15 July 2020 by Jacqueline Woods
Lawyers and forensic accountants alike are kept busy because of the incidence of disputes between parties over the interpretation of contractual clauses and obligations. At the time of entering into an agreement, the parties may well be satisfied that it has been drafted to accurately capture their intentions. It is not until a dispute arises and the spotlight is turned on the relevant clauses that any ambiguity and looseness in the drafting of financial obligations become apparent.
When engaged as a forensic accountant in, for example, shareholder disputes, we have no regard to the original intentions of the parties; we give our view on how we believe the relevant areas of the contract should be interpreted from an accounting perspective.
I’ve seen shareholder and partnership agreements refer to accounting frameworks, such as Generally Accepted Accounting Principles (GAAP), Australian GAAP, Australian Accounting Standards and International Financial Reporting Standards (IFRS). I’ve seen the terms general purpose financial statements, audited financial accounts and annual company accounts used interchangeably. To a non-accountant, they may have the same, or very similar, meanings. But to an accountant, they don’t.
The opportunity for alternative interpretations can be minimised by ensuring the wording, phrasing and terminology are accurately drafted and structured to reflect the intentions of the parties in a manner that is consistent with accounting policies, practices and definitions.
So, here are my top three tips for mitigating the risk of dispute in the interpretation of accounting-related matters in contracts and agreements:
- Be specific about the relevant accounting framework, policies and practices;
- Be specific about critical accounting terms and references;
- Be specific about the calculation methodology to be adopted.
- Relevant accounting framework, policies and practices
Australian Accounting Standards, and other relevant authoritative pronouncements, are designed to provide a framework for determining a consistent meaning of ‘financial position’ and ‘profit or loss’ in financial reporting. It is important that the agreement clearly states the hierarchy of accounting frameworks and policies to be adopted in the event of a dispute. The hierarchy is typically:
- Specific accounting policies agreed between the parties;
- Consistency with statutory or management accounts;
Specific accounting policies agreed between the parties
If there are accounting policies specific to the business, describe the agreed policy or practice in sufficient detail that leaves no ambiguity as to how that item should be calculated. For example:
- Clearly outline the approach to calculating any doubtful debts provision to avoid one party manipulating profit through an aggressive policy designed to minimise profit in the year of dispute.
- Many small to medium enterprises (SMEs) are not obliged to, and don’t, record work-in-progress (WIP), which affects profit in a given accounting period. Unless specifically addressed (including the basis of calculating WIP), one of the parties to the dispute could be financially disadvantaged by not expressly explaining how unrecognised WIP is to be treated in the event of a dispute.
Consistency in preparation
The term “financial accounts” can have many meanings, so be clear about the form the accounts will take. For example:
- General purpose accounts comply with all accounting standards, whereas special purpose accounts need only comply with a reduced set of accounting standards.
- Statutory accounts refer to financial statements required to be prepared under the Corporations Act and can be either general or special purpose accounts.
- Management accounts are internally generated accounts for management purposes.
GAAP is the catchall, and should sit at the bottom of the hierarchy. It provides a set of general rules and guidelines for financial reporting. Specify which GAAP is relevant, as different countries adopt different GAAP.
- Critical accounting terms & references
Include clear and specific definitions of relevant accounting terms and references included in the drafting. For example:
- The term “gross profit” generally refers to sales revenue less the cost of the goods or services sold, however the internal book-keeping expense allocation may fail to apply wages directly referable to sales to the cost of sales section of the profit and loss statement, thus overstating gross profit.
- The term “net profit” is capable of wide interpretation. If not clearly defined, it may be taken to mean net profit disclosed in the annual financial statements, taxable net profit in the income tax return, or even profit after tax.
- The calculation methodology
If the parties have in mind a specific method to calculate an amount which may be payable in the event of a dispute, the desired calculation methodology should be clearly stated. This may require specific detail, such as certain expenditure to be added back for the purpose of the calculation. For example:
- Add back of private expenditure (such as luxury motor vehicle expenses) included as business expenditure.
- Add back of plant and equipment purchases fully expensed under the instant asset write off small business depreciation rules (currently set at $150,000 per asset as a result of COVID-19), with ‘normal’ depreciation deducted.
My advice is to manage the drafting risk by establishing agreement between the parties as to what they intend a clause to really mean should it be enforced, and seek accounting advice to cement the words that best reflect the intention.
“How many legs does a dog have, if you call a tail a leg? Four, because calling a tail a leg doesn't make it a leg.”
Warren Buffett, recounting a favourite riddle of Abraham Lincoln
Early forensic accounting input may assist in developing the best legal strategy. We are able to assist in identifying the financial intentions of the parties and drafting of related legal clauses. We aim to help, so please feel free to contact: