With a resurgence in acquisition activity and continued regulatory scrutiny over key audit issues, companies would be wise to review their deal accounting before auditors start doing the same.
Record low interest rates have provided low borrowing costs that have fueled significant merger and acquisition activity in 2015, according to M&A intelligence firm Mergermarket; deal value in the United States through Sept. 30 already surpasses all U.S. merger activity in 2014. “Bidders targeting the region seem willing to pay higher premiums for their deals,” the firm reports. The average premiums one day before purchase for transactions into the United States jumped from 26 to 32.6 percent year-over-year.
The Public Company Accounting Oversight Board has leaned hard on audit firms in the past few inspection cycles to get tougher on the more judgmental areas of accounting—such as estimates and fair-value measurements, which are key factors in the accounting for business combinations. In fact, a recent analysis of PCAOB inspection reports by valuation firm Acuitas shows audit deficiencies around fair-value measurements were 21.5 percent of all deficiencies in 2013 for firms inspected annually.
Within that group of deficiencies around fair-value measurement, nearly half arose from business combinations, Acuitas says. Further, that figure has jumped considerably in recent years. Only 9 percent of fair-value-related audit deficiencies arose from business combinations in 2011; the share jumped to 45 percent in 2012 and then 49 percent in 2013.
Scott Spencer, a partner in the audit group at Crowe Horwath, says auditors are expecting to spend more time on M&A accounting in the upcoming year-end audit cycle. “It’s going to be an area where increased skepticism is applied,” he says. “Both audit firms and regulatory bodies are certainly examining more items relative to fair value in acquisitions.”
“The audit committee needs to take a very active role in M&A. Most deal people are excited about the synergies, but the audit committee is responsible for the controls, the accounting policies, and making sure nobody is cutting corners or missing anything.”
Brian Christensen, Executive Vice President, Protiviti
Brian Christensen, executive vice president at consulting firm Protiviti, says he’s hearing more audit committees discussing their deal accounting as they prepare for the year-end audit, and well they should. “The audit committee needs to take a very active role in M&A,” he says. “Most deal people are excited about the synergies, but the audit committee is responsible for the controls and the accounting policies and making sure nobody is cutting corners or missing anything.”
Rick Hitt, managing director at consulting firm Navigant Capital Advisers, says he sees cases where companies pay more attention to integrating an acquired unit than to accounting for the acquisition correctly, which requires allocation of the purchase price across the many assets and liabilities acquired in the transaction. “A lot of times companies are not focused enough on that,” he says.
That is where estimates and assumptions enter the equation. Measuring the fair value of assets and liabilities acquired in a business combination might involve any number of such judgments to comply with accounting requirements. “Growth rates, discount rates, expected changes, market conditions—depending on how significant those are to the valuation, auditing those assumptions can be challenging,” says Adam Brown, national director of accounting at audit firm BDO USA. “Especially if you’re auditing future-oriented assumptions for which there is not a lot of history, it can be subjective. We have to understand the basis from an auditing standpoint.”
Companies should get their valuation support to auditors as early as possible to facilitate a smooth audit, Brown says, since auditors usually engage their own valuation experts to assist with the audit. “That adds time to the process,” he says. “If those documents and reports come in late, it can be a problem in managing the timeline in terms of when the [Form] 10-K is due.”
The allocation between tangible assets and intangible assets is particularly critical because it determines how much will be called “goodwill,” says Randi Lesnick, a partner at law firm Jones Day. Goodwill represents the value of an entity beyond its individual assets and liabilities. It’s an intangible asset that gets scrutinized each subsequent reporting period to determine if it is holding up or needs to be marked down.
ACUITAS INSPECTION REPORT FINDINGS
See below for Acuitas’ key findings and trends gleaned from the 2008 to 2013 PCAOB inspection reports.
43% of all audits inspected by the PCAOB had deficiencies in 2013. This rate has steadily increased from 2009 when the PCAOB found deficiencies in only 16.0% of the audits reviewed.
Fair-Value Measurement (FVM) audit deficiencies continue to be significant, making up 21.5% of total deficiencies for annually inspected firms in 2013. The PCAOB cited substantive failures associated with AU 328 Auditing Fair Value Measurement and Disclosures in 10.3% of the deficient audits in 2013.
FVM audit deficiencies are increasingly attributable to business combination engagements. The incidence FVM deficiencies related to business combinations jumped from an average of 9% for 2008 through 2011 to 45% in 2012 and increased further to 49% in 2013. This trend is likely caused by a rebound in merger and acquisition activity as the economy continues its recovery.
The number of deficiencies cited by the PCAOB caused solely by failures to assess risk and test internal controls increased sharply in 2012 and remains high in 2013 at 45% of all deficiencies for the top 25 firms.
These risk assessment and control deficiencies caused 45.3% of the FVM deficiencies and 32.3% of impairment deficiencies cited by the PCAOB in 2013. This is a significant shift from earlier years when FVM deficiencies were primarily caused by inadequate substantive testing of asset prices and impairment deficiencies were primarily caused by inadequate substantive testing of management’s prospective financial information (“PFI”).
Investors often study goodwill as an indicator of whether a particular business was worth the price a company paid to acquire it. Think of AOL acquiring Time Warner at the top of the dot-com boom in 2001, and writing off nearly $100 billion in goodwill years later after the tech market collapsed. Suffice to say that is an accounting outcome one wants to avoid.
“It’s critical to do strong intellectual property diligence to establish the useful lives of intangibles,” Lesnick says. “You run the risk of a having a goodwill impairment issue.” Companies would be wise to undertake a strong valuation exercise with auditors and the finance team kept in the loop, she says.
But Wait, There’s More
In addition to valuation issues, auditors also will be scrutinizing tax issues, and they can get quite complicated, experts say. “That’s a whole separate thicket of GAAP,” Brown says. “We have to make sure we have the right people from an auditing standpoint to engage on whatever tax analysis the company has put together.”
Companies also need to be prepared to dig deep after a transaction to look beyond what their pre-deal due diligence provided for any possible evidence of fraud, says Greg Wolski, a partner focused on forensics in transactions at EY. “The last thing you want to have is a diligence process where you’re flagging things for follow up, and then there’s no follow through,” he says. “Just because you completed pre-acquisition diligence doesn’t necessarily mean diligence is complete.”
Brown points out a few more common issues in business combination accounting that can get tricky if they are discovered late in the process. Those include the accounting for contingent consideration, when a company puts a contingency on what it will pay for a transaction based on some future performance metric. “It’s not at all infrequent that it turns out to be classified as a liability that has to be remeasured every quarter,” he says. “That creates volatility in the income statement that people don’t want.”
Another issue that tends to crop up, Brown says, is the oversight of disclosure requirements when companies post provisional amounts in financial statements. For example, if a valuation won’t be complete in time for a filing deadline, companies can report provisional measurement figures, but they must disclose it.
“Sometimes those disclosures are not as fulsome as they could be,” Brown says. The Financial Accounting Standards Board recently approved a measure that gives companies an easier path to transition their financial statements from provisional to final figures in subsequent periods, but that doesn’t change the disclosure requirement.
The earlier a company prepares, the better, Hitt says. “If you haven’t thought through the valuation and allocation issues and then you’re scrambling to get the books closed on time, it can be quite a fire drill,” he says.