The Shaq Attack on Fair Value

An accountant invokes the world of hoops to disparage fair-value purchase accounting.

The study, “Acquisition Accounting: New Rules & Shenanigans,” for example, notes on the one hand that FAS 141(R) will make it harder for buyers to manage earnings because the rule restricts the use of restructuring reserves and in-process research-and-development write-offs. At the same time, FAS 141(R) leaves “plenty of room for management discretion and potential abuse,” the report authors write.

What’s more, co-author Dan Mahoney says, fair-value accounting leaves the door open for companies to understate assets and overstate liabilities because the assumptions are subjective.

Manipulating fair-value assumptions during the so-called “stub” period is one way companies will abuse the new purchase-accounting rules, Mahoney told CFO.com. The stub period is the gap between the last time a target company reports interim results and the acquisition closing date.

Under 141(R), which takes effect for fiscal years beginning on or after December 15, companies are required to value the target company’s assets and liabilities, identifiable intangible assets, and some previously unrecognized contingencies at fair-market value at the time of the sale. As a result, an overly aggressive company could manipulate assumptions to understate acquired inventory, then turn around and sell the inventory and record revenue with an understated cost of sales, for example.

By doing that, a company would see a boost in gross margins and earnings when they sold the inventory at the proper market rates. Similarly, if the company uses fair-value assumptions to understate accounts receivable, it will receive a boost to earnings when the outstanding bills are eventually paid and recognized.

Mahoney also warns investors to scrutinize acquisition price adjustments in light of fair-value calculations. He explains that under U.S. generally accepted accounting principles, buyers have up to one year after a deal closes to make adjustments to the purchase price allocation for assets and liabilities of the target company. Accordingly, the same earnings-boosting games can be played during the post-acquisition period that are played during the stub period.

Organic growth, a non-GAAP metric, will also be ripe for gamesmanship in purchase accounting, says Mahoney. Generally, organic growth is defined as corporate growth minus benefits attributed to acquisitions. “However, companies have come up with their own definitions of organic growth than can be misleading,” write the authors.

The study cites a situation in which an acquiring company reports an “internal” growth revenue number that includes a portion of the target company’s annual revenue, rather than removing all of it—as the acquirer should do. That accounting treatment could allow buyers to acquire targets that have just signed large deals and then later label that growth as internal, contend the authors.

Where should investors look to unearth such non-GAAP shenanigans? In the Management’s Discussion and Analysis of the company’s annual report or in earnings releases where other non-GAAP measures are discussed, says Mahoney.

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