The principal objectives in auditing business combinations are to determine whether:
- The transaction is properly approved (Rights and obligations assertion)
- The transaction is a business combination (Existence, Completeness, Valuation/Measurement and Presentation and disclosure assertions)
- The acquirer is properly identified (Existence/Occurrence, Completeness, Valuation/Measurement, Rights and obligations and Presentation and disclosure assertions)
- The acquisition date is correct (Existence, Completeness and Valuation/Measurement assertions)
- The consideration transferred is properly identified, classified and measured (Existence, Completeness, Valuation/Measurement, Rights and obligations and Presentation and disclosure assertions)
- The identifiable assets acquired, liabilities assumed and any noncontrolling interests in the acquiree are properly recognized and measured (Existence, Completeness, Valuation/Measurement and Presentation and disclosure assertions)
- Goodwill or a gain from a bargain purchase is properly recognized and measured (Valuation/Measurement and Presentation and disclosure assertions)
- Subsequent adjustments are properly recognized (Existence/Occurrence, Completeness, Valuation/Measurement and Presentation and disclosure assertions)
This article is read in conjunction with Tianlong Audit Methodology.
1. Inherent risk factors
The following items are examples of inherent risk factors that may increase the inherent risk for the relevant assertion(s) for business combinations. When the opposite situations exist, that would decrease inherent risk for the relevant assertion(s) for this area.
|Inherent risk factor||Related assertions|
|Nature of the item|
|Our prior audit experience indicates that there have been frequent errors associated with the accounting for business combinations.||Existence, Completeness, Valuation, Presentation & Disclosure|
|The nature of the business combination is complex and/or significant.||Valuation, Presentation & Disclosure|
|The business combination is consummated at or near period end.||Existence, Completeness, Valuation|
|There is significant measurement uncertainty in valuing certain items of the business combination (e.g., consideration transferred, assets acquired, liabilities assumed).||Valuation|
|The entity expects the business combination to result in a bargain purchase.||Valuation, Presentation & Disclosure|
|Documentation is susceptible to manipulation by management.||Existence, Completeness, Valuation|
|Nature of the business/industry|
|The volume of transactions is high.||Existence, Completeness, Valuation|
|The entity operates in an industry that is consolidating resulting in stakeholder pressure to utilize excess cash to make an acquisition.||Valuation|
|There are non-standard journal entries that are recorded manually to account for the business combination.||Existence, Completeness, Valuation|
|Policies, procedures, and controls are not well defined, and management’s documentation is less rigorous than for more common classes of transactions.||Existence, Completeness, Valuation, Presentation & Disclosure , Rights & Obligations|
|The entity is required to consolidate a significant number of entities.||Existence, Completeness, Valuation, Presentation & Disclosure|
|Organization of the entity|
|Personnel responsible for this area have a lower level of competence or experience in accounting for business combinations.||Existence, Completeness, Valuation, Presentation & Disclosure|
|The entity has inadequate IT systems for the volume of transactions, size, and/or complexity of this area.||Existence, Completeness|
|Management employs a valuation specialist that is not competent, capable or objective.||Valuation|
2. Primary Substantive Procedures applicable to business combinations
The following is the list of PSPs for business combinations:
- 01: Review transaction agreement(s) and meeting minutes
- 02: Determine whether the transaction is a business combination
- 03: Identify the accounting acquirer
- 04: Evaluate the acquisition date
- 05: Determine what is part of the business combination
- 06: Test consideration transferred
- 07: Identify the assets acquired and liabilities assumed
- 08: Perform opening balance sheet procedures
- 09: Test goodwill (or bargain purchase gain)
- 10: Evaluate disclosure
- 11: Evaluate the measurement period and review subsequent adjustments
2.1 Review transaction agreement(s) and meeting minutes
Obtain and review the executed purchase and sale agreement and any related attachments, including any arrangements entered into contemporaneously or in contemplation of the transaction.
Obtain and review meeting minutes (and attachments) which include approval of the transaction by those charged with governance (TCWG).
Review key terms and conditions
Obtain the purchase and sale agreement and other relevant documents such as information memoranda, deal models or Board presentations. Review the key terms and conditions to determine whether they are consistent with those approved by TCWG.
Review TCWG support
Obtain and read any documents submitted to TCWG for the approval of the transaction, including presentations/valuations prepared by external financial advisors or internal mergers and acquisitions personnel.
Review TCWG approval
Obtain and review meeting minutes (and attachments) to determine whether the transaction was properly approved by TCWG (or others with appropriate levels of authority for approval).
2.2 Determine whether the transaction is a business combination
Obtain and review management’s analysis summarizing the accounting treatment of the acquisition.
Evaluate if set is a business
Evaluate whether the assets acquired and liabilities assumed meet the definition of a business.
If the assets acquired and liabilities assumed do not meet the definition of a business, the transaction is accounted for as an asset acquisition.
Evaluate the nature of the transaction
Understand the relationship of the parties to the transaction and determine whether the transaction should be accounted for as a business combination or a transfer between entities under common control or common ownership.
2.3 Identify the accounting acquirer
Obtain and review management’s analysis identifying the accounting acquirer.
Determine if the entity obtained control
Evaluate the guidance in the applicable financial reporting framework to determine whether the entity obtained control of the acquiree.
Determine acquirer when not obvious
When the acquirer is not obvious, evaluate the factors in the applicable financial reporting framework to determine the accounting acquirer (including consideration as to whether the transaction should be accounted for as a reverse acquisition).
In a business combination effected primarily by exchanging equity interests, the acquirer usually is the entity that issues its equity interests. However, the accounting acquirer may not always be obvious. In such situations, we apply judgment and assess whether the company has appropriately applied the following factors in determining the acquirer:
- Relative voting rights
- Existence of a large minority voting interest
- Composition of the governing body
- Composition of the senior management
- The terms of the exchange of equity interests
- Relative size of parties to the transaction
2.4 Evaluate the acquisition date
Obtain and review management’s analysis of the determination of the acquisition date.
Determine date control was obtained
Determine whether the date control was obtained is consistent with management’s determination of the acquisition date, including an evaluation of the date that consideration was transferred, assets were acquired or liabilities were assumed or incurred, or equity interests were issued (i.e., the closing date or consummation date).
If no consideration was transferred, determine whether the acquisition date is consistent with the date on which control was obtained.
If the business combination requires regulatory or shareholder approval (or shareholder approval is sought) by either the acquirer or the acquiree, control generally does not transfer until such approval is obtained.
2.5 Determine what is part of the business combination
Obtain and review management’s analysis of whether any transactions with the acquiree should be accounted for separate from the business combination (e.g., settlements of preexisting relationships, compensation to employees or former owners for future services, reimbursement to acquiree for acquisition-related costs).
Review the factors in the applicable financial reporting framework to determine whether any transactions with the acquiree should be accounted for separate from the business combination (e.g., settlements of preexisting relationships, compensation to employees or former owners for future services, reimbursement to acquiree for acquisition-related costs). Based on our understanding of the transaction(s) or arrangement(s), document our conclusion as to whether any such transactions should be accounted for separate from the business combination.
The general principle in assessing whether the arrangement is a separate transaction is based on the concept of who receives the primary benefits from the arrangement. If the arrangement is entered into by or on behalf of the acquirer or primarily for the benefit of the acquirer or the combined entity, rather than primarily for the benefit of the acquiree (or its former owners) before the combination, the arrangement is likely a separate transaction that should be accounted for separate from the business combination based on its economic substance. We apply judgment and assess whether the company has appropriately applied the following factors in determining whether the arrangement is a separate transaction:
- The reasons why the parties to the combination entered into the transaction or arrangement
- Who initiated the transaction
- The timing of the transaction
Determine whether contingent payments to employees or selling shareholders are part of the business combination or a separate compensation transaction.
We evaluate whether contingent payments to employees or selling shareholders are part of the business combination or a separate compensation transaction. In doing so, we apply judgment and assess whether the company has appropriately applied the following factors:
- Continuing employment
- Duration of continuing employment
- Level of compensation
- Incremental payments to employees
- Number of shares owned
- Linkage to the valuation
- Formula for determining contingent consideration
- Other agreements and issues
Determine whether any acquisition costs are recorded as an expense in the period that the related services are received unless the costs relate to the issuance of debt or equity, in which case, they should be recognized in accordance with other applicable accounting standards.
Obtain support (e.g., invoices, agreements) for any individually significant acquisition costs and vouch payment of these amounts. Document the basis on which the individually significant costs were determined.
When performing the search for unrecorded liabilities, consider potential acquisition-related costs. If any acquisition-related costs were identified, determine the appropriate accounting treatment.
2.6 Test consideration transferred
Agree consideration transferred (e.g., wire transfer, equity issuances) to the acquisition agreement and/or supporting documentation and to the total amount recorded and disclosed.
Determine whether the consideration transferred (including any contingent consideration and share-based payment replacement awards) is appropriately:
- Measured as of the acquisition date
- Classified (e.g., as a liability or equity)
Vouch cash consideration transferred to bank statement detail.
Vouch equity issuances to treasury/share detail where applicable.
Determine whether the consideration transferred has been appropriately measured in accordance with the applicable financial reporting framework. When consideration transferred (e.g., contingent consideration) has been measured using prospective financial information (PFI), consider engaging the assistance of Tianlong specialists when necessary.
Determine whether the contingent consideration arrangement is appropriately classified as a liability or equity.
Evaluate replacement awards
Determine whether share-based payment replacement awards are appropriately measured and accounted for, including the implications of any change-in-control provision in either the acquiree award or the purchase agreement.
When the acquirer is obligated to grant share-based payment awards as part of a business combination, the replacement awards should be considered in the determination of the amount of consideration transferred for the acquiree.
- terms of the acquisition agreement
- terms of the acquiree’s awards
- applicable laws or regulations to determine whether an obligation exists.
When a replacement obligation exists, we are alert to the following items and evaluate whether the company has appropriately considered them in the measurement of the consideration transferred:
- Whether the replacement award is subject to graded vesting or cliff vesting
- Estimated forfeitures
- Whether the replacement award has a performance or market condition
When a change-in-control provision exists either in the acquiree award or in the purchase agreement, it is important to determine whether such provisions were preexisting or added in contemplation of the business combination. We review the agreements and inquire of management to make such a determination.
2.7 Identify the assets acquired and liabilities assumed
Perform procedures to determine all assets acquired and liabilities assumed have been identified and exist.
Identify all assets and liabilities
Review the purchase and sale agreement and other available information (e.g., opening balance sheet) to determine whether all assets acquired and liabilities assumed have been identified.
Test closing balance sheet
Obtain closing balance sheet and perform audit procedures over significant accounts as of the transaction closing date.
The audit procedures performed over the closing balance sheet are similar in nature and extent to the primary substantive procedures and other substantive procedures required by TAM for the respective account.
Inquire of management and consider inquiring of predecessor auditors regarding any preacquisition contingencies (e.g., environmental liabilities, litigation losses, insurance claims, warranty obligations). Perform procedures to determine the identification, recognition and measurement of any preacquisition contingencies (e.g., review company press releases/disclosures about the acquisition, and review the financial statements of the acquiree).
Test account mapping
Obtain and test trial balance account mapping between the acquirer and acquiree accounting systems.
2.8 Perform opening balance sheet procedures
Obtain opening balance sheet and test whether the assets acquired and liabilities assumed have been appropriately recognized and measured in accordance with the applicable financial reporting framework.
Test fair values
Test the fair value of the assets acquired and liabilities assumed (including the reasonableness of assumptions and estimates used in the valuation, such as PFI).
If the fair value of assets acquired or liabilities assumed has been measured using PFI, consider performing the PSPs/ePSPs for PFI and engaging the assistance of other Tianlong specialists when necessary.
Evaluate the work of management’s specialist (employed by the entity or external), if applicable.
Evaluate deferred taxes
Evaluate the appropriateness of any deferred taxes related to the assets acquired and liabilities assumed. Assess the appropriateness of the tax rate used. Consider involving Tianlong Tax specialists.
Agree to GL
Agree on the recognized acquisition-date amounts (e.g., fair value) of the assets acquired and liabilities assumed to the general ledger.
2.9 Test goodwill (or bargain purchase gain)
Test and recalculate the calculation of goodwill (or bargain purchase gain) by comparing the fair value of the consideration transferred, the fair value of any noncontrolling interest and the fair value of any previously held equity interest in the acquired entity to the acquisition-date amounts of the assets acquired and liabilities assumed.
Test fair value of previously held equity interests
Test the fair value of any previously held equity interest retained in the acquired entity (including the reasonableness of assumptions and estimates used in the valuation, if any, such as PFI) and determine whether any resulting gain or loss has been appropriately recognized in earnings. If the acquirer recognized changes in the value of its equity interest in the acquiree in OCI in prior periods determine whether the amount has been appropriately reclassified and included in the calculation of the gain or loss as of the acquisition date.
Agree to GL
Agree with amounts in the calculation to the underlying support and trace the goodwill or bargain purchase gain amount to the general ledger.
Evaluate bargain purchase reassessment
Before recognizing a bargain purchase gain, determine whether management has made a thorough reassessment of all elements of the accounting for the acquisition, including understanding why there is a bargain purchase.
We obtain an understanding as to why there is a bargain purchase (i.e., why the seller would be willing to sell its business at an amount less than what a market participant would be willing to pay).
Before recognizing a gain on bargain purchase, we determine whether management has reassessed whether it has correctly identified all of the assets acquired and all of the liabilities assumed. This reassessment would include making sure that management properly measured:
- The identifiable assets acquired and liabilities assumed
- The noncontrolling interest in the acquiree, if any
- For a business combination achieved in stages, the acquirer’s previously held equity interest in the acquiree
- The consideration transferred
We obtain evidence demonstrating that management re-evaluated all aspects of the transaction (and challenge management’s conclusions), including whether:
- The resulting gain represents management’s best estimate of the economic effect of the transaction based on all information that existed as of the acquisition date
- If there are any aspects of the transaction that should be accounted for separately from the business combination
- All assets acquired were evaluated for any contingencies that could prohibit recognition as of the acquisition date
- All identified intangible assets met either the contractual-legal or separability criterion
- Conclusions reached with respect to assumed pension obligations were appropriate
- Preacquisition contingencies (e.g., legal contingencies or potential tax exposures) of the target were properly identified, measured and recognized
- All leases and other executory contracts were evaluated for any off-market components that should be recognized as of the acquisition date
- Conclusions reached with respect to the accounting for acquired or assumed deferred taxes were appropriate
- The buyer assessed the reasonableness of the fair value determinations by reviewing the procedures performed to measure the fair value of the consideration transferred, assets acquired, liabilities assumed and any noncontrolling interest
2.10 Evaluate disclosure
Perform procedures to evaluate management’s disclosure of the acquisition.
Evaluate disclosure and agree to support
Read the financial statements and determine whether management has complied with the disclosure requirements of the applicable financial reporting framework and other applicable rules and regulations.
Agree disclosed amounts to underlying support.
Evaluate management’s determination of the measurement period and obtain and review support for subsequent measurement period adjustments to determine whether they:
- Qualify as a measurement-period adjustment and
- are recorded appropriately.
Evaluate measurement period
Determine whether management has identified the appropriate measurement period.
The measurement period ends once the entity has determined that it has obtained all necessary information that existed as of the acquisition date or has determined that such information is unavailable. The measurement period does not extend beyond one year from the acquisition date.
Test material subsequent adjustments by agreeing to the supporting documentation, clerically testing and agreeing to the general ledger.
Determine whether the subsequent adjustment qualifies as a measurement-period adjustment.
An acquirer records a measurement period adjustment only if the adjustment results from facts and circumstances that existed as of the acquisition date.
Review the financial statement disclosures to identify whether the measurement period adjustment is consistent with the company’s disclosures that amounts have been recorded on a provisional basis and the nature of items for which the initial accounting is incomplete.
3. Procedures mapped to what can go wrongs
The following table maps the PSPs to a sample of what can go wrongs (WCGW) that affect the SCOTs in the area of business combinations.
|Possible WCGW||Primary Substantive Procedure|
|• The transaction is not properly approved by those charged with governance or others with appropriate levels of authority for approval. |
• Approval of the transaction is made based on materials that are incomplete or are materially inaccurate.
|2.1 Review transaction agreement(s) and meeting minutes|
|• The acquisition is accounted for as a business combination but does not meet the definition of a business combination in accordance with the applicable financial reporting framework.||2.2 Determine whether the transaction is a business combination|
|• The accounting acquirer is not properly identified.||2.3 Identify the accounting acquirer|
|• The acquisition is not accounted for on the appropriate date.||2.4 Evaluate the acquisition date|
|• The business combination accounting incorrectly includes items that should be accounted for as separate transactions.||2.5 Determine what is part of the business combination|
|• The consideration transferred by the acquirer is not properly identified. |
• The consideration transferred by the acquirer is not properly measured.
• The consideration transferred by the acquirer is not properly authorized.
• The value of a share-based payment replacement award is not properly attributed to consideration transferred and post-combination compensation expense.
• The contingent consideration is not properly classified as a liability or equity.
|2.6 Test consideration transferred|
|• Assets acquired and liabilities assumed are not properly identified.||2.7 Identify the assets acquired and liabilities assumed|
|• Assets acquired and liabilities assumed are not properly recognized and measured.||2.7 Identify the assets acquired and liabilities assumed |
2.8 Perform opening balance sheet procedures
|• The fair value of the asset or liability is not accurate due to the use of an improper valuation model or the use of unreasonable assumptions, estimates or data. |
• The valuation of assets acquired and liabilities assumed is performed by an internal or third-party valuation specialist who does not have the appropriate skills and expertise.
|2.8 Perform opening balance sheet procedures|
|• Recognized goodwill or a bargain purchase does not agree to underlying support or is not calculated correctly. |
• Noncontrolling interest is not properly measured and recorded.
• Previously held equity interests in the acquired entity and any related gain or loss are not properly measured or recorded.
|2.9 Test goodwill (or bargain purchase gain)|
|• The business combination disclosures do not comply with the applicable financial reporting framework.||2.10 Evaluate disclosure|
|• Subsequent adjustments to the provisional amounts recorded at the acquisition date are not valid measurement period adjustments. |
• Subsequent adjustments to the provisional amounts recorded at the acquisition date are not properly recorded.
|2.11 Evaluate the measurement period and review subsequent adjustments|