It’s the time of year when we start to reflect on the past 12 months and plan for the next. Like many, we are seeing more and more earn-outs in connection with business acquisitions as well as the continued widespread use of profit-based employee incentives.
Sale and purchase agreements
As always, it is prudent to ensure that the key metrics of earn-outs are very clearly described. Any confusion or room for manipulation could give rise to disputes between sellers and buyers. There are often high multiples of dollars at stake.
Any new judgmental areas of accounting opened up by new accounting standards create more opportunity for manipulation by the parties and therefore increase the risk of disputes.
It is now more important than ever to check the terms of your earn-outs because of the effect of the new accounting standards, including IFRS 16 and AASB 16 (Leases) for reporting periods beginning on or after 1 January 2019.
For sectors that extensively use significant operating leases, the impact could be large. The new leasing requirements may impact companies significantly, including by:
- changing operating lease expenses from above the EBITDA line to below it
- increasing assets
- increasing financial liabilities.
Hopefully, if you have already signed earn-out clauses which include EBITDA or EBIT in their calculations (to be made for reporting periods beginning on or after 1 January 2019), then they specifically require EBITDA or EBIT to be calculated for this purpose on the same basis as in the historical accounts before signing (with any appropriate adjustments). If not, then you may need to find opportunities to amend the earn-outs or mitigate against unintended outcomes.
Care must also be used with debt clauses in sale and purchase agreements in 2019 to ensure that leases are dealt with in accordance with the intentions of the parties.
Taken together with the impact of IFRS 15/AASB 15 (Revenue from Contracts with Customers) which applied from 1 January 2018, this may mean that the financial statements of a company for the years ended 30 June 2018, 2019 and 2020 are prepared on three different bases, making it harder to assess any progress over that period.
Valuation and other implications
Perhaps even more significantly, going forward, valuation multiples of EBITDA and EBIT will need to account for these changes, reported cash flows will be presented differently and some of the benefits of sales and lease backs may be eliminated. In addition, more companies may need to be audited.
You should also reconsider the terms of employee incentives including bonuses and equity plans. If they include EBITDA or EBIT in their calculations, then the new accounting standards may give rise to undesirable consequences. If you are reviewing your employee arrangements or plans, then please check the metrics with your accountants now so that you can implement changes with employees perhaps as part of their next remuneration review. Obviously, care must be taken with any changes to avoid tax and other accounting implications.
Ratios, banks, dividend policies and thin capitalisation
In addition to EBITDA and EBIT, depending on the nature of the business and its funding, the new accounting standards may seriously impact financial ratios, such as gearing ratios and current ratios as well as interest cover for existing and new debt arrangements. Discussions with your bank may be required. You may also need to reconsider your dividend policies and compliance with thin capitalisation requirements.