Question

You have just joined a company as a new staff accountant. Your company is in an acquisition mode (acquiring 5 to 10 smaller companies each of the last 4 years). You are excited to hear that you are going with an acquisition team to facilitate another acquisition (Company X). You have been instructed to sit down with Company X’s controller and explain some pre-acquisition (before the acquisition is finalized) accounting expectations.

Expectations for Company X before the acquisition is finalized.

a) Company X is expected to accelerate the payment of liabilities

b) Company X is expected to delay recording the collections of revenue

d) Company X is expected to increase the estimated amounts in reserve accounts

As you are driving to the Company X headquarters, your gut is telling you something is not right? You pull your car over and call your old classmate who is now an auditor for Ernst and Young. You explain the “expectations” and your old classmate provides the following feedback…

(Old Classmate) There are ways that the three expectations could be managed within the rules provided by GAAP, but would be regarded by many as pushing the limits of GAAP.

Not satisfied with your old classmates answer you call your old accounting professor. Your accounting professor reminds you what he used to say in class,

(Old Professor) “There are gray areas in accounting that many accountants will be influenced to step into. Often, this results in unethical behavior (at a minimum) and in many cases results in illegal acts.” “It’s a dangerous path and I recommend that you stay away from gray.”

answer the following questions…

1) What effect does each of the three items have on the reported net income of the acquired company before the acquisition and on the reported net income of the combined company in the first year of the acquisition and future years?

2) What effect does each of the three items have on the cash from operations of the acquired company before the acquisition and on the cash from operations of the combined company in the first year of the acquisition and future years?

3) If you are the controller of Company X, how would you respond to these suggestions?

Answer 1

1. Effect of each of the 3 expectations on net income of the acquired company before acquisition and on the reported net income of the combined company in the first year of acquisition and future years:

Accelerating expenses or delaying the recognition of income or increasing the estimated amounts of reserve accounts reduces the acquired companies' pre-acquisition earnings. This would result in understatement of earnings of acquired company in the pre-acquisition period and that in turn would result in earnings growth of acquiring entity to be biased upward in the post-acquisition period because of the depressed levels for the acquirees. This is the case of clear manipulation of accounts.

2. Similar effect on cash from operations can be observed. Accelerating expenses or delaying the recognition of income or increasing the estimated amounts of reserve accounts reduces the acquired companies' pre-acquisition cash flows. This would result in understatement of cash flow of acquired company in the pre-acquisition period and that in turn would result in cash flow of acquiring entity to be biased upward in the post-acquisition period because of the depressed levels for the acquirees. This is again manipulating the accounts and distorting the real picture.

3. Understating the cash flow and earnings of one's own company is never a good idea. The controller of X wants to sell X and fetch good price for it, this could be done on the basis of strong earning figures and cash flow. Controller of X shall have the power to negotiate the terms of acquisition on the basis of promising numbers appearing in his financial statements. Plus, manipulation of market for short term in this manner would result in permanent loss of reputation of the management and it would be difficult for them as well to regain the confidence of public for raising money in the future.