Working Capital Definition

Working capital can be both more and less than meets the eye. Intuitively, it seems sufficient to calculate net working capital as the difference between current assets and current liabilities as determined according to GAAP and the historical practices of the target company. The reality, however, is that GAAP provides wide latitude on many accounting issues. Moreover, the company whose financials are being dissected may have changed its accounting policies over its life. Many controversies come down to differences between the company’s accounting policies and those of the buyer when a buyer comes to believe post-closing that the target company’s accounting policies were incorrect or improper. Conceptually, SRS Acquiom believes that net working capital should be thought of as the company’s final closing balance sheet, and not the buyer’s opening balance sheet.

In order to provide clarity to both the buyer and the shareholder representative, consider the following suggestions for preparing the final closing balance sheet and the net working capital calculations:

1. Attach as an exhibit to the merger agreement a particular set of financial statements, and note that the final closing balance sheet should be determined with the same accounting policies and procedures used in the preparation of this exhibit.
2. Do not define assets and liabilities merely by customary account names. Include as an attachment the company’s chart of accounts with account numbers, and define inclusions and exclusions to working capital by specific account name and number. We recommend creating the estimates at a trial balance level of detail for each subsidiary of the business. Clarity is the cornerstone to avoiding or minimizing the severity of accounting disputes, so the estimates should be developed at the same level of granularity at which accountants normally work. Importantly, retain a copy of the detailed analysis used to develop the estimates and provide it to your shareholder representative.
3. Include as an exhibit specific accounting procedures and policies used to determine any estimates or cut-offs, such as inventory reserves, allowances for bad debts, or accrued liabilities. Often these policies may already be documented in the notes to the company’s audited financial statements. However, specific guidance should be developed for detailed account level results. The goal is to create a final closing balance sheet using the specific accounting policies and procedures used to prepare the estimated closing balance sheet and that were the company’s historic practice.

In summary, be precise to avoid future disputes with your working capital definition. The parties’ attorneys and accountants need to work intensely and cooperatively to try to ensure that the merger agreement specifically defines how to treat issues that may have accounting rule ambiguity, or in which management made judgment calls prior to closing.