Chapter 14

Audit of Acquisitions, Related Equity Transactions, Long-Term Liabilities, and Equity

Review Mergers and Acquisitions

There are three valuation issues associated with acquisitions:

Valuing the assets and associate liabilities upon acquisition

Measuring restructuring charges and recognition of the liability

Measuring impairment of assets after operation begins

Discuss Acquisition - Asset Valuation Issues

Major issues associated with valuing an acquisition are:

Determining the cost of the acquisition

Valuing identifiable tangible and intangible assets and liabilities

Valuing goodwill

Comment on Determining the Cost of the Acquisition

Normally, cost is amount paid to acquire the companyHowever, there are things that make the assessment

more complicated: Acquisitions made using stock rather than cash Where the final price is contingent on the assets

received (post-audit) Where the final price is contingent on acquired

entity's performanceAuditor must assess likelihood of acquired entity

meeting performance objectives - if highly likely, the full cost should be recognized at the time of acquisition

Valuing Identifiable Tangible & Intangible Assets & Liabilities

Acquiring company records assets at their fair market value at time of acquisition:

Company usually hires appraiser to value tangible assets Intangibles should be valued at net present value of future

cash flows Auditor cannot simply accept appraisal and management's

assessment of fair value of assets Auditor must gather independent evidence to determine

whether assessed values are appropriateAuditor may rely on the specialist hired by management or hire

their own specialist. Either way, the auditor should: Evaluate qualifications of the specialist Determine if specialist is independent of management Review the methodology used by the specialist

How do you value goodwill?

Goodwill is the excess of purchase cost over the fair market value of tangible and intangible assets acquired in a purchase

SFAS 142 requires goodwill be specifically identified with an operating or reporting unit

Important so goodwill can be tested for impairment on an annual basis

Valuation and testing of impairment is facilitated if company uses capital budgeting process

Discuss Restructuring Charges

When companies restructure operations, GAAP requires companies recognize the cost of restructuring and associated liabilities

The auditor should examine restructuring charges though these procedures:

Review FASB pronouncements and EITF statements Review how company estimated restructuring charges Review actions taken by management that indicate

restructuring has moved beyond a plan Test estimates by reviewing contracts, property appraisals,

severance contracts, and other restructuring documents Mathematically test estimates Develop conclusion as to reasonableness of liability and

appropriateness of client accounting

Comment on Testing for Goodwill Impairment

GAAP requires goodwill must be tested every year for impairment

The company must determine the fair market value of the reporting unit and compare it to the reporting unit's carrying value (including goodwill)

If fair market value is less than carrying value, it is inferred that goodwill has been impaired and must be written down

The reporting unit may be the company or a sub-unit of the company

The auditor must evaluate: Management's methodology for assessing

impairment Whether an objective evaluation supports the

client's conclusion

Annual Audits: Risk Factors and Goodwill Impairment

In addition to the annual review, situations may arise which impair goodwill:

Significant adverse change in legal factors or the business environment

Adverse action or assessment by regulator Unanticipated competition that significantly reduces

value of company's products Significant loss of key personnel Expectation that reporting unit will be disposed of Significant asset group within a reporting unit tested

for recoverability Impairment recognized by subsidiaryAudit tests for goodwill impairment will require

considerable judgment and business knowledge

Review Transactions with Related Parties

Related party transactions have been used to manipulate financial reporting and should, therefore, be considered high risk

Auditor must consider that a client may not want to have its related party transactions discovered

To uncover these transactions, the auditor will: Obtain a list of all related parties; then develop a list

of all transactions with those parties Carefully examine all unusual transactions to

determine whether the transactions involved a related party

The auditor then investigates the transactions to determine if they have been properly recorded and disclosed

Discuss Audits of Long-Term Liabilities and Owners Equity

Liabilities with significant subjective judgments:

Restructuring reserves

Warranty reserves

Pension obligations

Other post-retirement benefits

Define & Explain Warranty Reserves

The warranty reserve represents expected future cost related to sales of a company's product; it is estimated and recorded when the product is sold

The estimate is typically based on past experience of the company and adjusted for

Changes in the product, including those that change its quality

Changes in the warranty Changes in sales volume Changes in the average cost of repairing products

under warrantyThe auditor can examine the account by Testing the information system used by the client Developing an estimate based on the factors above

Pension Obligations

The amount of pension obligations are based on a number factors:

Estimated lifetime of pensioners Future earnings of employees prior to retiring Earnings rate on invested pension assets Long-term interest rates used to discount future

costs Changes in pension plansThe client will usually hire an actuarial firm to help

make the estimatesThe auditor must determine that the actuarial firm is

independent, competent, and has sufficient reliable information to develop the estimates

Discuss Bonds & Stockholders' Equity

Companies issue capital stock (equity) and bonds (borrowing) to raise long-term funds

Other financing activity accounts include: Notes payable Mortgages payable Contracts payable Special bonds

Payment-in- kind bonds Convertible bonds

Mandatory redeemable preferred stock Stock options and warrants Stock options - employee stock compensation

program

Explain Auditing Bonds Payable

Bonds are issued to finance major expansions or refinance existing debt. While bond issues are infrequent, each transaction is material

Primary considerations in auditing bonds or other long-term debt:

Valuation and amortization of premium or discount Auditor will review loan documents If debt is issued during the audit period, receipt of cash may

be traced to cash receipts journal and bank Principal payments may be traced to the disbursements

journal Auditor may confirm year-end balances with debt holders

Computation of interest expenseAuditor will usually recalculate interest expense

including amortization of any discount or premium

Accounting for gains or losses on debt refinancing

Disclosure of major restrictions in bond indenturesAuditor typically reviews loan documents and

makes inquiries of client

Explain Auditing Bonds Payable

Discuss Common Stock and Owners' Equity

Transactions affecting stockholders' equity:New stock issuesTreasury stock transactionsDeclaration and issuance of stock dividends

or splitsDeclaration and payment of cash dividendsDonated capitalTransactions involving retained earningsPrior period adjustments

Common Stock and Owners' Equity: Audit Procedures

Since most equity transactions require Board approval, auditor should review the minutes of Board meetings for approval and intent

Valuation of equity transactions is fairly straight forward, except when shares are issued for non-cash assets

Disclosure items: Number of shares of stock authorized, issued, and

outstanding Stock options and warrants Any significant stock features like convertible

feature Appropriations of retained earnings Prior period adjustments