Audit of Acquisitions,

Related-Entity Transactions,
Long-Term Liabilities
and Equity
 ASA 250 The Consideration of Laws and Regulations in an Audit
of a Financial Report
 ASA 315 Understanding the Entity and Its Environment and
Assessing the Risks of Material Misstatement
 ASA 320 Materiality and Audit Adjustments
 ASA 330 The Auditor’s Procedures in Response to Assessed
Risks
 ASA 402 Audit Considerations Relating to Entities Using Service
Organisations
 ASA 500 Audit Evidence
 There are three valuation issues associated with acquisitions:
 valuing the assets and associate liabilities upon acquisition
 measuring restructuring charges and recognition of the
liability
 measuring impairment of assets after operation begins.
 Major issues associated with valuing an acquisition are:
 determining the cost of the acquisition
 valuing identifiable tangible and intangible assets and
liabilities
 valuing goodwill.
 Normally, cost is the amount paid to acquire the company.
However, there are things that make the assessment more
complicated:
 acquisitions made using stock rather than cash
 acquisitions in which the final price is contingent on the assets
received (post-audit)
 acquisitions in which the final price is contingent on the acquired
entity’s performance.
 The auditor must assess the likelihood of the acquired entity
meeting performance objectives.
 If highly likely, the full cost should be recognised at the time of
acquisition.
 Acquiring company records assets at their fair market value at
time of acquisition.
 Company usually hires appraiser to value tangible assets.
 Intangibles should be valued at net present value of future
cash flows.
 Auditor cannot simply accept the appraisal and
management’s assessment of fair value of assets.
 Auditor must gather independent evidence to determine whether
assessed values are appropriate.
 Auditor may rely on the specialist hired by management or
hire their own specialist. Either way, the auditor should:
 evaluate the qualifications of the specialist
 determine if specialist is independent of management
 review the methodology used by the specialist.
 Goodwill is the excess of purchase cost over the fair market
value of tangible and intangible assets acquired in a purchase.
 AASB 138 requires goodwill be specifically identified with an
operating or reporting unit.
 This is important so goodwill can be tested for impairment on
an annual basis.
 Valuation and testing of impairment is facilitated if the
company uses a capital budgeting process.
 When companies restructure operations, accounting
standards require that the cost of restructuring and
associated liabilities is recognised.
 The auditor should examine restructuring charges by using
the following procedures:
 reviewing AASB pronouncements
 reviewing how the company estimated
restructuring charges
 reviewing actions taken by management that indicate
restructuring has moved beyond a plan.
 testing estimates by reviewing contracts, property
appraisals, severance contracts and other restructuring
documents.
 mathematically testing estimates.
 developing a conclusion as to reasonableness of liability
and appropriateness of client accounting.
 AASB 136 requires testing goodwill every year for impairment.
 The company must determine fair market value of the reporting
unit and compare it to the reporting unit’s carrying value
(including goodwill).
 If fair market value is less than carrying value, it is inferred that
goodwill has been impaired and must be written down.
 The reporting unit may be the company or a sub-unit of the
company.
 The auditor must evaluate:
 management’s methodology for assessing impairment
 whether an objective evaluation supports the client’s conclusion.
 In addition to the annual review, situations may arise which impair
goodwill:
 significant adverse change in legal factors or the business
environment
 adverse action or assessment by regulator
 unanticipated competition that significantly reduces the value of
the company’s products
 significant loss of key personnel
 expectation that reporting unit will be disposed of
 significant asset group within a reporting unit tested for
recoverability
 impairment recognised by subsidiary.

 Audit tests for goodwill impairment will require considerable

judgement and business knowledge.
 Related-entity transactions have been used to manipulate financial reporting
and should, therefore, be considered high risk.
 Auditor must consider that a client may not want
to have its related-entity transactions discovered.
 To uncover these transactions, the auditor should:
 obtain a list of all related entities, then develop
a list of all transactions with those entities
 carefully examine all unusual transactions to determine whether the
transactions involved
a related entity.
 The auditor then investigates the transactions
to determine if they have been properly recorded
and disclosed.
 Some liabilities require significant subjective judgements:

 restructuring reserves
 warranty reserves
 pension obligations
 other post-retirement benefits.
 The provision reserve represents the expected future cost related to
sales of a company’s product. It is estimated and recorded when the
product is sold.
 The estimate is typically based on past experience of the company and
adjusted for changes in:
 the product, including those that change its quality
 the warranty
 sales volume
 the average cost of repairing products under warranty.
 The auditor can examine the account by:
 testing the information system used by the client
 developing an estimate based on the factors above.
 Companies issue capital stock (equity) and bonds (borrowing) to
raise long-term funds.
 Other financing activity accounts include:
 notes payable
 debentures
 contracts payable
 special bonds:
 payment-in-kind bonds
 convertible notes
 redeemable preference shares
 stock options and warrants
 stock options as part of employee stock compensation
programs.
 Debentures are issued to finance major expansions or refinance
existing debt. While issues are infrequent, each transaction is
material.
 Considerations in auditing debentures or other long-term debt
include valuation and amortisation of premium or discount.
 Audit procedure:
 Auditor reviews loan documents.
 If debt is issued during the audit period, receipt of cash may be
traced to cash receipts journal and bank.
 Principal payments may be traced to the disbursements journal.
 Auditor may confirm year-end balances with debt holders.
 Computation of interest expense
 Auditor will usually recalculate interest expense including
amortisation of any discount or premium.
 Accounting for gains or losses on debt refinancing.
 Disclosure of major restrictions in bond indentures.
 Auditor typically reviews loan documents and makes
inquiries of client.
 Transactions affecting shareholders’ equity that should be
addressed during an audit:
 new issues
 share repurchase
 bonus issues
 declaration and payment of cash dividends
 transactions involving retained earnings
 prior period adjustments.