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Auditing - A Business Risk ApproachBy RITTENBERG/SCHWIEGER/JOHNSTONESLIDES
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Rittenberg/Schwieger/JohnstoneAuditing: A Business Risk Approach
Sixth Edition
Chapter 15
Audit of Acquisitions, Related Entity
Transactions, Long-Term Liabilities, and Equity
Copyright © 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
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
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
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
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
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 unitImportant so goodwill can be tested for
impairment on an annual basisValuation and testing of impairment is
facilitated if company uses capital budgeting process
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
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 subsidiary
Audit tests for goodwill impairment will require considerable judgment and business knowledge
Transactions withRelated 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
Audits of Long-Term Liabilities and Owners Equity
Liabilities with significant subjective judgments:
Restructuring reserves
Warranty reserves
Pension obligations
Other post-retirement benefits
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
Pension Obligations
The amount of pension obligations are based on a number factors:Estimated lifetime of pensionersFuture earnings of employees prior to retiringEarnings rate on invested pension assetsLong-term interest rates used to discount future costsChanges 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
Bonds and 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 bondsPayment-in- kind bonds
Convertible bonds
Mandatory redeemable preferred stock
Stock options and warrants
Stock options - employee stock compensation program
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 documentsIf debt is issued during the audit period, receipt of cash may
be traced to cash receipts journal and bankPrincipal payments may be traced to the disbursements
journalAuditor 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
Auditing Bonds Payable (continued)
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
Recommended