Beware of Deferred Tax Assets and Liabilities

Most private equity sales include post-closing adjustments for differences in net working capital from either an amount estimated at closing or a target negotiated between the parties. While most agreements call for the various balance sheets to be GAAP compliant and based on the historical practices of the target company, it is, as we’ve said in prior posts important that the parties clearly understand (and define in the merger agreement) the calculation of net working capital.

Net working capital is supposed to represent those assets and liabilities that are expected to have a short-term impact on cash and equity. Current assets are generally those that are expected to generate cash within twelve months and current liabilities are generally those that are expected to use cash within the same time frame. Looking at the name alone, most people think deferred tax assets and liabilities refer to expected tax refunds or taxes due. However, deferred tax assets and liabilities are not the actual taxes, but are in fact only an accounting concept. They refer to “timing differences”, an accounting term used to describe a situation where certain revenue and expenses are recognized differently for tax purposes and book purposes and are non-cash in nature. Even though they may be classified as short-term on the balance sheet, the calculation is derived from the classification of the underlying asset or liability that has the timing difference for tax purposes. It does not necessarily follow that the deferred tax asset or liability will have any impact on cash within twelve months or ever.

Our friend, Damon Lewis, from Ireland San Filippo, therefore, recommends that non-cash items, such as deferred tax assets and liabilities, be specifically excluded from the definition of working capital in merger agreements. But, if in your transaction they aren’t, pay special attention to their anticipated impact on the determination of the estimated balance sheet or any target level of net working capital. Otherwise, one of the parties might find themselves writing checks for amounts and reasons not expected.