THE THOUGHT PROCESS

An Occasional Newsletter
Published by Value Concepts LLC
Wyndmoor, PA January 2003

ACQUISITIONS and ALLOCATIONS

Introduction

Title II of the Sarbanes-Oxley Act states that it shall be unlawful for a registered public accounting firm, that performs for any issuer any audit required by the rules of the SEC, to provide to that issuer any non-audit service, including appraisal or valuation services.

As written, Sarbanes-Oxley applies solely to audits of publicly traded companies. By contrast, the set of rules created by the FASB, known as GAAP, or GAAS, applies to all US business entities, both public and private.

SFAS 141 requires all acquisitions to be accounted for as purchase transactions. As a consequence, there is renewed emphasis on allocation of purchase price for financial reporting purposes. For example, considerable care must be exercised in the valuation and disclosure of purchased intangible assets, as noted in SFAS 142.

In this article, we briefly survey allocation of purchase price, in light of the above, as it affects (1) smaller private companies; (2) larger private companies; (3) smaller public companies; and (4) larger public companies.

I. Smaller Private Companies

Following an acquisition, the smaller private company will at the very least prepare an allocation for tax purposes under Section 1060. Intangibles need not be valued separately because as a residual they can be lumped with goodwill and depreciated over 15 years. Most very small companies, often family operated, are almost exclusively concerned with the tax implications of their decisions. The firm may not even prepare statements in accordance with GAAP, because its total interested constituency may be no more than several individuals.

However, if the small family-run firm is considering a sale, it is advisable for it to have good audited financials. The generally larger buyer will want as smooth a transaction and integration as possible. The preparation of 3-5 years of audited financials facilitates this process, and creates confidence in the buyer that the seller’s property is well-prepared for sale.

If the small private company is a start-up or early stage firm, it will need audited financials. If it is to grow rapidly through acquisitions, it is important for it to have an appraisal / allocation done by an outside independent valuation firm, even though this is not legally required at this point. This is due to the likelihood that the firm will soon either become a public company, or be acquired by one. When this happens, it will need to find appraisers independent of its auditing firm to be in compliance with Sarbanes-Oxley. In addition, both the audited financial statements and the appraised asset values may be perceived as more credible if the company has engaged an appraiser other than its auditing firm.

II. Larger Private Companies

By the time a firm is large enough to be acquiring another firm, it begins to have a few more shareholders, perhaps other than family members. GAAP-based financials may become more necessary due to the consistency of presentation of such statements, the perceived decrease in risk, and to facilitate bank financing. If the company is committed to having audited statements, then the accountants will not sign off on a statement that includes an allocation of purchase price unless it has been done in accordance with SFAS 141-142. The auditing firm may have one or more valuation consultants on staff to handle the intangibles. There will not be a Sarbanes-Oxley auditor independence problem because the company is private.

A larger private firm is larger for one of two basic reasons: (1) By internal or external means, the company has grown from a small company over a significant period of time; or (2) It may have been a large public company, that has been taken private through an LBO. In either of these cases, the firm is almost certain to be preparing audited financials. If it has been private for its entire existence, it now has enough shareholders and other constituencies to necessitate audited financials. If an LBO situation, the buyout group is fully familiar with the financials of the company when it was public, and will want to continue to track its performance very carefully as it moves toward an exit strategy.

By virtue of having audited financials, these firms will be obliged to follow SFAS 141-142 for the treatment of the allocation of purchase price for any acquisition initiated after June 30, 2001 (the effective date of SFAS 141-142).

III. Smaller Public Companies

The smaller public firm is generally either a recent IPO, or else is a spin-off of a larger public entity. It will definitely have audited financials, prepared by a firm that is registered with the SEC to audit publicly traded companies. When making an acquisition allocation, it will be required to use an appraisal firm that is independent of its auditors. The SEC has recently demonstrated its intent to monitor and discipline small public firms in as thorough and consistent a manner as large public firms. If the statements do not conform to GAAP, the now sharp-eyed investment community will raise questions. If the appraisal firm is not independent of the auditor, the SEC will enforce the auditor independence article of Sarbanes-Oxley.

IV. Larger Public Companies

A larger public firm must have audited financial statements, as well as file innumerable documents with the SEC, most of which are available for public viewing. The accounting for an acquisition by a larger public company must follow SFAS 141 and 142. Sarbanes-Oxley specifies that an outside, independent appraiser must be engaged to assist in the allocation of the purchase.

For tax purposes, such firms may well use the values developed for financial reporting purposes. The incremental cost of transferring these values to Form 1060 is minimal. There is the added benefit of establishing the tax basis of the firm’s intangibles, something rarely done through most of the 1990s.

A large company is likely to have a large accounting firm doing its books. Without exception, the larger accounting firms have (until very recently) had valuation specialists on staff. Many still do.

The valuation arms of some of the largest accounting firms have recently become legally separate from their audit divisions. A larger public company may choose to engage the services of the recently separated valuation group of its Big Four auditor. However, for any number of reasons, the Big Four and their until-recently-affiliated entities will be charging more for their services than previously. For the cost-conscious mid-sized public company, the opportunity to work with a truly independent appraisal firm is presented as never before.

Summary

Smart companies, whether large or small, public or private, will have audited financials prepared. To do this, their auditors must follow GAAP. Recent FASB statements require purchase-only accounting for acquisitions, and a revised, much more rigorous allocation of the purchase price. In most cases, the new GAAP rules necessitate the use of valuation consultants (appraisers), especially in the valuation of intangible assets.

If you are a private company, you may engage valuation consultants that are members of the same accounting firm that audits your financial statements. If you are a public firm, Sarbanes-Oxley specifies that you must use valuation consultants that are members of a firm OTHER than the accounting firm that audits your financial statements. This is part of Title II of the new law, entitled Auditor Independence. Auditing and valuation (as well as most other types of consulting) must be separate.

Value Concepts has been an independent appraisal firm since 1996. To learn more about us, visit our web site at www.valueconcepts.net .

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