recurring, exceptional and extraordinary items of income or expenditure.
Before we explore some of the terms in these example warranties, it is first important to provide a cautionary note on accounting frameworks.
When preparing a set of accounts – whether financial statements or management accounts – it is necessary for the preparer to apply an accounting framework that sets out the rules and principles in accordance with which the accounts will be prepared. There are a number of different accounting frameworks in use across the world and, although the overarching general principles of different accounting frameworks are often broadly consistent with one another, there are differences in the specific rules required by each framework. Moreover, accounting frameworks themselves are subject to continual update and refinement. It is important, therefore, to consider any accounts warranty by reference to the extant accounting framework applicable to the financial information being warranted. As such, the guidance in this chapter is provided in general terms, rather than in respect of a specific accounting framework applicable to financial information prepared during a specific period.
Warranting compliance with an applicable accounting framework
The financial statements for the year ending 31 December 20XX comply with the requirements of applicable laws and International Financial Reporting Standards as consistently applied by the Company.
A key requirement of most accounts warranties is that the financial statements being warranted have been prepared in accordance with an applicable accounting framework. The example accounts warranty here refers to International Financial Reporting Standards (typically abbreviated to IFRS). However, other accounting frameworks – often referring to the relevant jurisdiction – may also be applied, such as the US Generally Accepted Accounting Principles (US GAAP) or the UK Generally Accepted Accounting Practice (UK GAAP).
The accounting framework chosen by a company in its financial statements is commonly stipulated by the local company law or regulations. For example, companies whose shares are listed on public exchanges in the European Union are required to prepare their financial statements in accordance with the IFRS accounting framework. However, privately owned companies in the European Union may be permitted by local law to adopt a relevant local accounting framework.
Regardless of the accounting framework adopted, in most instances the financial statements prepared by a company will include:
- a statement showing the financial performance of the business during the reporting period (often referred to as an income statement or a statement of profit and loss);
- a statement showing the financial position of the business at the end of the reporting period (often referred to as a statement of financial position or a balance sheet);
- a statement showing the movement in the cash position of a business during the reporting period; and
- related notes providing breakdowns of items or narrative descriptions.
The recognition, measurement, presentation and disclosure of the items reported in these financial statements is governed by the applicable accounting framework.
So, what causes financial statements to be non-compliant with an accounting framework (and, therefore, at face value, in breach of an accounts warranty)? The simple answer is ‘errors’. At its most basic, an error is a misstatement about, or omission from, the information included in a set of financial statements when compared with the information required to be reported by the relevant accounting framework. Errors in financial statements arise because the company has failed to use (or has misused) information that was, or should have been, available at the time the financial statements were issued. Common errors include:
- mathematical mistakes;
- ignorance or misinterpretations of relevant facts and information;
- misapplication of the requirements of the accounting framework;
- inadequate or omitted disclosures; and
Accounting frameworks appreciate that, owing to time and monetary restraints on preparers of financial statements, it is not expected that financial statements will be entirely free from error. However, financial statements will not comply with the accounting framework if they contain errors deemed to be ‘material’, either individually or in aggregate, or that are immaterial but made intentionally to achieve a particular presentation within the financial statements. The concept of materiality, and consideration of what is and what is not considered material, is critical, therefore, in determining whether a set of financial statements complies with the stated accounting framework.
Different financial reporting frameworks discuss the concept of materiality in different terms, but generally they explain that information is material if its omission or misstatement, individually or in aggregate, could reasonably be expected to influence the economic decisions that users make on the basis of the financial statements.
Given that materiality is an entity-specific measure, it is perhaps not surprising that accounting frameworks do not set specific thresholds or benchmarks that should be adopted when assessing whether an item of information is material. A common feature of many disputes involving accounts warranties, therefore, involves an assessment of whether identified errors are material and consequently cause the warranted financial statements to be non-compliant with the relevant accounting framework.
Although the quantum of an error is obviously relevant to an assessment of its materiality, it is also necessary to consider the nature of the error. Certain qualitative factors might render a misstatement material regardless of its size, for example if the error affects the company’s compliance with loan covenants, masks a change in earnings or other trends, or has the effect of increasing management compensation (such as by ensuring that the requirements for the award of bonuses may be satisfied).
It is also important to note that, in many instances, the financial statements being warranted will not have been prepared specifically for an individual user, such as the buyer, but will have been prepared for use by a wide range of users, including the general public, lenders and potential investors. When considering whether financial statements comply with an accounting framework, it is the economic decisions of a wide range of users that typically needs to be considered, rather than the specific economic decisions made by individual users, such as the buyer in a transaction.
Although the existence of an error will often be clear, it is not always the case. This is because the inherent uncertainties arising from business activities mean that many of the items reported in a set of financial statements cannot be measured with absolute precision. Instead, preparers of financial statements will frequently be required to use the latest available, reliable information to estimate the value of certain items, such as the recoverable value of debts or the eventual outcome of contracts that span a number of years.
Preparers may determine that the estimated value of an item reported in previous financial statements needs to be changed in subsequent financial statements. In and of itself, this does not mean that the previously issued financial statements contained an error. For example, if the change in estimated value arose as a result of new information, more experience or subsequent developments that could not reasonably have been taken into account by the company when the original estimate was made, the original estimate would not be considered an error, even if the value had subsequently altered significantly.
However, if the change in estimated value was deemed necessary because the company had overlooked or misused information that was available when the original estimate was made, or had made computational errors when calculating the original estimate, then the original estimate typically would be considered an error.
Warranting a ‘true and fair’ view
. . . and give a true and fair view of the financial state of affairs, assets, liabilities, financial conditions, financial performance and results of the Company.
Another common feature of an accounts warranty is a confirmation that the financial statements provide what is described as a ‘true and fair view’ of the company’s financial conditions, financial performance and financial results. This may be presented as a separate warranty, distinct from the requirement for the financial statements to have been prepared in accordance with an applicable accounting framework.
The need for companies to prepare financial statements that give a true and fair view is a requirement of many legal and regulatory regimes. This requirement is often coupled with what is referred to as a ‘true and fair override’, which requires financial statements to deviate from the requirements of the applicable accounting framework where necessary to achieve a true and fair view.
A number of papers, reports and legal judgments have been prepared by regulators and standard setters that consider what it means for a set of financial statements to give a true and fair view. In general, these papers explain that the concept of a true and fair view requires preparers of financial statements to stand back and consider the presentation of the financial statements as a whole, rather than simply mechanically applying the requirements of the accounting framework.
However, consistent with this concept of ‘true and fair’ is the fact that the overarching objective of many accounting frameworks is to produce financial statements that provide a fair presentation. Moreover, most accounting frameworks that require fair presentation explicitly require preparers to depart from the accounting framework where necessary to achieve a fair presentation; indeed, where such a requirement exists, failing to make such a departure would itself cause the financial statements to not be compliant with the accounting framework. As such, there may be minimal substantive difference between financial statements that give a true and fair view and those that comply with the relevant applicable accounting framework.
In any event, although an accounting framework might require a deviation from its requirements where necessary to achieve a fair presentation, most also contain the qualification that such a deviation will only be necessary in extremely rare circumstances. Similarly, in practice, it is very uncommon to encounter a true and fair override, as sometimes required by statute, in a set of financial statements.
Periods covered by accounts warranty and relevance of information arising after balance sheet date
as at the date the financial statements for the year ending 31 December 20XX were authorised for issue.
Often, a potential breach of an accounts warranty is identified as a consequence of information that is discovered after the financial statements were warranted, for example the completion of a long-term construction contract, the sale of inventory held by the company, or the settlement of a court case. It is important, therefore, to understand how, if at all, such events can affect financial statements subject to an accounts warranty.
From an accounting perspective, there are two particular dates relevant to a set of financial statements. The first is the reporting date. As we have already explained, financial statements provide the financial performance of a company during a specified period, and the reporting date is the last day of that reporting period. The reporting date is also the date as at which the financial position of the company is presented in the financial statements.
The process of compiling, organising and presenting financial information into a set of financial statements takes time, meaning that there is an unavoidable delay between the reporting date and the date the financial statements are finalised and issued. The actual procedures for finalising a set of financial statements will vary depending on the management structure of the company and statutory requirements, but generally involves individuals with appropriate levels of authority approving the financial statements for issue. The date at which this approval is given is referred to as the authorisation date.
When considering events that take place after the reporting date but prior to the authorisation date, accounting frameworks typically distinguish between (1) those events that provide information or evidence about conditions that existed as at the reporting date and (2) those events that provide information or evidence about conditions that arose after the reporting date.
The difference between these two types of events is significant. Financial statements should only be adjusted to reflect events that provide information or evidence about conditions that existed as at the reporting date. A commonly cited example of an event that would require an adjustment is when a company is owed a debt by a counterparty who enters bankruptcy proceedings shortly after the reporting date. In such a situation, it is likely that the debt was irrecoverable at the reporting date, and this should be reflected in the financial statements. Conversely, financial statements should not be adjusted for events that provide information or evidence about conditions that arose after the reporting date. A commonly cited example is a fire that destroys a warehouse after the reporting date. In this situation, the warehouse existed at the reporting date and should not be adjusted for, although a disclosure in the financial statements may be required.
The above two examples are relatively clear. However, in many instances, determining whether events after the reporting period gave evidence of conditions that existed as at the reporting date is not straightforward, and disputes involving accounts warranties often revolve around that very question.
In most instances, the accounts warranty will have been provided after the authorisation date of the financial statements and (with the exception of very rare situations) it is not feasible to make adjustments to financial statements that have already been authorised for issue. Nevertheless, information that meets the criteria of point (1), above, can still be relevant to an accounts warranty, even if it is only discovered after the authorisation date and after the financial statements have been warranted.
When such a situation arises, in addition to considering whether the information gives evidence of conditions that existed as at the reporting date, it is also necessary to consider whether the information was available, or could reasonably be expected to have been available, as at the authorisation date. If the answer to this question is yes, then events occurring, or information discovered, long after the authorisation date could be evidence that the warranted financial statements contained errors that, if material, would have caused them to be non-compliant with the relevant accounting framework.
Determining whether information could reasonably have been expected to have been available as at the authorisation date can be just as contentious as determining whether events after the reporting date provide evidence of conditions that existed as at the reporting date.
Warranting audited accounts
The financial statements for the year ending 31 December 20XX and have been audited by [an Audit Firm] who have issued an unmodified audit opinion.
In some instances, an accounts warranty will warrant that the financial statements had been subject to an audit and received an unmodified, or clean, audit opinion. Even if not separately warranted, the existence of an unmodified audit opinion on the financial statements is often of relevance to other more common warranties, such as those relating to compliance with an applicable accounting framework or the provision of a true and fair view, as explained above.
An audit opinion is relevant, as the objective of an audit of a set of financial statements is for the auditor to obtain reasonable assurance about whether financial statements as a whole are free from material misstatement, whether because of fraud or error, thereby enabling them to express an opinion on whether the financial statements are prepared, in all material respects, in accordance with an applicable accounting framework. The existence of a reputable third-party audit firm expressing an independent opinion (prepared outside the context of an arbitration) that the warranted financial statements complied with the applicable accounting framework and provided a true and fair view can therefore be persuasive evidence in defence of an alleged breach of an accounts warranty.
Notwithstanding this, an unmodified audit opinion is not a concrete guarantee that the financial statements had been prepared in accordance with an accounting framework. An audit is designed to give reasonable assurance that, although a high level, is not absolute assurance. There will always be a risk that material misstatements in a set of financial statements are not detected by the auditor. For example, there is a possibility that management or others may not have provided, intentionally or otherwise, the complete information that was relevant to the financial statements or that had been requested by the auditor.
The risk that an audit fails to identify material misstatements is amplified in situations where a fraud has occurred (or is alleged). Frauds often involve complex and organised schemes that are designed to conceal the existence of the fraud. Audit procedures used to gather audit evidence may be ineffective, therefore, for detecting intentional misstatements that involve, for example, falsified or deliberately withheld documents or other types of collusion. Moreover, an audit is not an official or forensic investigation into an alleged wrongdoing. Accordingly, the auditor is not given specific legal powers that could compel the company to provide certain types of information. A forensic review performed after the signing of the audit report, therefore, may reveal information that was not available to the auditor, and provide evidence of material misstatements that the auditor could not have identified.
Warranting management accounts
The management accounts for the nine months ending 30 September 20XX have been prepared with due care on a basis consistent with the financial statements for the year ending 31 December 20XX and in accordance with the Company’s accounting policies.
So far, we have been referring to the financial statements of a company. Financial statements are prepared for the benefit of a wide range of stakeholders (including those external to the company) and cover a set accounting period, which is typically a year.
Not surprisingly, management of a business will generally require information about its financial performance and position more frequently than the accounting periods used in the preparation of financial statements. This information is usually provided via the production of what are often described as management accounts, which might report the financial performance and position of the company once a month or even weekly.
Management accounts are not financial statements. Unlike financial statements, which have to be prepared in accordance with accounting frameworks determined by an external standard setter, there are no fixed rules regarding the form and content of management accounts. Indeed, it is common for the form and content to vary from company to company, in response to the information needs of those running the business. As such it should not be expected that management accounts prepared by a business comply with an accounting framework or provide a true and fair view.
In many share and purchase agreements, the seller provides a warranty in relation to the target company’s management accounts. Although the absence of a prescribed accounting framework means that the specific wording of a management accounts warranty can vary from transaction to transaction, it is not uncommon for an accounts warranty to refer to the figures in the management accounts having been prepared in accordance with a specified accounting framework, or in a manner that is consistent with the target company’s financial statements. Disputes often arise in relation to these warranties.
As a primary observation, in order for financial statements to have been prepared in accordance with an accounting framework, they must comply with all of the requirements of that framework. This includes disclosure requirements, for example, to disclose the sources of estimation uncertainty faced by the company and to disclose how the company has responded to certain risks. Management accounts that just provide an income statement and balance sheet without such accompanying disclosures would be non-compliant, therefore, with an accounting framework, even if the items reported had followed the recognition and measurement criteria required by the accounting framework.
Moreover, in many instances, management accounts will not be formally authorised for issue in the same manner as financial statements. As explained above, there is often a delay between the reporting date and the authorisation date of a set of financial statements, which is necessary to determine the appropriate accounting treatment of events that occur after the reporting date. The absence of an explicit authorisation date, therefore, can create challenges as to what information should be reflected in any management accounts.
Finally, although local statutes or regulations often require financial statements to be audited, it is rare that statutory or regulatory bodies require management accounts to be similarly audited or otherwise reviewed. Indeed, even in instances where management accounts are reviewed by an external party (for example, at the request of the company itself), such engagements are often structured to provide limited rather than reasonable assurance. Rather than providing a positive opinion that management accounts are prepared in accordance with the relevant accounting framework, reviews of management accounts typically will conclude that nothing had come to the reviewers’ attention that caused them to believe that the management accounts were not prepared in accordance with the relevant accounting framework. It goes without saying that this is a significantly lower level of assurance.
Warranting entity-specific performance measures
EBITDA is reported in accordance with International Financial Reporting Standards with adjustment for non-recurring, exceptional and extraordinary items of income or expenditure.
Sometimes accounts warranties refer to concepts that, although having generally understood meanings, are not strictly defined in the specified accounting framework. These are often referred to as ‘non-GAAP’ or ‘alternative performance’ measures.
Accounting frameworks do not generally prohibit companies from calculating and reporting their own non-GAAP performance measures. Where such measures are reported, accounting frameworks also typically require companies to include supplementary disclosures explaining, among other things, how the alternative performance measure was determined.
Given that accounting frameworks do not prescribe methods that companies should adopt when determining non-GAAP measures, the way one company determines a non-GAAP measure is not necessarily comparable with the way another company determines its own non-GAAP measure, even if both companies use the same name for the non-GAAP measure they are reporting.
Take, for example, the performance measure EBITDA. It is commonly understood that EBITDA means earnings before interest, taxation, depreciation and amortisation. However, within this commonly understood meaning, there remains scope for items to be treated differently: it is possible that two different companies may take different approaches regarding the inclusion of bad debt expenses or inventory write-downs in their respective calculations of EBITDA. Similarly, different companies may have different interpretations of terms such as ‘non-recurring’, ‘out of the ordinary course of business’ or other terms not defined in the relevant accounting framework.
These different interpretations are often at the heart of disputes about accounts warranties. These are particularly common where the non-GAAP measure specified in the accounts warranty is not one that has previously been presented (and explained) by the company in its financial statements, or that is not clearly defined separately in the contract between the buyer and seller. In some cases, the different interpretation of non-GAAP measures can result in significantly different conclusions regarding the financial performance or position of the company.
In the introduction to this chapter, we set out three example accounts warranties that are typical of those we see in M&A agreements. Superficially, these example warranties may appear to be basic assurances: straightforward promises made by the seller, breaches of which should be easy to identify and difficult to dispute.
However, as we hope we have demonstrated, even the simplest of accounts warranties can be a term of art that is pregnant with further rules and principles. The application of these rules and principles can often require the use of judgement and the interpretation of complex sets of facts and conditions; and wherever judgement and interpretation go, disputes often follow.
 Chris Drewe is a partner, Patricia Moroney is a director and James Fox is an associate director at Mazars LLP.