Ten Tips To Avoid SEC Problems in Acquisition Accounting

The Securities and Exchange Commission has trumpeted that 1999 is the "year of accounting." From Chairman Levitt, who has made accounting issues the focus of several major speeches, to the review staff in the Division of Corporation Finance and the investigators in the Enforcement Division, the SEC is taking a searching look at accounting practices. Among the principal areas of concern is acquisition accounting. Based on our own recent experience in counseling clients in both review and enforcement matters, we have identified the following ten rules of the road for mergers and acquisition lawyers who want to avoid SEC intervention that may substantially delay or even kill a deal.

If your client acquires a significant "business," Section 3.05 of the SEC's Regulation S-X requires that your client file audited historical financial statements going back one to three years, depending on the size of the deal. The SEC staff has an expansive view of what is a "business" and will argue that any collection of assets that produces an identifiably separate revenue stream is a "business." If the seller hasn't prepared audited financial statements for the assets your client is acquiring, your client may be kept out of the public markets, and may be in default of its 1934 Act reporting requirements, until you can produce the required audited statements. This costs time and money and may even be impossible.

If you make a significant acquisition, or agree to a business combination, the other side's accounting issues will become your issues. If they have any of the problems discussed below, the SEC staff will likely pick them up and processing of your deal will be delayed. If the staff fails to identify problems in the review process and serious accounting irregularities emerge after the acquisition is complete, your headaches will be even worse. Your auditors need to interview the other side's auditors and review their work papers, analyzing their application of GAAP, looking carefully at their acquisition accounting over the preceding three years, and reviewing any prior SEC accounting comments before you commit to the deal and to the timetable.

The SEC and the Financial Accounting Standards Board are focusing hard on accounting for goodwill in purchase accounting transactions. The SEC staff is questioning value allocations as between various classes of intangible assets and amortization schedules. Particularly in the rapidly moving high tech world, lengthy amortization periods are not being accepted. In other situations, where acquired assets are sold immediately after an acquisition at a substantial premium, the SEC has been known to question whether assets were undervalued and goodwill was overstated to increase earnings in the near term.

As has been heavily publicized—the immediate write off of "in process research and development" to eliminate a future earnings drag is also under severe scrutiny. The classification of too large a portion of the costs of an acquisition as "in process R&D," which is then written off in a one-time charge will certainly capture the attention of the SEC. You need to cross-examine your auditors closely as to whether the amount of "in process R&D" being written off is defensible in the current climate.

Far too many companies still record and report revenues and expenses in the wrong period. Revenues are anticipated by holding periods open to record late shipments or by recording what are really contingent transactions; expenses are deferred or improperly capitalized. The result is a distortion of the earnings cycle and potentially inaccurate disclosures about sales and earnings trends. Your financial officers and auditors need to review thoroughly revenue recognition and expense recording policies and procedures to be sure that they understand the earnings process, and the revenue and expense recording practices, of the other party before you agree to the deal. The problems HFS (later Cendant) unwittingly bought into with the acquisition of CUCInternational are a cautionary tale for all M&A lawyers.

Inventory accounting is another area of frequent SEC staff focus. Inventory accounting has a direct impact on cost of goods sold and hence on reported earnings. Many an acquisition candidate has delayed - or looked the other way at - inventory that is obsolete or overvalued in hopes the buyer won't notice. Danger signals include inventory build up, introductions of new products or product enhancements, a history of "surprise" past write downs and noted deficiencies in inventory controls in prior auditor management letters or in your team's diligence process.

Inventory is not the only asset that may be overstated. Other assets may have declined in value. In particular, goodwill and other intangibles arising from prior acquisitions should be carefully reviewed, applying FASB No. 5 standards, to be sure the continuing value is still there. These adjustments should be determined before you price and announce your deal.

Reserves are provisions for known—or reasonably probable—future liabilities. The SEC applies a Goldilocks test in reviewing them: they can't be too big, and they can't be too small. They have to be "just right." The problem, of course, is that the SEC applies this test in retrospect—with all the benefit of knowing facts your client or the other party did not know when the reserve estimates were made. Thus, you need to carefully review prior reserve decisions—including loan loss reserves, reserves for product returns, reserves for cost overruns and tax liability reserves—to be sure that you are still comfortable that the reserve amounts are appropriate at the time of your deal.

The SEC accounting staff simply doesn't buy the answer, "well it's only a timing issue." They strongly believe that in most cases there is only one appropriate reporting period for each item of revenue and expense. And they can be very tough in insisting that reserve provisions or write-offs of impaired assets should have been taken earlier or that revenue should have been recorded later. Thus, when looking at a potential acquisition or merger partner, it is critical to take a skeptical look at any prior significant write-offs or loss provisions and to be satisfied that you and the other party can persuade the SEC staff that timing was right. As noted above, it is also important to understand both parties' earning cycles and practices for booking items of revenue and expense.

The SEC and the new Independence Standards Board are taking a hard look at auditor independence issues. If your auditor doesn't meet the evolving independence standards, you don't have audited financial statements. It has long been a basic principle that an auditor can't audit its own accounting and bookkeeping decisions. The auditor can advise on such decisions, but it can't step into management's shoes and make such actual decisions as asset valuation and loss or impairment estimates. Many acquisition-minded companies have used their auditors not only to perform diligence on the other party, but also to assist in valuing, and allocating values among, acquired assets. This can lead to significant independence questions. Recently, for example, the SEC staff has been raising formal, written independence questions when auditors have performed asset valuation services for a client. While the SEC has not yet rejected audits in such cases, they have formally reserved the right to do so in the future, and the right to make referrals to the Enforcement Division, by requiring a "Tandy" undertaking in such cases.

These then are the ten short accounting rules to bear in mind as you work with your client to plan for acquisitions and business combinations. Hopefully, with these danger signals as a guide, you will be able to avoid the pitfalls and delays at the SEC that are increasingly befalling M&A transactions.