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 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 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 subsidiary
Audit 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 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 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
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
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
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
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 noncash 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