Question

How can acquisitions inflate cash flow and distort the metrics used to evaluate performance?

Explain why and note the GAAP that is involved.

Answer 1

Cash Flows can be inflated using acquisitions in the following ways:

a. Inhereting operating cash flows from target - Assume a business with a long operating cycle, for example a construction business. By acquiring a company with large and frequent business, such as a restuarant the Company can hide its lack of cash flows in the consolidated financial statements

b. Writing off fraudulent cash flows against acquisitions - A company may report inflated and fraudlent cash flows from operations, and simaltaneously pay for acquisitions at inflated asset prices. This would increase the Cash Flow from Operations, making it seem that the operations are very good while acquisitions are the reasons the company's cash flow is poor.

Acquistions can also be used to hide other performance indicators. For example, increasing the Fair Value of acquired assets, creating a deferred tax asset which will in turn inflate total earnings. A company may also attempt to inflate the primary business earnings and deflate the acquired business earnings in order to protect the business that matters more.

In most of the above cases, the distortion would require manipulation of Fair Value of the acquired business prior to acquisition. In order to provide for the fair measurement of assets ASC 805 - Business Combinations provides for rules and measures for acquistion accounting. IFRS3 - Business Combinations deals with the same with respect to IFRS.