Expertise, sensitivity, multiple factors / inputs into complex financial and economic models, the myth of mathematical accuracy, underlying assumptions and significant judgements, uncertainty and variability of cash flows are all factors that may arise in different business models. Auditors generally rely on management to provide them with information that whatever financial results they present are a fair representation of the company’s business model and activities during a particular financial year. They thus place reliance on management’s interpretation of their own business model and interpretation of the financial reporting standards.
Fair value accounting purports to present a reliable estimate of the fair value of the business based on the present value of the company’s future cash flows. However, because it relies on a determination of future cash flows (where the discounted value method is applied), it involves significant judgements and assumptions about the future, some of these are based on contractual agreements where future cash flows can be reliably determined (for example loan assets provided to clients by banks with fixed or variable interest rates and fixed terms of repayment). By nature estimates of fair value are based on forecasts of future conditions, and on this basis alone auditors cannot vouch for the accuracy of forecasts but can assess the reasonability of assumptions upon discussion with management. Where contractual arrangements are in place and a relatively easily determinable client risk profile is available, it can be easy to test assumptions made by management. However, in most cases determination of fair value is not as straightforward especially when it comes to acquisitions and related party transactions.
Every accounting student that has done group accounting can attest to the complexity of group accounting and the notion of goodwill in consolidated financial statements. Growth through acquisitions is one of the quickest ways to achieve growth in a company, to gain market share in a particular market or diversify the company’s operations and as a result increase its earnings base, resulting in the generation of additional value for shareholders. Typically a company is acquired from its existing shareholders at a determined price which is agreed by upon between management and the acquiring company which are ideally approved by shareholders in a shareholders meeting (there are certain laws, and requirements by stock exchanges around the world pertaining to acquisitions, I will not delve into these). The whole process involves the engagement of expert advisors, lawyers and independent valuers who ultimately determine a “fair value” of the shares to be acquired and draft the terms and conditions of the approval with inputs from the competition commissions.
In the case of acquisitions it is not uncommon to hear of a “premium” to current market values being paid for the acquisition of shares. Such a premium for accounting purposes will normally result in the creation of goodwill which is the excess of purchase consideration less the net asset value of the company after consideration of the fair value of any contingent liabilities or reliably measurable intangible assets. Such goodwill is recognised as an asset in the group’s financial statements as it represents the premium which the company could potentially realise in the future, however, it is impossible to measure whether such goodwill is realisable or not. A prudent approach would be to write of the goodwill as soon as it arises and focus on creating value from the acquired assets. Research has proven time and again that most mergers and acquisitions fail due to cultural clashes or failure to realises the synergistic benefits initially envisaged for the business, thus whatever “premium” is paid for the business is mostly for the benefit of shareholders in the company being acquired and not necessarily a measure of the company’s ability to generate future cash flow.
When buying a second hand car, a seller will make sure to polish the exterior and highlight the positive things about the car, whatever happens after the sale is normally the buyer’s problem. This phenom is true with companies as well, at times over and above the purchase price, the acquiring company ends up having to spend additional costs post acquisition in order to streamline the two businesses before generating any value from the acquired business. Typically the issues discussed above are what management has to grapple with when making an acquisition and determining a fair value to pay when acquiring a company. All of these have an impact on the company’s short term perform, risk profile of the business as well as the funding requirement.
Acquisitions can bye funded by a company’s cash resources, through a rights issue, an exchange of shares or debt financing. All of these increase the company’s financial risk profile; a) where existing cash resources are used, the company runs the risk of not having sufficient cash to cover post acquisition expenses or future working capital requirements, b) where a rights issue is made, the company will be under pressure to increase returns to shareholders immediately after the acquisition and c) where debt is issued the company will increase its level of gearing and interest expenses may erode any returns expected from the acquisition in the short term.
Management has to take all these factors into consideration in making a decision to acquire a new company, these have a pervasive impact on the company’s risk profile and its business model. Given these complexities auditors have to provide reasonable assurance about whether the financial statements are free from material misstatement whether due to error or fraud. When evaluating multiple assumptions in determining fair value, the margin of error is relatively high, especially where a single factor has a compounded impact on the results of a mathematical/financial model. To pass this risk on management generally request (at a fee) the services of an independent expert valuer to advise on an appropriate value to pay for a target company and the relevant means of financing thereof, even with the involvement of experts, the margin of error is still high as the future cannot be accurately predicted. Auditors may be involved in providing reasonable assurance on the financial statements of the target company, however, that is only limited to the information provided to them at that time.
Where businesses have complex business models, management resorts to simple explanations of the phenomena they are dealing with and auditors rely on these representations to determine the reasonability of financial information presented by management. What is clear is that audit opinions on their own are not sufficient for investors to make a decision on whether or not to invest in a company. The financial statements presented should be able to disclose enough information for users to be able to analyse an entity’s business model and risk profile and then make an investment decision based on the information available to them. It is easy to point to the auditors when things go sour, but investors themselves need to have an understanding of accounting to see through the smoke and mirrors that is fair value accounting.
Given the complex environment we find ourselves in, auditors should be able to step out and say that they don’t understand what’s happening in the company’s that they are dealing with but from the evidence provided to them by management everything seems to be alright but there is a possibility that it might not be the case. Wait, they already are saying that! How much are you paying your directors?
*Views written herein are my own and do not in any way purport to be factual representations, some accounting terms are used herein, these may have been incorrectly applied as I rely on my understanding of accounting thus far in this analogy (this does not purport to be a technical report).