In a frothy M&A market, you can bet that some CFOs and their management teams, somewhere, are acquiring more trouble than they bargained for — and a lot less value than what they paid for.
In the first half of 2015, aggregate acquisition purchase prices increased almost 50%, to $1.7 trillion, the highest level in 10 years. Meanwhile, the median enterprise value to EBITDA multiple increased to 12.2x — also the highest level in more than decade.
Many studies have shown that acquisitions tend to underperform. Aggressive accounting practices on the part of target companies can mask the true economic value of acquisitions, exposing boards, management, and CFOs to reputation, career, and legal risks when expectations do not materialize.
For CFOs who are analyzing acquisition targets, the following five accounting issues are the financial reporting equivalent of thunder before a rainstorm — clear warning signals that trouble could lie ahead.
Revenue-cycle working capital issues. Revenue recognition is the most common area of financial fraud and financial engineering. While there are dozens of ways to manipulate revenue, method and intentions are irrelevant. Acquirers should be solely concerned with the question of whether reported revenue (or revenue growth) is sustainable.
The easiest way to assess revenue sustainability is to evaluate revenue-cycle working capital: receivables and deferred revenue. Is the target firm collecting cash for its sales? Are customers still making upfront cash payments? Many companies and their advisers overlook this kind of analysis.
A case in point is one of the largest U.S. healthcare consulting firms. In April 2015, the $1 billion company acquired a smaller firm to provide “new competency in areas” strategic to growth. The acquired firm was growing revenue at 15.1%. That level of growth may have justified a purchase price equivalent to 4.2x revenue, nearly double the multiple of comparable firms.
However, the acquired business experienced a significant increase in days sales outstanding. The revenue quality of the acquired business clearly deteriorated and revenue growth is likely unsustainable.
Non-GAAP financial statements. Companies use non-GAAP adjustments to more accurately reflect the underlying business economics. In many instances, however, aggressive non-GAAP adjustments have the exact opposite effect: The true economics of the business are obfuscated by deceptive, non-GAAP reporting.
Widespread adoption of non-GAAP financial reporting by investors has resulted in valuations (and acquisition purchase prices) based on non-GAAP financial metrics. Accordingly, it is important to assess whether a non-GAAP adjustment better reflects or clouds economic reality.
In 2014, for example, a multi-billion dollar health-care company made more than $1 billion in acquisitions. Much of the acquired assets were capitalized as intangible assets, which largely reflect research and development efforts at the acquired firm. However, the acquirer excluded amortization of acquired intangibles from its non-GAAP financials. The amortization of intangibles is just a different form of research and development, and the exclusion of these expenses muddied the underlying economics of the business.
Changes in financial statement disclosure. Financial statements are heavily scrutinized to minimize legal risk before being filed with the Securities and Exchange Commission. Accordingly, every change in an SEC filing is meaningful and can be easily identified in the blackline filings (filings that show additions, deletions, and changes — available from most data providers). Occasionally, the blackline financial disclosure will highlight material information not readily disclosed to investors or potential acquirers.
Consider, for example, a $1 billion electronic material and equipment provider. In August of last year the company provided guidance for fiscal year 2014 revenue of $600 million to $700 million and said that it expected “non-GAAP EPS to be $0.12 to $0.18, which is at the high end of our previous range.”
Then, in the company’s second-quarter 2014 10Q filed just two days later, the company added multiple new risk factors to its filing and disclosed that a large customer had “no minimum purchase obligation.” Additionally, the company noted that its large debt burden would result in default if it didn’t produce “significant revenue” from that large customer. The company filed for bankruptcy less than two months later.
Selective financial reporting. Companies often engage in selective financial reporting to obscure unfavorable, underlying trends. Selective reporting tactics include ceasing disclosure of key performance indicators, changes in segment reporting, lack of pro forma financial results, and changes in non-GAAP reporting, among many other tactics.
One of the largest consulting firms in U.S., for example, completed nearly $2 billion in acquisitions in the past three years — but did not disclose pro forma financial results. This type of selective reporting conceals the underlying growth trajectory of the legacy business.
Similarly, the largest manufacturer of recreational vehicle in the U.S. recently changed its segment reporting in a way that serves to hide the growth rate of the company’s largest segment. Such changes may be symptomatic of the acquisition target’s corporate culture.
IT system implementations and internal controls. While the goal of an IT system upgrade, such as enhancements to an enterprise resource planning (ERP) system, is to streamline business operations, the implementation process may increase the risk of accounting irregularities and inconsistent financial statement reporting. Financial reporting miscues from implementation issues may be exacerbated if a company is converting or consolidating multiple information systems. Persistent system implementation issues may be indicative of company-wide under-investment in information technology.
In 2013, a provider of orthotic and prosthetic services and products announced the planned implementation of a clinical management and billing system that would continue through 2016. The system implementation was designed to improve previously decentralized and potentially manual processes. In 2015, the company announced certain misstatements dating back to 2012. The misstatements included items related to billing data and invoicing controls. The company had under-invested in information technology, which resulted in the misstatements.
Alex Cook, CPA, is the president of Voyant Advisors LLC, a San Diego-based research and consulting firm specializing in merger and acquisition risk assessment, financial statement and working capital analysis, and forensic accounting. Cook formerly worked as an auditor for KPMG LLP and is a certified public accountant.