Chapter 14

1. Chapter 14 Audit of Acquisitions, Related Equity Transactions, Long-Term Liabilities, and Equity

2. 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

3. 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

4. Comment on Determining the Cost of the Acquisition Normally, cost is amount paid to acquire the company However, 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 performance Auditor must assess likelihood of acquired entity meeting performance objectives - if highly likely, the full cost should be recognized at the time of acquisition

5. 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 appropriate Auditor 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

6. 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

7. 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

8. 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

9. 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 subsidiary Audit tests for goodwill impairment will require considerable judgment and business knowledge

10. 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

11. Discuss Audits of Long-Term Liabilities and Owners Equity Liabilities with significant subjective judgments: • Restructuring reserves • Warranty reserves • Pension obligations • Other post-retirement benefits

12. 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 warranty The auditor can examine the account by • Testing the information system used by the client • Developing an estimate based on the factors above

13. 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 plans The client will usually hire an actuarial firm to help make the estimates The auditor must determine that the actuarial firm is independent, competent, and has sufficient reliable information to develop the estimates

14. 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

15. 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

16. Explain Auditing Bonds Payable • Computation of interest expense • Auditor 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 indentures • Auditor typically reviews loan documents and makes inquiries of client

17. Discuss Common Stock and Owners' Equity Transactions affecting stockholders' equity: • New stock issues • Treasury stock transactions • Declaration and issuance of stock dividends or splits • Declaration and payment of cash dividends • Donated capital • Transactions involving retained earnings • Prior period adjustments

18. 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