VOLUME 8
ISSUE 1
April 2002
B USINESS VALUATI O N
D I G E S T
A publication devoted
to articles on Business
Valu ation a nd related
matters.
BY JAMES R. DUNCAN
IN THIS
ISSUE
Twenty Pressures to
Manage Earnings . . 1
Auditors and Earnings
Management . . . . 8
Caveat Aestimator:
Evaluating Hidden
Liabilities and
Risks . . . . . . . . . . . 16
The Business Valuation Digest is a
publication of The Canadian Institute of
Chartered Business Valuators. It is
published semi-annually and is
supplied free of charge to all Members,
Subscribers and Registered Students
of the Institute.
Statements and opinions expressed by
the authors and contributors in the
articles published in the Digest are
their own, and are not endorsed by,
nor are they necessarily those of the
Institute or the Editorial Advisory
Board.
EDITOR:
Tony P. Cancelliere, CA, CBV
EDITORIAL ADVISORY BOARD:
Mark L. Berenblut, CA, CBV
Nora V. Murrant, CA, FCBV
Blair Roblin, CBV, LLB
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Twenty Pressures to Manage
Earnings
Since SE C
C hairman A rthur Levitt's
" N umbers G ame" speech before the N Y U
Center for Law and B usiness in September
1998, earnings management has been the
focus of regulatory attention. Levitt attacked
accounting "hocus-pocus" as a serious threat
to the viability of the financial reporting that
underpins the U .S. capital markets. H is
speech contained a nice-point attack on
earnings management and provided the
impetus for three new Staff A ccounting
B ulletins (SA B; see box on page 2), a report
f rom the Public O versight Board's (P O B)
Panel on A udit E ffectiveness, and new
recommendations f rom the Blue Ribbon
Panel on I mproving the E ffectiveness of
Corporate A udit Committees.
Levitt defined earnings management as
practices by which "earnings reports reflect
the desires of management rather than the
underlying financial per formance of the
company." Companies use various devices to
in fluence earnings outcomes, including "big
bath" charges, "cookie jar" reserves, and the
abuse of materiality and revenue recognition
principles. T hese practices tend to erode the
quality of earnings and financial reporting
and deceive financial statement users.
A 1998 Business Week poll reported that
12% of C F Os had managed earnings at the
request of their superiors and an additional
55% of C F Os said they were asked to
manage earnings but refused to do so.
A ccording to C F O Magazine (September
1999), 60% of C F Os have felt pressure to
manage earnings. T his pressure is often most
strongly felt by those in personnel. T his
author's own research (" I nvestigating
Behavioral A ntecedents of Earnings
Management," Research on Accounting Ethics,
v.6) found that earnings pressure was by far
the most significant factor affecting earnings
management behavior.
Pressure to manage earnings does not stem
f rom a single source. Pressure to in fluence
reported results can arise f rom forces outside
the company, f rom conditions and programs
within the company, or f rom motivations
held by individuals that choose to engage in
earnings management activity.
External Forces
Analysts' forecasts. Companies that fail to
reach analysts' estimates for multiple quarters
can see their stocks drop precipitously.
W hen Procter & G amble warned that it
would not meet analysts' consensus forecast
in the first quart3r of 2000, its stock price
fell 30%. W hen P& G issued further
warnings just before the end of the second
quarter of 2000, the stock price fell another
10% and P& G's C F O was fired. As reported
in C F O Magazine (December 1998), one C F O
told SE C C hief A ccountant Lynn Turner that
when the C F O warned an analyst that the
company might just miss consensus estimates,
the analyst told him, " You're a bright guy;
you'll figure out how to make it."
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Access to debt markets. Many companies
depend on financial leverage in optimizing
returns to stakeholders. To establish a
business's creditworthiness, debt rating
agencies use much of the same in formation as
stock analysts. A slight drop in earnings or
negative expectations about future prospects
could cause a decline in a company's debt
rating, increasing its cost of capital and
diminishing prospects for new debt issues.
Contractual obligations. Many debt and lease
agreements, as well as other contractual
ar rangements, contain covenants in which a
company agrees to attain certain earnings, debt, or
other ratios, or limit payment sot shareholder.
W hen a company is in danger of missing one of
the covenants, the agreement may provide for
immediate repayment or other specified
per formance. Manipulating earnings slightly can
improve ratios enough to avert such dangers.
Competition. Companies in highly
competitive industries may want to maintain
an edge in revenues or market share. I n
1998, Sensormatic Electronics, a maker of
security systems, actually stopped its clocks,
which stamped shipping dates and times on
finished products, 15 minutes before noon on
the last day of a quarter, so it could continue
to make customer shipments within the
quarter until it had reached its sales target.
T he SE C brought charges and Sensormatic
settled without admitting or denying
misconduct.
Roaring stock market. A red-hot stock market
continues upward pressure on investor expectations
and companies to achieve those outlooks. To
support rising stock prices, firms could risk the
improper recognition of revenues by recording
false sales, shipping products before customers
agree to buy, and recording up-f ront revenue f rom
long-term contracts. Some observers say this
pressure is strongest in the technology sector.
A ccording to N ational Economic Research
Associates, in the first half of 1999 more than 50%
of securities f raud lawsuits involved improper
revenue recognition practices, compared to 20% for
the preceding year.
In Brief
A cluster of Contributing Factors
SE C C hairman A rthur Levitt's attack on
corporate earnings management turned up
the heat on the quality of financial reporting
that underpins the success of U .S. capital
markets. T he results so far have included
an examination of the audit process for
public companies, stronger guidelines for
corporate audit committees, and three staff
accounting bulletins (SA B) to circumscribe
interpretations of materiality, guide
restructuring and impairment charges, and
restrict improper revenue recognition.
Studies show that, rather than having a
single cause, earnings pressure results f rom
multiple factors in a company's environment,
culture, or management and can lead to
erosion in the quality of financial reporting.
I ncreasing awareness of earnings
management will promote its identification
and treatment and enhance financial
statement users' trust in the accounting
system.
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New financial transactions. E merging financial
instruments (e.g., derivatives) allow room for
discretion in accounting treatment. A ccounting
guidance specifies treating derivatives as hedges or
speculative transactions, depending on facts and
management intent and capability. A uthoritative
guidance for derivative accounting is complex, and
different entities with similar derivatives might
document these transactions in a wide variety of
ways in order to obtain favorable outcomes. For
software companies, another significant decision is
when to treat large investments in software
development as an asset.
Market disregard of big charges. T he financial
markets seem conditioned to disregard big
nonoperating charges, thereby providing incentive
for managers to make them as big as possible.
F requently, earnings announcements quote numbers
"before one-time items." War ren B u ffett cites an
R. G . Associates 1998 compilation of charges
recorde3d for restructuring, in-process research and
development, merger-related items, and writedowns. T he list totaled more then 1,300 charges
aggregating more than $72 billion.
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Company Culture
Merger attractiveness. G ood financial
per formance can enhance the attractiveness of
merger target companies. Prior to the merger of
H FS incorporated and C U C I nternational into
Cendant Corporation, certain business units of C U C
engaged in accounting ir regularities that in flated
company revenues by nearly $500 million. W hen
the situation came to light, Cendant restated
earnings and agreed to change its revenue
accounting practices. Cendant's stock price and
reputation su ffered in the process, and several
members of its board of directors resigned.
Management compensation. Companies f requently
tie executive stock option and bonus programs to
earnings per formance, attempting to align
management's objectives with ownership's but also
creating power ful incentives for managers to
manipulate earnings to achieve compensation
payouts. Some companies even increase the
pressure by lending money to employees for the
purchase of company stock. Last year, Conseco,
I nc., and I ndiana-based financial services company,
guaranteed about $600 million in employee loans to
purchase its stock. T his practice can create pressure
to meet optimistic earnings projections intended to
maintain the stock price.
Short-term focus. I nevitably, some companies
focus on short-term per formance regardless of the
future. A usterity programs are implemented,
investment spending is delayed, and employees are
fired to achieve a short-term earnings goal while
undermining long-term per formance. O ccasionally,
firms will defer or capitalize expenditures that
should be expensed. A few years ago, A merica
O nline recorded a $385 million charge because it
had inappropriately defer red marketing expenses;
the charge wiped out all of AO L's earnings to that
point.
Unrealistic plans and budgets. Companies
sometimes establish unrealistic annual plans and
budgets to push managers to overachieve. O ne such
company consistently establishes internal plans 20%
over the previous year, regardless of economic or
business factors. T he idea is solid: U nless the bar is
set high, managers won't try to jump it. Setting
budgets beyond the achievable, however,
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encourages managers to fudge the numbers
to get as close as possible.
Period-end requests from superiors. A
significant pressure to manage earnings often
derives f rom corporate superiors requesting
that division personnel provide additional
profit to meet quarterly and year-end targets.
T he late-quarter phone call asking, " W hat
else can you do?" provides a cultural
incentive for managers to learn to play the
earnings game.
Excessive profit followed by fear of decline.
Some companies fear that a famine will
follow feast years. W.R. G race & Co. held
back excess earnings f rom a medical
subsidiary to create a $60 million reserve to
smooth earnings over future, less profitable
years. G race used "materiality" to convince
auditors that adjustment of the reserve was
not required. U pon SE C investigation, G race
was fined, cease-and-desist orders were filed
against two auditors, and civil charges were
brought against the C F O .
Concealing unlawful transactions.
Companies fear that disclosing unlawful
transactions will damage their reputations.
Companies and individuals can use earnings
manipulation practices to cover up
embezzlement, f raud, misappropriation, and
bribery. ZZZZ Best Company, I nc., went to
great lengths to create a paper trail of false
transactions to cover for a lack of business.
T he C E O even issued a press release
reporting record profits just before his
schemes unraveled and the company
collapsed.
Personal Factors
Personal bonuses. Company executive
compensation policies are f requently weighted
more heavily toward incentives than a base
salary. With a few good years, individuals can
establish their personal finances for
retirement. T he prospect of a giant bonus
may provide su fficient motivation to fudge a
few accounting numbers.
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Promotions. Some individuals will do
whatever it takes to get the next promotion.
T heir obsession with climbing the corporate
ladder engenders behavior that will shed the
best light on their actions. T he combination of
personal ambition and a corporate tendency to
reward the "best" per formers can create an
incendiary situation.
the least significant factor in a manager's decision
to engage in earnings management practices.
Interaction of pressures. Earnings management
can also be the product of interaction between
various pressures. T he E xternal and companyculture forces many have greater effects on
managers overly concerned with compensation or
job security. Conversely, a company culture that
respects genuine and ethical achievement is less
likely to encourage managers to respond to
external pressures in inappropriate ways. I n any
situation, factors in all three categories must be
evaluated in order to understand the pressures that
lead to earnings management.
Focus on team. I n a company that stresses a
team culture, "team players" receive the
promotions and raises. O ften, the financial
team has the greatest opportunity to impact
reported results at the last minute. I ndividuals
striving for team success can undermine
financial reporting by making the late
adjustments that will achieve financial targets.
Is There an Upside?
Job retention. I n the 1990s, downsizing
became the prefer red method for cutting costs
and enhancing profitability. W hen companies
struggle to meet expectations, managers of
under-per forming areas risk losing their jobs. A
little judicious earnings manipulation could
improve the profit picture and keep a
manager's position secure.
Many of the pressures that can lead to earnings
management have positive aspects as well:
n A nalysts and debt rating agencies provide
valuable services to investors and creditors by
absorbing and summarizing volumes of financial
in formation in easy-to-understand formats.
n I nvestors seeking to use historical results to
predict future per formance results to predict future
per formance should ignore legitimate nonrecur ring
charges.
Hero or turnaround specialist. I ndividuals
can be motivated to manage earnings in order
to be viewed as heroes or turnaround
specialists. Sunbeam hired A l D unlap to reverse
their per formance trends, but some have
alleged that he pursued "accounting gimmicks"
as part of his efforts to improve company
per formance. D unlap resigned in 1998 after
the start of an SE C investigation, and the
company subsequently restated results for 1997
and part of 1998.
n Management compensation structures and team
focus can be effective tools to align manager
objectives with those of other stakeholders.
n Downsizing and cost-reduction programs can be
a necessary belt-tightening for companies that have
built unnecessary layers of bureaucracy.
Some observers even declare that a certain amount
of earnings management is good for companies and
individual stakeholders, based on a belief that
companies should make operating decisions that
propel long-term per formance by sometimes
defer ring spending or taking one-time charges that
benefit the future. A ctions that manipulate
perceptions but have no lasting impact-actions
solely directed toward controlling the decisions of
financial statement users-may, however, cross the
line.
Low regard for auditors. I n Rewarding Results,
K enneth Merchant indicated that managers
have a low opinion of an auditor's ability to
detect earnings management. I n large
companies, almost nothing in an individual
division is material to the overall financial
statements; consequently, managers believe they
can manipulate earnings in ways that an
auditor will not detect. Some managers believe
that even if the manipulation is detected, they
can invent a satisfactory justification. I n this
author's experience, likelihood of detection was
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T he initiatives that have followed in the wake of
the " N umbers G ame" mark the start of addressing
the problem of earnings management. N evertheless,
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one cannot help but think these actions will fall
short in creating the environmental, corporate, and
individual cultures necessary to reverse the erosion
of quality in financial reporting. I f we are to fully
understand the phenomenon of earnings
management, we must comprehend the pressures
that lead to this behavior. I f financial statement
users understand the existence of these pressures,
they have the opportunity to adjust their decisions
accordingly.
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Summary of SABs 99, 100, 101
Staff accounting bulletins (SA B) are
intended to describe the SE C staff's
interpretation of existing G A A P, not
develop new or modified G A A P. A ll
SA Bs are available online a www.sec.gov.
To mitigate earnings management by
public companies, the SE C issued three
SA Bs in 1999: SA B 99, Materiality
(A ugust 12, 1999); SA B 100,
Restructuring and I mpairment Charges
(N ovember 24, 1999); SA B 101, Revenue
Recognition (December 3, 1999).
T he SE C believed public companies
focus their earnings management activity
in these three areas. SA B 101 was so
sweeping in its implication that the SE C
twice defer red its effective date in
response to requests f rom companies and
auditors.
Materiality. U nder SA B 99,
companies cannot rely exclusively on
numerical thresholds to ascertain the
materiality of an item. T he SE C claimed
that many companies and auditors had
developed a practice of declaring items
to be immaterial merely because they
were less than 5% or 10% of a particular
financial statement amount.
F urthermore, SA B 99 indicates that
misstatements are not immaterial and
must be cor rected.
Materiality decisions incorporate both
quantitative and qualitative factors.
Q ualitative factors may render even
small amounts material. T he qualitative
factors to be considered include-
James R. Duncan, PhD, CPA, is an assistant professor of
accounting at Ball State University, Muncie, Ind. From 1976
to 1985 the practiced public accounting with Ernst &
Young, and from 1985 to 1993 he was vice president and
controller of KFC Corporation.
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whether the item is capable of
precise measurement;
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whether a misstatement covers the
failure to meet analysts' earnings
forecasts;
n
whether a misstatement produces
income when a loss might
otherwise exist;
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whether a misstatement affects
compliance with loan covenants or
regulatory requirements, or
conceals an unlawful transaction;
and
n
N ot relate to any continuing
activities;
n
N ot contribute to any future revenues;
n
Be an incremental and direct result of
the exit plan or incur red under a
continuing contractual obligation with no
economic benefit or be a penalty for
cancellation of a commitment.
whether a misstatement increase
management compensation.
Managing earnings to a specified
target could be considered a violation of
SA B 99's materiality requirements. SA B
99 also urges caution in aggregating or
offsetting known misstatements. K nown
misstatements should not be recorded,
and known er rors should be cor rected.
Regarding impairment charges, SA B 100
describes the elements of a plan to dispose of
assets, which are similar to the elements
required for a plan to discontinue operations.
T he SE C staff will challenge impairment
charges when a company has failed to evaluate
and adjust useful lives and residual values of
long-lived assets. SA B 100 provides guidance
for evaluation of the impairment of enterpriselevel goodwill and gives the staffs interpretation
of cash flow estimates used in assessing and
measuring impairment looses.
Restructuring and impairment charges.
SA B 100 describes accounting and
disclosures for employee termination costs
and impairment costs associated with
restructuring and business combinations.
T he SE C believed that these areas are
susceptible to earnings management.
Revenue recognition. SA B 101 provides
guidance on revenue recognition issues. T he
bulletin cites a study sponsored by the
Committee of Sponsoring O rganizations
(C OSO ; " F raudulent Financial Reporting: 19871997: A n A nalysis of U .S. Public Companies,"
March 1999) indicating that one-half of
financial reporting f rauds involve overstated
revenue. SA B 101 discusses accounting for the
following:
I n a purchase business combination,
liabilities for product war ranties and
environmental costs of the acquired
company should be recorded at fair
value. I f the acquired company did not
follow G A A P in establishing those
liabilities, the cor rection should not be
made as a part of the purchase price
allocation; rather, it should be made to
the historical financial statements of the
acquired company. I n addition, including
"cushions" to such liabilities in the
purchase price allocation is inappropriate.
A ccrual of employee severance and
other exit costs pursuant to a
restructuring plan should not be made
until a detailed plan exists and
management at the appropriate authority
level approves the plan. A detailed plan
must include specific actions and
timetables, and the effects of the plan's
actions must be reasonably estimable. T he
exit plan must be contemplated within a
time period that makes significant
changes unlikely. E xit costs should -
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n
Bill-and-hold transactions,
n
U p-f ront fees with seller continuing
involvement,
n
Long-term service transactions,
n
Refundable membership fees, and
n
Contingent rental income.
I n general, revenue should be recognized
only when realized or realizable and earned.
T he SE C staff considers that all of the
following conditions must be met;
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Persuasive evidence of an ar rangement
exists.
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Delivery has occur red or services have
been rendered.
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T he seller's price is fixed or
determinable.
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Collect ability is reasonably assured.
T he SA B provides SE C staff guidance
for the following issues:
n
E xecution of a written sales agreement;
n
Recognition involving bill-and-hold
ar rangements, layaway transactions, nonrefundable up-f ront fees, and set-up
fees;
n
T he effects of side agreements, customer
cancellation provisions, refundable
membership fees, and contingent lease
ar rangements on a fixed or determinable
price; and
n
T he recording of revenue when a
company acts as an agent or broker in a
transaction.
Companies must include their revenue
recognition policies in the footnotes to financial
statements. I n addition, management's
discussion and analysis (M D & A) must discuss
any unusual or in f requent revenue transactions
that would help in understanding revenue
results and trends. T he SE C staff will not
object if the accounting interpretations in the
SA B have not been followed in the past,
provided that the company reports a change in
accounting principles. Companies that have not
complied with G A A P in the past should
account for the change as a prior period
adjustment for the cor rection of an er ror.
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A fter agreeing to defer SA B 101 until
the fourth quarter of 2000, the SE C
issued a question-and-answer document
("SA B 101: Revenue Recognition in
Financial Statements-F requently Asked
Q uestions and A nswers," O ctober 2,
2000) in response to inquiries f rom
auditors, preparers, and analysts about
applying SA B 101 to specific
transactions. T he document addresses 31
questions on eight topics.
I n June 1999, the Financial E xecutives
I nstitute (F E I) Committee on Corporate
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Reporting, in a letter to SE C C hief
A ccountant Lynn Turner, urged the
SE C
to further delay the effective date of
SA B 101 until the fourth quarter of
1000. F E I said that its members needed
more time to study and implement the
provisions of the bulletin, because its
implications were more significant than
anticipated. T he F E I also maintained
that SA B 101 effectively changed
accepted recognition practices, an action
that would have been better addressed
by the F ASB through due process.
Deferral of SAB 101. T he original effective
date for SA B 101 was years beginning after
December 15, 1999, even though the bulletin
was only issued December 3, 1999. Companies
and auditors complained that SA B 101
effectively changed historically accepted
revenue recognition practices and asked for
more time to study and evaluate the effects of
the interpretations. T he SE C initially defer red
the effective date to fiscal years beginning after
March 15, 2000.
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Auditors and Earnings
management
BY SCOTT B. JACKSON, ASA, FCA
BY MARSHALL K. PITMAN, ASA, FCA CBA, A,FM
T here is growing concern
in the investment
community that certain practices of earnings
management are eroding public con fidence
in external financial reporting and impeding
the efficient flow of capital in financial
markets. C ritics contend that managers abuse
the discretion afforded them by generally
accepted accounting principles (G A A P) and
intentionally distort in formation contained in
financial statements. I n his September 1998
" N umbers G ame" speech, SE C C hairman
A rthur Levitt, Jr., expressed concern about
the practice of earnings management and the
negative effects that this practice can have on
earnings quality and financial reporting.
I ndependent auditors should lead the
crusade to prevent deceptive accounting
practices, because they not only possess indepth knowledge of accounting and
reporting matters, but they also have access
to the audit committee and the board of
directors responsible for scrutinizing a
company's decision makers. F urthermore,
over the past decade the SE C has devoted
considerable effort to empowering audit
committees so that their members can more
effectively discharge their oversight
responsibilities. Consequently, auditors are in
a prime position to curtail abusive earnings
management and help maintain and enhance
public con fidence in financial reporting.
Earnings Management and
Professional Literature
" Earnings management" has been defined
in various ways. O ne definition is
"purposeful intervention in the external
financial reporting process with the intent of
obtaining some private gain." A nother
definition is the "use of judgment in
financial reporting and in structuring
transactions to alter financial reports to
either mislead some stakeholders about the
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underlying economic per formance of the company,
or to in fluence contractual outcomes that depend
on reported accounting judgments." Yet a third
definition is "an intentional structuring of reporting
or production/investment decisions around the
bottom line impact."
Most f requently, accounting accruals (estimates)adjustments to operating cash flows in calculating
net income-are the means for achieving a desired
earnings figure. By their nature, accruals involve
estimation, require subjective judgments, and are
difficult for auditors to objectively verify before
their realization. A lthough auditors are likely to
scrutinize financial statement accounts involving
managers' subjective judgment, it is nonetheless
unlikely that they could fully counteract deliberate,
pervasive efforts to shade accruals in one direction
or another. A uditors develop a range of reasonable
values for an account but rarely insist upon an
exact estimate within that range. N onetheless,
auditors, financial executives, and regulators must
understand the motivations for earnings
management in order to counteract it effectively.
A uditing standards directly relevant to the issue
of earnings management include SAS 57, Auditing
Accounting Estimates; SAS 82, Consideration of Fraud
in Financial Statement Audits; SAS 89, Audit
Adjustments; and SAS 90, Audit Committee
Communications. SAS 57 warns of the potential for
bias in determining accounting estimates. A uditors
should be sensitive to the increased likelihood of
account misstatement that accompanies the
increased judgment inherent in the determination
of its balance. I ntentional, as well as unintentional,
bias in the process of formulating significant
accounting estimates is a common form of earnings
management. Managers' accounting biases stem
f rom a variety of circumstances and incentives. A n
adequate understanding of those circumstances and
incentives is necessary to comply with the spirit of
SAS 57.
T he SE C has addressed the problem, providing
specific, limited advice in relevant SE C
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administrative proceedings, such as its A ccounting
and A uditing E n forcement Releases (A A E R), which
can be found at www.sec.gov/ litigation/admin.shtml.
B roader guidance can be found in the three Staff
A ccounting B ulletins (SA B) released by the SE C in
1999: SA Bs 99, 100, and 101.
SA B 99, Materiality, indicates that qualitative
factors are important considerations in evaluating
the materiality of financial statement misstatements.
T he exclusive reliance on quantitative benchmarks
is unacceptable. For example, an amount, though
quantitatively small, may be considered material if it
affects financial statement trends, allows a company
to meet analysts' earnings expectations, or affects
compliance with loan covenants. Moreover,
misstatements introduced into the accounting
records with the intent of managing earnings are
unacceptable regardless of materiality. T he
difficulties in determining intent notwithstanding,
In Brief
Inside the Motivations and the Methods
Former SE C C hairman A rthur Levitt spoke
loudly and often about the widespread negative
effect on the investing public when it learns that
management has manipulated earnings to report
good per formance when in reality per formance has
been poor. T he SE C has focused on this problem
and, through several staff accounting bulletins,
provided guidance to prevent it. Within the business
community, auditors are the best-equipped
professionals to detect and curtail inappropriate
earnings management.
A uditors can be most effective when they
understand the motivations and methods behind
abusive earnings management. T here are a number
of incentives for managers to manipulate reported
earnings, such as meeting contractual requirements
or
augmenting per formance-based compensation.
W hatever the motivation, there are as many avenues
to earnings management as there are accounting
judgments, estimates, and accruals. As additional
abuses become known, involved parties' reputations
will su ffer and the results they report may look
meaningless to the investing public-and invite
additional regulatory scrutiny and possible penalties.
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business circumstances, including the
incentives discussed below, provide some
vital insights. SA B 99 applies only to SE C
registrants, although it covers issues relevant
to all audit engagements.
SA B 100, Restructuring and I mpairment
Charges, addresses potential accounting
abuses related to restructuring charges,
purchase accounting, and impairment writeoffs that have attracted increased scrutiny
over the last ten years. I n SA B 100, the SE C
staff nar rowly interpreted existing
accounting principles and required additional
disclosures to enhance financial statement
transparency. I n a practical sense, SA B
100 places an increased burden on auditors
to carefully evaluate and scrutinize client
accounting for restructuring activities,
business combinations, and asset impairments
because managers appear to abuse their
discretion in such instances.
SA B 101, Revenue Recognition in Financial
Statements, provides the staff's views on
applying G A A P to selected revenue
recognition issues. G enerally, for revenue to
be recognized, it must be realized or
realizable and earned. T hese criteria are
generally satisfied whenn there is persuasive evidence of an
agreement,
n delivery has occur red or services have
been rendered,
n the exchange price is fixed or
determinable, and
n collectibility is reasonably assured.
SA B 101 also stipulates the revenue
recognition disclosures that registrants
should provide in their financial statements
and in management's discussion and analysis.
It is sometimes difficult to determine when
to recognize revenue, and managers may
make questionable judgments despite their
best efforts. A mbiguity about when to
recognize revenue indicates that these
transactions engender substantial risks for
auditors.
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Incentives to Engage in Earnings
Management
I ncentives lie at the heart of earnings
management. A bsent certain incentives,
managers would make accounting judgments
and decisions solely with the intention of
fairly reporting operating per formance. I n a
variety of situations, however, there are
compelling economic incentives for managers
to engage in earnings management, because
the value of the firm and the wealth of its
managers or owners are inextricably linked to
reported earnings. See the Sidebar for
research related to contractual, market, and
regulatory incentives.
Contractual incentives. Contractual
incentives to manage earnings arise when
contracts between a company and other
parties rely upon accounting numbers to
determine exchanges between them. By
managing the results of operations, managers
can alter the amount and timing of those
exchanges. Four major contractual situations
could stimulate earnings management: debt
covenants, management compensation
agreements, job security, and union
negotiations.
Debt covenants f requently involve accounting
numbers or derivatives of those numbers (i.e.,
working capital, number of times interest
earned). Managers of firms close to violating
those covenants can avoid default by making
income-increasing accounting choices. Even
firms that have violated debt covenants are
candidates for managing earnings because
such actions may improve the firm's
bargaining position in case of renegotiations.
T hese incentives are likely to be compelling
because violations of debt covenants usually
lead to higher cost of bor rowing or new
restrictive covenants.
Management compensation agreements
typically provide for bonuses that are
determined, in part, by firm earnings. By
managing accounting numbers, managers can
in fluence their cur rent and future
compensation. To illustrate, consider a bonus
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ar rangement in which the C E O earns no bonus if
earnings are below a predetermined amount, no
incremental bonus if earnings are above another
predetermined amount, and a predetermined
percentage of earnings if earnings are between
these two amounts. W hen earnings are below the
lower amount or above the upper amount, there
are incentives to manage earnings downward to
improve future results. W hen earnings are between
the two amounts, there are incentives to manage
earnings upward to maximize cur rent-period
compensation.
Managers may also attempt to smooth earnings
out of concern for job security. W hen cur rent
earnings are poor and future earnings are expected
to be good, managers may shift earnings f rom the
future to the present. Conversely, when cur rent
earnings are good and future earnings are expected
to be poor, managers may shift earnings f rom the
present to the future. Managers believe that a
smooth earnings profile is valued highly by
financial analysts and therefore may enter a variety
of transactions and alter operating decisions to
maintain a smooth earnings profile.
D uring negotiations with unions, managers have
incentives to dampen earnings to support a claim
that the company cannot grant wage increases or
needs labor concessions to survive. Because union
representatives are likely to focus on company
earnings, the financial incentives to manage
earnings downward could be quite compelling.
Market incentives. Market incentives to manage
earnings arise when firm managers perceive a
connection between reported earnings and the
company's market value. Casual observation and the
financial press rein force this connection. Managers
can use their accounting discretion to bolster
earnings in the periods sur rounding initial public
offerings and seasoned equity offerings (i.e., stock
offerings by companies that have previously sold
stock to the public) in an apparent effort to alter
investors' perceptions. N ot surprisingly, high
accruals in the periods before stock offerings
presage an earnings decline following offerings,
which is consistent with the claim that managers
shift earnings to the present at the expense of the
future. I nterestingly, earnings declines often lead to
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shareholder lawsuits, suggesting that earnings
management may result in costly litigation.
Management buyout offers (M B Os) of public
stockholders may also encourage earnings
management. Managers typically engage
independent investment bankers to evaluate the
adequacy of buyout offers. I n turn, investment
bankers typically use earnings-based valuation
methods, creating a link between earnings and the
amount that must be paid to consummate an M B O .
Because managers have a financial incentive to
minimize the buyout price, it is not surprising that
some managers choose to manipulate earnings
downward before M B Os.
T he capital markets are sensitive to companies
that miss analysts' earnings expectations or
management's earnings forecasts. Companies in
danger of falling below these earnings targets may
use their discretion to manage earnings upwards. I n
addition, research indicates that managers may
manipulate earnings in an effort to report positive
earnings and earnings growth.
Companies reporting a long string of annual
earnings increases enjoy a higher earnings multiple
than other companies; breaking this pattern often
results in a lower multiple. T he desire to avoid an
earnings decline in this situation could lead to
earnings management.
Finally, investors may look beyond a onetime loss
and only focus on future earnings. Companies
having a bad year may include an unusually large
amount of expenses in cur rent-year earnings (i.e., a
"big bath") to ensure an earnings turnaround in
future years. Big bath charges are quite common,
particularly when there has been a change in top
management, in order to clean up the balance sheet
and provide a f resh start.
Regulatory incentives. Regulatory incentives to
manage earnings arise when reported earnings are
thought to in fluence the actions of regulators or
government officials. By managing the results of
operations, managers may in fluence the actions of
regulators or government officials, thereby
minimizing political scrutiny and the effects of
regulation.
For example, the debate over healthcare reform
during the first two years of the Clinton
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administration centered on prescription drug
prices. I n support of their calls for government
regulation, political leaders called attention to
the "obscene" profits of pharmaceutical
companies. I n response to this scrutiny,
managers of pharmaceutical companies
apparently used their accounting discretion to
dampen earnings during the healthcare debate.
Similarly, there is evidence that managers of
oil companies managed earnings downward
during the 1990 Persian G ulf crisis to deflect
political scrutiny.
T he Department of Justice and the Federal
Trade Commission use accounting earnings as
evidence in prosecuting antitrust cases. T he
costs of an un favorable antitrust ruling can be
extremely high, creating a compelling stimulus
for earnings management. N ot surprisingly,
some companies under antitrust investigation
report downward earnings trends as evidence
to undermine the case against them.
Similarly, the U .S. I nternational Trade
Commission uses accounting earnings as
evidence in evaluating requests for import
relief (e.g., tariff increases, quota restrictions).
Companies that obtain import relief capture
financial benefits. Companies seeking import
relief f requently exhibit reduced earnings
during import relief investigations to
exaggerate the harm caused by foreign
competition and increase the likelihood of a
favorable ruling.
Banking regulators use accounting numbers
to determine compliance with capital adequacy
ratios. Banks close to regulatory minimums
have an incentive to avoid noncompliance and
the costs of increased regulation. Some banks
close to minimum capital adequacy ratios have
undertaken a variety of accounting actions
designed to avoid regulatory noncompliance.
Methods of Earnings Management
T he G A A P accrual accounting system
requires managers to make numerous
accounting judgments that have a profound
impact on reported earnings. E xamples of
accounting discretionary judgments that could
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subtly shade earnings in one direction or
another include:
n Long-term construction contracts require
estimates of progress toward completion and
costs to complete. Managers could use
optimistic estimates of progress toward
completion to in flate earnings.
n Depreciation computations require
estimates of useful lives and salvage values.
Managers could use optimistic estimates of
the life and salvage value of depreciable
assets, reducing depreciation expense.
n A ccounts receivable must be stated at net
realizable value. Managers could use
optimistic estimates of collectibility to
overstate earnings.
n Costs must be classified as product costs or
period costs. By classifying some borderline
costs as product rather than period costs,
managers can reduce expenses during times
of inventory growth.
n G ains on asset dispositions may be fully
recognized in the period of sale. Managers
could time the sale of appreciated assets such
as marketable securities and fixed assets to
bolster earnings.
n Software development companies must
estimate the point at which technological
feasibility is reached for software products
and capitalize software development costs
after that point. Managers could accelerate
this date to avoid immediately expensing
some software development costs.
n A nticipated costs of satisfying war ranty
obligations must be accrued and matched to
revenues. By making optimistic estimates of
product war ranty costs, managers could
reduce cur rent expenses.
n O rdinary repairs are expensed as
incur red, while major repairs are capitalized.
By treating ordinary repairs as major repairs,
managers could bolster cur rent earnings.
n Managers could offer incentives (i.e., price
concessions) to their customers to accelerate
sales and bolster earnings.
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n I nventories must be stated at the lower of cost
or market. Managers could use optimistic market
values, resulting in reduced inventory write-downs.
Audit Procedures
G A A P requires management to make the
discretionary judgments highlighted above. A uditors
should be alert to the situations that could motivate
management to abuse their accounting discretion.
T here are some positive steps that auditors can
undertake to curtail earnings management:
n D uring the risk assessment phase, effort should
be devoted to identifying contractual, market, and
regulatory incentives to manage earnings. A udit
programs and procedures should reflect this
knowledge. T he audit staff should be aware of
company-specific incentives so that tests,
conclusions, and reviews reflect an appropriate
degree of professional skepticism.
n A schedule should be prepared to accumulate
differences between significant management
estimates used to prepare the financial statements
and the best estimates indicated by the audit
evidence, even if these differences are individually
immaterial. I f the individual differences consistently
rein force a directional effect on earnings and the
aggregate difference is material, the auditor should
evaluate the reasonableness of management
estimates taken as a whole.
n A uditors should per form analytical procedures
on total accruals and significant individual accrual
accounts. T hese procedures might include
comparing total accruals in the cur rent year to total
accruals in prior years and total accruals elsewhere
in the industry. Caution should be exercised in
drawing firm conclusions f rom such analyses
because there may be a legitimate basis for
unusually large or small total accruals.
n Conservatism should not by itself be a
justification for unusually large, income-decreasing
accounting estimates or accruals. O verstating
expense in one year means that there will be
upward pressure on earnings in subsequent years,
effectively creating an earnings turnaround.
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n A uditors should explain to management the
unintended consequences of earnings management.
T hese consequences include loss of reputation,
lower-quality earnings, and meaningless numbers.
F urthermore, managing earnings in the cur rent
period may only exacerbate problems in the future.
For example, understating the allowance for
uncollectible accounts in one year puts upward
pressure on bad debt expense in subsequent years.
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FURTHER READING:
INCENTIVES FOR EARNINGS
MANAGEMENT
Contractual Incentives
Debt Covenants
" Debt covenant violation and
manipulation of accruals", by M. Defond
and J. Jiambalvo, Journal of A ccounting
and Economics (May 1994)
" Debt-covenant violations and managers
accounting responses", by A . Sweeney,
Journal of A ccounting and Economics
(May 1994)
Management Compensation
" A dditional evidence on bonus plans and
income management", by J. G aver, K .
G aver, and J. A ustin, Journal of
A ccounting and Economics (February
1995)
" A nnual bonus schemes and the
manipulation of earnings", by R.
H olthausen, D. Larcker, and R. Sloan,
Journal of A ccounting and Economics
(February 1995)
" Earnings-based bonus plans and
earnings management by business unit
managers", by F. G uidry, A . Leone, and
S. Rock, Journal of A ccounting and
Economics (January 1999)
Job Security and Smooth Earnings
" T he in fluence of institutional investors
on myopic R& D I nvestment behavior", by
B. B ushee, T he A ccounting Review (July
1998)
"Smoothing income in anticipation of
future income," M. Defond and C. Park,
Journal of A ccounting and Economics
(June 1997)
" T he timing of asset sales and earnings
manipulation," by E. Bartov, T he
A ccounting Review (O ctober 1993)
Scott B. Jackson, PhD, CPA, is an assistant professor, and
Marshall K. Pitman, PhD, CMA, CPA, an associate professor,
both at the division of accounting and information systems,
University of Texas at San Antonio.
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Union Negotiations
" Earnings management to exceed thresholds,"
by F. Degeorge, J. Patel, and R. Zeckhauser,
Journal of B usiness (January 1999)
" A ccounting choice and troubled
companies," by H . De A ngelo, L. Deanelo,
and D. Skinner, Journal of A ccounting
and Economics (January 1994)
" Market rewards associated with patterns of
increasing earnings," by M. Barth, J. Elliott, M.
Finn, Journal of A ccounting Research (A utumn
1999)
" Labor union contract negotiations and
accounting choices," by S. Liberty and J.
Zimmerman, T he accounting Review
(O ctober 1986)
" O n the association between voluntary disclosure
and earnings management," by R. K asznik,
Journal of A ccounting Research (Spring 1999)
" U nion negotiations and corporate
policy," by H . De A ngelo and L.
De A ngelo, Journal of Financial
Economics (N ovember 1991)
Big Bath Charges
" A ccounting choices of issuers of initial public
offerings," by J. F riedlan, Contemporary
A ccounting Research (Summer 1994)
Market Incentives
Initial Public Offerings
" Causes and effects of discretionary asset writeoffs," by J. F rances, D. H anna, and L. V incent,
Journal of A ccounting Research (1996,
Supplement)
" Earnings management and the long-run
market per formance of initial public
offerings," by S. H . Teoh, I. Welch, and
T.J. Wong, Journal of Finance (December
1998)
" Earnings management and nonroutine
executive changes," by S. Pourciau, Journal of
A ccounting and Economics (January 1993)
" Earnings management and the
per formance of seasoned equity offers,"
by S. Rangan, Journal of financial
Economics (O ctober 1998)
" A n investigation of asset write-downs and
concur rent abnormal accruals," by L. Rees, S.
G ill, and R. G ore, Journal of A ccounting
Research (1996, Supplement)
" Earnings management and the
underper formance of seasoned equity
offerings," by S. H . Teoh, L. Welch, and
T. J. Wong, Journal of Financial
Economics (O ctober 1998)
" Write-offs as accounting procedures to manage
perceptions," by J. Elliott and W. Shaw Journal
of A ccounting Research 26 (1988 Supplement)
Regulatory Incentives
" I nitial public offerings, accounting
choices, and earnings management," by J.
A harony, C. Lin, and M. Loeb,
Contemporary A ccounting Research (Fall
1993)
Political Scrutiny
" Earnings management, the pharmaceutical
industry and health care reform," by J. Legoria,
Research in A ccounting Regulation (v.14, 2000)
" T he effects of proposed health care reform on
accounting accruals," by S. Jackson and M.
Taylor, Journal of A ccounting and B usiness
Research (v.6, 1998)
Management Buyout Offers
" Earnings management preceding
management buyout offers," by S. Per ry
and T. Williams, Journal of A ccounting
and Economics (September 1994)
"Political costs and earnings management of oil
companies during the 1990 Persian G ulf crisis,"
J. H an and S. Wang, T he A ccounting Review
(January 1998)
Earnings Forecasts and G rowth
" Earnings management to avoid earnings
decreases and losses," by D. B urgstahler
and I. Dichev, Journal of A ccounting
and Economics (December 1997)
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Antitrust Investigations
" T he effect of antitrust investigations on
discretionary accruals," by S. Caha, T he
A ccounting Review (January 1992)
Import Relief
" Earnings management during import relief
investigation," by J. Jones, Journal of
A ccounting Research (A utumn 1991)
Banking Regulation
" Capital adequacy ratio regulations and
accounting choices in commercial banks," by S.
Moyer, Journal of A ccounting and Economics
(July 1990)
" Managing financial reports of commercial
banks," by A . Beatty, S. C hamberlain, and J.
Magliolo, Journal of A ccounting Research
(A utumn 1995)
" Tax planning, regulatory capital planning, and
financial reporting strategy for commercial
banks," by M. Scholes, P. Wilson, and M.
Wolfson, Review of Financial Studies (1990)
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Caveat Aestimator: Evaluating
Hidden Liabilities and Risks
BY RICHARD M. WISE, ASA, MCBV, FCBV, FCA
BY
A ny
proper valuation analysis would include
in formation not only regarding the assets,
future prospects and potential of the
business, but will also consider the risks and
liabilities that will be assumed by the
purchaser as part of the transaction. W hile a
business may have a number of off-balancesheet assets-perhaps in the form of
intellectual property, valuable dies and molds,
tools, litigious claims, etc.-there may also be a
host of off-balance-sheet liabilities, whether
contingent, actual or latent, as well as specific
risks. As many of these may not be apparent
at first glance, the business appraiser must
attempt to identify any such exposure that is
neither reflected on the subject's financial
statements nor otherwise apparent. T his
article provides a partial checklist as to the
areas that the purchaser's business valuator
may wish to visit.
"Skeletons in the closet", including hidden
and/or potential liabilities and risks, can
normally be identified f rom management
interviews, a review of files and documents
and, in some cases, f rom external sources.
Some industries typically face constant
exposure, e.g., environmental liability in the
case of certain manu facturers, or loss (or
suspension) of a license in the case of
regulated businesses.
I n the open market (as opposed to the
notional market), adjustments to the
negotiated transaction price may address such
types of concerns. T he use of priceadjustment clauses, or the specific way the
deal is structured, may be a means for the
buyer and seller to address hidden liabilities
or risks that may not be evident. I n notional
" fair market value" determinations, however,
the business valuator must express his or her
valuation opinion in terms of money or
money's worth as of the effective valuation
date; hindsight is inadmissible.
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W hile some of these potential off-balance-sheet
liabilities and risks may be obvious, there are those
that might not immediately come to mind.
1. Foreign Ownership
I n valuing a Canadian business, a U .S. valuator
should be aware of restrictions imposed in certain
cases by the Canadian government on foreign
investment.
T he Department of I ndustry, through I ndustry
Canada, administers "notifications" of new
investments and applications for foreign-investment
approval. O ther than with respect to new
investments by non-residents that would have a
significant effect on the public interest, or on
Canada's "national identity" or "cultural heritage"
(e.g., publishing, filmmaking, videos and music
investments), new business ventures by nonCanadians are subject to either an approval
measure or a notification requirement, depending
on the size and degree of control of the
investment. A lso, to limit the growth of foreigncontrolled businesses in specified Canadian
industries, foreign control is restricted in the
banking, media, airline, insurance, trust, and loan
industries. T he purchaser must in form I ndustry
Canada of the new investment within 30 days of
the transaction. N o further in formation is required
unless the investment is an acquisition of an
existing business by a non-Canadian and exceeds
the specific size and percentage-of-control
thresholds noted below.
U .S. investors are exempt by the North A merican
Free Trade Agreement (N A F T A) in certain situations.
E xcluding the exceptions, an investment review
by the Canadian government will be made when a
foreign entity acquires control of an existing
Canadian business and either of the following two
conditions exists:
1. T he business is being acquired directly
(rather than indirectly through the
acquisition of the non-Canadian parent of
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the Canadian business) and the assets of
the business have a value of at least C dn.
$5,000,000; and
2. T he business is being acquired indirectly
(through the acquisition of a parent
company outside Canada) and the
Canadian assets have a value of at least
C dn. $50,000,000. (W here the Canadian
assets represent more than one-half of the
total value of the deal, in which case the
above-noted $5,000,000 threshold applies).
A ny direct and indirect investments by nonCanadians, which exceed the notification thresholds,
will be reviewed by I ndustry Canada for purposes
of assessing the net benefit to the country. I f the
acquisition of a Canadian business might give rise
to implications regarding Canada's national identity
or cultural heritage, they will be subject to review
by I ndustry Canada, whether or not the abovenoted thresholds apply. U nder N A F TA , the
thresholds are more favorable for U .S. investors, in
that they are higher.
I ndustry Canada considers a number of specific
factors when assessing the net benefit of an
acquisition to Canada in order to ensure that no
detriment to Canada will result f rom the
transaction. 1 T hese include for example, the effects
on competition within Canadian industries, the
compatibility of the activities of the acquiree with
the industrial, economic, and cultural policies of the
federal and provincial governments concerned, the
effect of the investment on Canada's competitive
position in world markets, and so forth.
T herefore, particularly when considering the
market for the business when determining fair
market value, a U .S. business valuator should have
regard to the foregoing, as applicable. A Canadian
business valuator would also have regard thereto,
because who says the market must be limited to
Canadian purchasers? T his was a critical issue in the
valuation of Canadian Regional A irlines during the
arbitration hearings last year between A ir Canada
and the Competition B ureau in O ttawa, because the
voting shares of domestic airlines in Canada may
not be more than 25% foreign-owned and control
must, in substance, be Canadian.
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I mportant foreign-ownership tax issues
may also arise when a " Canadian-controlled
private corporation" (" C CPC ") loses its status
because it becomes foreign-controlled. I n
such circumstances, it can lose (a) the benefit
of lower income tax rates otherwise enjoyed
on business profits, and (b) potential of
recovering "refundable dividend taxes" paid.
I n this later respect, Canada imposes full tax
rates on investment income (other than on
dividends, which are taxed at a special,
lower, flat rate), a portion of which tax is a
permanent tax cost to the C CPC, the other
portion being refundable only if and when
the C CPC, in turn, pays taxable dividends to
its shareholders. A C CPC might have large
amounts of refundable dividend tax
accumulated, awaiting a propitious time to
pay dividends thus triggering the tax refund.
H ence, if control of the C CPC is acquired by
a U .S. buyer, any refundable tax balance is
lost. As with the foreign-control issue
outlined earlier, the valuator must consider
this tax consequence when the most likely
buyer in the marketplace is a non-Canadian.
2. Environmental Risks
A purchaser may face two types of
environmental liability: O ne as the result of
the condition of the acquired facilities as of
the date of the acquisition, the other relating
to the ongoing operations of the facility.
As with income tax war ranties — typical
in any share purchase agreement —
environmental-risk exposure to a purchaser
is generally covered through representations
and war ranties f rom the vendor. O ften, an
environmental assessment will be per formed
by environmental engineers or scientists
prior to closing. Routine environmental
assessment is critical to any corporate
compliance program. A routine audit will, at
least as a minimum, identify problems such
as spillage, discharges, and emissions.
Because of potential non-compliance with
environmental laws, a purchaser of a
business (mainly manu facturing or
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processing) may be exposed to charges that it
violated environmental laws in the past and
is violating them cur rently. I n cases where
there is no violation of environmental law
(because, say, the air or water emissions are
not significant and may be in compliance
with the relevant environmental law), they
may nonetheless be leading toward an
environmental liability. (For example, claims
in respect of toxic and chemical exposure are
becoming more popular and are being
asserted through new and novel theories
such as medical monitoring. 2 It is therefore
essential for the purchaser to be aware of
tort and regulatory implications with respect
to the acquiree's business strategies.)
I n an asset transaction as opposed to a
share transaction, the purchaser may have
the obligation of per forming a clean-up of
the property being acquired — even the
neighboring properties that may have the
potential of being adversely affected. O n the
other hand, in a share (versus assets)
transaction, the purchaser might be held
liable for past spillages and/or discharges
which may have contaminated adjacent
properties. W hile, in practice, these types of
exposure are dealt with by representations
and war ranties provided by the vendor, it is
not unusual for environmental issues to
affect the price paid in a transaction. I f
environmental risk does exist, it is often
difficult for the buyer to obtain an indemnity
f rom the seller, because the latter would
have no desire to pay for a third party's
car rying out of remediation, because:
•
•
Even though the seller would have sold
the acquiree, there would still be an
outstanding "long-term" liability; and
I f the seller were to be liable for a future
contingent liability, it would certainly
wish to have control over the business
operations and certainly over the
remediation process.
Real-world buyers and sellers often
negotiate between themselves a price that
would be fair to the buyer, considering that
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the task and responsibility of complying with the
environmental law requirements will be with the
new owner.
For example, a more recent statute enacted in
the U .S. is the Endangered Species Act, which may
come into play where there are wetlands, in the
case of commercial business.
3. Fraud Allegations
I n some cases there might be potential criminal
allegations against the company for past f raudulent
practices, and if ultimately such types of allegations
are war ranted, they may expose the business to loss
of reputation and goodwill as well as to other
financial loss. W hile the valuator needs not be a
sleuth, due diligence would suggest that certain of
the company's files, including cor respondence and
claims f rom third parties, might be reviewed and
discussed with management and/or counsel.
T he valuator might also discreetly inquire as to
whether any of the senior management personnel
or directors of the company have been involved in
major civil litigation, criminal proceedings,
regulatory commission violations, or investigation by
Securities Commissions or income tax authorities.
4. Potential Tax Liabilities
Probably the most common war ranties given by
the vendor of shares in an open-market transaction
relate to taxation. T he tax authorities might
per form a field audit (income tax, sales tax, G oods
and Services Tax in Canada, etc.) a few years
following the transaction and reassess the company
for taxes relating to the taxation years preceding
the transaction. Typically, purchase and sale
agreements address this issue. Tax evasion 3 is
another story, however.
I n Canada, for example, a worst-case scenario
would be when the declared net income had been
suppressed through a tax-evasion scheme. I n such
event, the company would face significant interest
and penalties, neither of which would be taxdeductible. For example, assuming $400,000 of
undeclared income, there would be taxes, interest,
and penalties, in aggregate, of at least $600,000,
i.e., 150% of the undeclared income, as follows:
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Federal income tax
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Penalties (civil) - federal and provincial
102,000
Interest thereon - say
162,000
Fine imposed for tax evasion (equal to federal
Income tax evaded)
132,000
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customer(s) prior to the transaction date.
W hile the "writing was on the wall,"
disclosure was never made to the purchaser
— or to the valuator — with lawsuits
resulting because of lack of disclosure.
$132,000
Provincial income tax
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$600,000
Technically, under the Income Tax Act , 4 the fine
could amount to 200% (rather than the $132,000
above, which equals "only" 100% of the federal tax
evaded). A ctions taken by Canada Customs and
Revenue A gency (" C C R A ") are not limited to
income tax evasion. C C R A will also attack f raud
perpetrated by 'entitlement f raudsters," in the case
of Canadian and provincial government incentive
grants, loans, and subsidies. T he business valuator
should make reasonable inquiry when the company's
balance sheet (or a note thereto) refers to such types
of government funding.
I n Canada, potential liabilities can even result
f rom how the deal is structured. Q uite apart f rom
the typical "assets vs. shares" valuation and pricing
issues, in an asset purchase, the federal G oods and
Services Tax would be imposed. 5 Provincial retail
sales taxes may also become exigible on the sale of
tangible personal property or goods (the tax being
payable where the properties or goods are located). 6
Canadian land and buildings transfer red in an asset
sale would subject the purchaser to land transfer
tax.
T hese latter types of taxes are quantifiable and,
while not appearing on the financial statements, are
matters to be considered by the valuator.
A review should also be made of key
supplier, employee and banking
relationships as to continuity, reliability, and
harmony. Will these possibly be adversely
affected following acquisition? A lso, if there
is a reorganization or "shake-up," and a key
or senior employee is being moved f rom his
or her position (or asked to leave the
company), might the company face exposure
to a potential wrongful-dismissal suit? W hat
if a key employee also owns shares of the
company? Will the company also face the
risk of an oppression-remedy lawsuit under
the relevant business corporations act?7 I n
some cases the lawsuit can be doublebar reled: alleged wrongful dismissal as well
as shareholder oppression.
6. Other Risks and Potential
Liabilities
I n addition to the foregoing types of risks
and potential liabilities, there are host of
other risks that could give rise to liabilities
or exposure which would generally not raise
a "red flag" resulting f rom a review of the
financial statements. T he following is a list
of some additional areas that may require
review by the business valuator in addressing
issues that may impact "price" and, hence,
value:
(a) Warranties and guarantees
5. Potential Loss of Customers,
Suppliers and Key Employees
•
T he potential risk of losing valuable customers,
clients, suppliers, key employees and/or other
intangible assets, including relationships, must also
be considered. Many valuators have seen instances
in which a business was acquired, and shortly
thereafter, a major customer was lost. I n many of
these cases, there had been f requent exchanges of
cor respondence between the company and its
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A ccountants official H andbook 8
recognizes that there are certain
unlikely contingent looses which, if
con firmed, would have a significant
adverse effect on the financial
position of an enterprise, and
suggests that such unlikely contingent
losses, which might include
guarantees on behalf of others, be
disclosed.
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•
A re there possible loan guarantees
with respect to which the company
being valued may be called upon to
honor?
•
A manu facturer that war rants its
products or services has an obligation
to cover the costs of providing the
war ranty work for units that have
been sold. W here an acquisition has
taken place, customers expect the
acquiror to stand behind these
war ranties. To the extent possible, a
value estimate should be made as to
the contingent liability with respect
thereto. (O n the other hand, if the
financial statements of the acquiree
include a war ranty reserve liability,
which is deducted f rom the purchase
price, no valuation may be necessary). 9
•
With respect to guarantees (where the
business was not the bor rower but
rather a guarantor), was an analysis
made as to the likelihood of the
company being called upon in the
future to make good?
creditors) who may have reason to file an
application under the oppression-remedy
provisions of the relevant corporate statute?
I n many jurisdictions, winding-up — rather
than a buy-back of the minority shares — is
what is sought.
(e) Patent, copyright, trademark and trade name
infringement risk
Does the business operate, purchase
and/or sell internationally? I f so, does
it protect itself with cur rency futures,
and for what future term? A n import
or export business' bottom line can be
materially affected. A re foreign
exchange gains and losses dealt with
appropriately in the valuation?
A re there possible intellectual property
in f ringement claims that might be filed by
another party? I n Canadian copyright and
trademark cases, for example, the owner is
entitled to both the damages it actually
su ffered as well as the in f ringer's gains (to
the extent the latter do not duplicate those
included in the recovery of lost profits). 10
•
D ue diligence should be exercised in
connection with potential allegations by third
parties with respect to copyright, trademark,
trade-name, and patent in f ringement, and
un fair competition.
(f) Political risk (where a change in government may
materially affect the acquiree).
(g) Penalty clauses in existing contracts
(b) Currency exchange risk
•
•
•
T he valuator might inquire as to
whether the company has been
"delivering" as promised (or pursuant
to agreements)?
•
A re there potential penalties, damages,
or adverse, long-term effects f rom
poor deliveries?
(h) Supplier risk
•
(c) Currency risk
•
Is there a risk of the notional
purchaser not being able to repatriate
funds f rom the country(ies) in which
certain of the subject's businesses are
being conducted? A nd if the funds
can come out, what are the
withholding taxes? A re they creditable
against the recipient's taxes? Is there
tax-treaty protection?
(i) Weather risk
•
(d) Oppression remedy risk
•
A re there shareholders (or even
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To what extent does the company rely
upon one or two major suppliers, in
that the failure of them to deliver
product may expose the company to
liability to its own customers by nondelivery? A re there long-term contracts
in place? A re these suppliers stable? I f
there is a unionized work force, do they
have good working relationships with
the union?
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I n certain industries, weather may have
a bearing on the fortunes of the
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business. Such industries include, in
particular, ski resorts, transportation,
f ruits and wheat crops, etc. 11 A dverse
effects to the business f rom weather
conditions can potentially cause a
company to default on certain of its
bor rowing covenants, thereby
subjecting it to future adverse risks
and liabilities. H ow are these addressed
by the valuator?
•
Litigation resulting f rom product
liability is not in f requent, and
un fortunately does not generally
sur face until after the acquisition has
been completed.
•
W hile there is no precise mathematical
formula for evaluating litigious claims
that remain with the company, the
following factors may be relevant in
attempting to assess the risk inherent
in such proceedings when valuing the
shares:
For many businesses, location is critical.
Is there the possibility/probability of an
expropriation of the property on which the
target is conducting its business? Can a
justifiable alternative location be found?
W hat about zoning issues? Recently, the
City of Windsor, O ntario, expropriated an
entire city block of prime property, f ronting
on the Detroit River, to make way for the
new Daimler C hrysler building. Some
of the businesses affected had to move
to comparatively disadvantageous
locations.
•
Management representations are typically
obtained as to whether lawsuits or other
claims have been filed against the company
and, if so, the status thereof. To the extent
that there are lawsuits, but the company has
filed a counterclaim against the plaintiff, the
net effect on the financial position of the
company should be evaluated to the extent
possible. W here proceedings have already
been instituted or commenced, it is unlikely
that the buyer would want to inherit the
attendant problems and exposure. (I n
the open market, if the possible exposure is
material, the transaction may be structured
in a particular way, subject to the relevant
legal constraints.)
ž T he availability, as well as the
credibility and ability (both actual
and perceived), of fact witnesses
and expert witnesses who may be
called by the parties;
ž T he controllable and uncontrollable
costs of the proceedings (including
motions and trial), to both the
defendant and the plaintiff,
including legal fees, expert fees,
witness fess, court costs, etc.;
ž T he possibility/probability of appeal
by either party;
ž I nterest rates — both market and
pre-judgment — which may be
applicable;
ž T he length of time for the trial and
subsequent appeals;
ž Settlement prospects;
ž Prospect of arbitration or
mediation;
ž E xtent and quality of documentary
evidence available to the respective
parties, etc.
(l) Contractual Obligations
Even if the company itself is not involved in
any significant litigation or threatened by
pending or unsettled claims, it is possible
that the industry as a whole may be facing
legal problems or potential litigation.
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T here may be potential antitrust
problems; is a possible review by the
Canadian Competition B ureau or the
U .S. Justice Department imminent?
(k) Litigation
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(j) Expropriation (eminent domain)
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T he valuator should be apprised of
the following, as applicable:
ž Commitments that involve a high
degree of speculative risk, where
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the taking of such risks is not
inherent in the nature of the
subject's business;
ž Commitments to make expenditures
that are abnormal in relation to the
financial position or usual business
operations, e.g., commitments for
substantial fixed-asset expenditures;
expanding technology risks. H ow has the
valuator considered this, if applicable?
•
(o) Other
ž Commitments to issue shares and/or
options and war rants;
•
U nrecorded liabilities may also include
vacation pay, sales returns, (volume and
cask) allowances and discounts, loss contracts,
etc. F uture government legislative changes
are also a risk assumed by the purchaser;
however, there is no way to evaluate such a
potential "liability".
•
I f there is a collective agreement with
employees, this should be analyzed by the
purchaser's valuator.
•
A re there potential rebates and allowances
of a material nature that may be triggered
following acquisition? H as provision been
made in the financial statements (or other
disclosures) of the business? Depending on
the particular status as of the relevant date,
it may be possible to quantify this liability for
valuation purposes.
ž Commitments that will govern the
level of a certain type of
expenditure for a considerable
period into the future.
(m) Government loans and grants
•
T he company may have received
government assistance in the form of
loans, grants, sub-vention payments
and/or other help. T here may be
requirements under the terms of such
assistance ar rangements whereby the
company must, under certain
specified conditions, repay all or a
portion of these funds. T he valuator
should attempt to assess the likelihood
of these liabilities becoming exigible,
and quantify them to the extent
possible.
(n) Technology risks
•
A con ference in the U nited States
presented by the B usiness Litigation
and I nsurance Law Committees of the
Defense Research I nstitute introduced
its subject matter by stating that
increasing investment in, and
reliance on, in formation technology is
creating entire new areas of litigation
for which businesses must be
prepared. System hardware and
software claims, security breaches, the
pervasiveness of the I nternet, and
burgeoning intellectual property claims
are the rapid growth areas in
litigation. Major insurance
underwriters are developing
innovative products to cover new and
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T he business valuator should attempt to
identify potential risks and exposure that the
business may be facing in connection with
possible in f ringement claims.
7. Conclusion
I n a section on contingencies entitled
" Measurement of U ncertainty", the Canadian
I nstitute of C hartered A ccountants H andbook refers
to the uncertainty relating to the occur rence or
non-occur rence of a future event which would
determine the outcome of a contingency. T he
C I C A states that this can be expressed by a range
of probabilities, which provide a basis for
establishing the appropriate accounting treatment.
I n this regard, the business valuator might wish to
analyze future contingencies in the context of
three areas of a range of probabilities, by a general
description as follows:
a. " Likely" — the chance of the occur rence
(or non — occur rence) of the future
event(s) is high;
b. " U nlikely"-the chance of the
occur rence (or non-occur rence) of the
future event(s) is slight;
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c. " N ot determinable" — the chance of the
occur rence (or non-occur rence) of the
future event(s) cannot be determined.
I n real-world acquisitions, adjustments are made
to the purchase price in connection with one or
more of the above-noted contingencies, which are
but an example of the types of issues that may
impact price/value.
H aving per formed the analysis, the valuator should
then ask himself or herself: "would I advise a client
to buy for the price??"
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10. For a discussion involving damages
resulting f rom intellectual-property
in f ringement, see Valuing Intellectual
Property and Calculating Infringement
Damages, Consulting Services Practice A id
99-2, A merican I nstitute of Certified
Public A ccountants (1999); and Richard
M. Wise, " Valuation of I ntellectual
Property", Making Sense of Intellectual
Property, T he Meredith Memorial
Lectures, McG ill U niversity Faculty of
Law (Montreal, 1996).
11. I n Arctic Gardens Ltd. v. CIBC , 1993 RJQ
1086, one of the issues addressed by the
Q uebec Superior Court was the effect of
the weather on plaintiff's business.
Endnotes
1. Since the enactment of the Investment
Canada Act (1985), only one investment by
a non-resident of Canada has been
rejected under his process.
12. N ovember 2-3, 2000, C hicago, U .S. A .
13. C I C A H andbook , Section 3290.06. I n the
U .S., the Federal A ccounting Standards
Board has also addressed this issue in
Statements 5 and 11.
2. For example, neuropsychiatric and
neuropsychological claims, epidemiology
and toxicology, child and adolescent
development and toxic exposure, toxic
shock, etc.
3. Wise, Richard M., " Tax F raud and Mens
Rea Forensic A ccounting", Proceedings of the
Sixth Annual Fraud Conference , Association
of Certified F raud E xaminers (Montreal:
2000).
4. Paragraph 239(1)(f).
5. Section 165 of the Canadian Excise Tax Act , RSC
1985, c. E-15.
6. Certain exemptions f rom provincial retail
sales tax are available with respect to
inventories, real property and other assets,
depending on the province.
7. For example, in Canada it would be under
section 241 of the Canada Business
Corporations Act .
Richard M. Wise of Wise, Blackman, a Montreal-
8. Section 3290.171. T he H andbook contains
the accounting and auditing standards of
the C I C A as well as related
recommendations to its members.
based business valuation firm, was President of the
CICBV, International Governor of the ASA, Secretary
of the ASA BV Committee, and is a member of its
Standards subcommittee. He is author of Financial
Litigation—Quantifying Business Damages and
9. I f the acquiree would be reimbursed by
the manu facturer for any portion of the
parts and labor, this would be taken into
account.
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Values and co-author of Guide to Canadian Business
Valuations.
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