Rittenberg/Schwieger/Johnstone

Auditing: 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
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
 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 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
 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 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
 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 bonds
 Payment-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 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
 Auditing Bonds Payable
(continued)

 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
 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 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