Role: • An accounting advisor engaged by a lawyer to help with concerns about an earnout arrangement (payment for the purchase of a business based on performance after the sale has closed).
Key users: • Ms. Kellett and Mr. Jones are the only relevant users. Ms. Kellett will use the report to assist her in assessing the earnout agreement.
Key facts: • Earnout arrangement being proposed for sale of company.
• Selling price will depend on earnings after the sale closes and buyer (role is working for the seller) will prepare the financial statements.
• Ms. Kellett and Mr. Jones are unsophisticated financial statement users.
• Financial statements have a number of “soft spots” that could lead to Mr. Jones being disadvantaged by the earnout arrangement.
Constraints: • The purchaser has suggested the earnout state that the financial statements be prepared using GAAP consistently applied. A clean audit opinion would also be required. Tighter constraints are required because GAAP still provides significant leeway to the new owners that will allow them to disadvantage Mr. Jones.
Objectives: • Identify soft spots in the financial statements and propose ways to protect Mr. Jones from not receiving fair compensation for his business
Issues: • Possible non-arm’s length transactions.
• Inuvik will be a major supplier to other companies that the buyer owns.
• This is a reasonable strategy for the buyer but it creates risks for Mr. Jones because transactions between Inuvik and the other companies are not at arm’s length and the selling price used in the transactions may not be at market value.
• The new owner could require sales to occur at below market value, which would lower Inuvik’s net income and lower the payment to Mr. Jones. Doing this would be beneficial to the new owner.
• Contract should specify that sales to related parties should be at fair value and that