M&A Disputes: Does a booming stock market lower the efficacy of financial statement warranties?

On November 8, 2024, at the end of the week in which the US elections were held, US stock markets closed at record highs, driven by technology firms. For the companies included in the S&P 500, the average Price-to-Book (P/B) ratio on the day amounted to 5.2. This ratio means that over 80% of the market value of the companies in the S&P 500 is not captured in the net asset figure reported in their financial statements. In other words, the average book values of net assets reported on corporate balance sheets account for less than 20% of the S&P’s market value. Fifty years ago, they accounted for closer to 70%.

Financial statement warranties in Sale and Purchase Agreements (SPAs) are among the most important contractual protections a buyer in a mergers & acquisitions (M&A) transaction can obtain. To provide meaningful protection from commercial loss, however, warranted accounting figures, or book values, must be linked to the commercial value of what is being acquired. A common way to express this link between market price (which this blog post equates with commercial value) and book values is the P/B ratio. It compares the value at which a share trades on an organised exchange to the accounting value of the same firm’s net assets by dividing the current market price per share by the book value per share (where book value means total assets less total liabilities).

A growing disconnect between market and accounting values raises important questions about the efficacy of accounting-based warranties in SPAs. If accounting values now reflect less than 20% of market value, can respondents in disputes credibly argue that an accounting warranty breach does not result in significant commercial loss? Consider a hypothetical firm for which book values have nothing to do with commercial value. An accounting warranty may then afford no meaningful protection against accounting misstatements. Conversely, a perfect correlation may suggest highly effective protection. Does this suggest that accounting warranties today provide, on average, less effective protection than in the past?

The issue is not new. Significant gaps between accounting and market values have historically coincided with periods of high stock market valuations. For example, the average P/B ratio of the S&P 500 also exceeded five in December 1999 at the height of the dot-com boom. Alan Greenspan, the former Federal Reserve Board Chairman, complained at the time that accounting wasn’t tracking investments in knowledge assets.  More recently, articles have discussed ‘Accounting Dark Matter’, and books have predicted ‘The End of Accounting’, referring to an increasing gap, or disconnect, between accounting figures and commercial value.

But has the valuation-relevance of accounting figures really decreased? While current P/B ratios certainly suggest a low explanatory power of accounting figures, the metric only captures the value-relevance of net assets. When other accrual accounting information is considered (such as information about intangible assets), a decrease in value-relevance seems less clear.

Even if the valuation gap between market and accounting values has widened, note that the main driver is the increasing importance of intangible assets. By some estimates, 90% of today’s S&P 500 market value reflects intangible assets. Fifty years ago, the equivalent ratio was 17%.

The issue inherent in the lower valuation-relevance of reported net assets therefore centres on the accounting for intangibles. This is closely related to the notion of ‘fair value accounting’: if all liabilities and assets, including intangibles, were recognised and measured at fair value, then deducting one from the other would give a net asset figure that is also a measure of fair value. (Strictly speaking, this requires frictionless markets that set efficient prices for an asset in every use, even when combined with other assets.) However, most ‘knowledge assets’, intellectual property, customer relationships, ‘organisational capital’, human capital, and other intangibles are not even on the balance sheet, at least before an acquisition.

It is frequently argued that accounting for intangible assets is akin to putting speculative values, or, as Benjamin Graham wrote over 80 years ago, ‘water’ in the balance sheet (Graham was referring to assets that had been written up at the peak of the 1929 market). To illustrate the issue of valuing intangibles, consider that the Wright Brothers’ ‘flight technology’ in 1903 was clearly a groundbreaking knowledge asset. But would its value on a balance sheet have been meaningful? And who would have measured it?

Historical cost accounting, which is the basis of accounting standards today (although there are many exceptions for individual assets and liabilities), tends to result in book values below market values. This means that value is captured on the balance sheet only once uncertainty has been substantially resolved. Such conservative accounting leaves the estimate of unrealised profits to the market, where prices are established. Accounting does not communicate commercial values through the balance sheet; yet it remains instrumental to the valuation of the firm when balance sheets and income statements are used jointly. The observation that many intangible assets are not on the balance sheet, or are recorded at values vastly below their market value, does not mean that financial statement warranties have become less effective as a consequence, for three reasons.

First, book values of many short-term assets and liabilities are generally close to fair values, and lofty market valuations of intangibles do not (directly) matter to them. For example, working capital, cash or debt are important to the valuation of a firm as well as purchase price adjustments in M&A transactions. A financial statement warranty will continue to provide protection from accounting errors in relation to these items.

Second, for long-term assets, including intangibles, financial statement warranties continue to be effective where incorrectly capitalised costs are used to inflate earnings (which are the basis of multiple-based and other valuations), thus falsely portraying a more profitable business than what was actually acquired. Accounting warranties protect buyers in this regard, even beyond the book value of the asset: erroneously capitalised recurring costs, once expensed, perpetuate in the valuation, meaning a lower actual value than that implied in the warranty promise.

Third, beyond this protection from erroneously capitalised cost, buyers of fast-growing technology and other businesses heavily reliant on intangibles will primarily be concerned with the commercial (rather than the accounting) value of the technology assets. Accounting warranties were never the best tool to mitigate commercial risks, or ‘hope values’, when acquiring high-growth technology firms, and increasing valuations do not change this. More effective tools include commercial or technical due diligence, warranties unrelated to accounting figures, earn-outs linked to future returns of intangible assets, or a reinvestment by the seller that helps align incentives between the parties.

Finding effective ways to protect deal value in times of high valuations may also require some new thinking outside standard warranty catalogues and standard due diligence procedures. However, high valuations give rise to issues that are not primarily a matter of accounting treatment, and financial statement warranties will generally continue to provide effective protection from accounting misstatements.

Heiko Ziehms is Senior Managing Director at FTI Consulting.

The views expressed herein are those of the author and not necessarily the views of FTI Consulting, Inc., its management, its subsidiaries, its affiliates, or its other professionals.