Financial Accounting Presentation from ABA Annual Meeting
- 1. Understanding The Use Of Financial Accounting Provisions In Private Acquisition Agreements August 4, 2012 Mark Stoneman
- 2. Scope of Discussion Financial Accounting (compared to tax provisions) Private Acquisition Agreements
- 3. An Example Cable Company Example Buyer wants high margin customers Attorney relies on standard agreement Failure to understand interaction between 3 areas
- 4. Critical Interaction Lawyer Appraiser Accountant
- 5. Goal of Presentation Increase understanding of key concepts Teach lawyers to interact with Accountants and Appraisers Attorney must be flexible
- 6. Topics to be Discussed Summary of Valuation The General Financial Statements Representation Supplemental Representations
- 7. Valuation Methods Market-based Valuation Income Approach Valuation
- 8. Market-Based Select accounting metric examined in comparable companies Examples include P/E Price/Sales Multiples of EBIDTA, Earnings, etc. Based upon past or current data Rule of thumb approach
- 9. Known Company Unknown Company (Comparable) (Target) Price $20,000,000 ? = = Earnings $1,000,000 $500,000
- 10. Comparable Transactions (numbers in millions) Company Date EBITDA Sale Price Multiple ABC 1/1/2012 10 99 9.9 DEF 2/1/2012 6 45 7.5 GHI 3/1/2012 5 35 7 JKL 4/1/2012 15 150 10 Average Multiple: 8.6
- 11. Issues for Market-Based Approach What Multiple? Growth? Size of the Company? Barriers to Entry? What about the Balance Sheet?
- 12. Income Approach Greater focus on economic values, as compared to accounting figures Examples: Discounted Cash Flows Economic Profit Option pricing models Appraiser predicts future of target Can rely heavily on leading indicators
- 13. Valuing the Business Discounted Cash Flows Example
- 14. Free Cash Flow Growth 12.00 10.00 8.00 Cash Flow (in millions) CapEX 6.00 Cash Flow 4.00 2.00 - 2010 2011 2012 2013 2014 2015 2016 Year
- 15. Year Discount 2010 2011 2012 2013 2014 2015 2016 NPV Rate Free Cash Flow 0% 6.0 6.3 6.7 7.1 7.5 8.0 8.5 50.3 12% 6.0 5.6 5.3 5.0 4.8 4.5 4.3 35.8 14% 6.0 5.5 5.1 4.8 4.4 4.1 3.8 34.1 16% 6.0 5.4 5.0 4.5 4.1 3.8 3.4 32.5
- 16. Valuing the Business DCF Issues Predicting Cash Flows Appropriate Discount Rate Comparable Investments/Competing Bidders Risk 80% of companies use DCF to value investment opportunities, but no consensus on calculation of discount rate
- 17. Keys from Valuation Valuation methods require different inputs Some data within financial statements is critically relevant Some critically relevant financial data is not within the financial statements Some data within financial statements has little relevance
- 18. General Representation Somewhat standardized Key points Identify statements Fairly present position and results In accordance with GAAP Key issues Materiality Audit reports Interim Financial Statements
- 19. Materiality Materiality in M&A Agreements Double-Materiality Materiality in General Representation Express Materiality Implied Materiality
- 20. Who Wins on Materiality Depends upon bargaining power Sellers argument Buyers argument Depends upon significance of provision Significance is a function of valuation method Example
- 21. TARGET COMPANY: Motorcycle Sales COMPARABLE: Harley Davidson METRIC: 3x Sales Reported Revenue $10,000 Actual Revenue $9,000 Overstatement $1,000 Reported Valuation $30,000 Actual Valuation $27,000 Overstatement $3,000
- 22. Effect of Revenue Overstatement on P/Sales Valuation $30,000 $27,000 Dollar Value (in 1,000s) $10,000 $9,000 $3,000 $1,000 Reported Actual Overstatement Reported Actual Overstatement Revenue Revenue Valuation Valuation
- 23. TARGET COMPANY: Motorcycle Seller COMPARABLE: Harley Davidson METRIC: 20x Earnings Reported Revenue $10,000 Actual Revenue $9,000 Reported Earnings $1,500 Actual Earnings $500 Revenue Overstatement $1,000 Reported Valuation $30,000 Actual Valuation $10,000 Overstatement $20,000
- 24. Revenue Overstatement in P/E Valuation Dollar Values (1,000s) $30,000 $20,000 $10,000 $10,000 $9,000 $1,000 Reported Actual Revenue Reported Actual Overstatement Revenue Revenue Overstatement Valuation Valuation
- 25. Existence of a Report Various types of Reports Audited Reviewed Compiled Should the General Representation change based upon report? With audit Without audit
- 26. Interim Statements Not in compliance with GAAP Missing Footnotes Missing Year-end accruals Missing audit Management Statements Should General Representation Change?
- 27. Supplemental Representations Common Representations Off-Balance Sheet Liabilities Inventory Accounts Receivable Other Possibilities
- 28. Off-Balance Sheet Liabilities Description of Representation Common reasons Contingent liabilities Unknown liabilities Seller tactic
- 29. Inventory/Accounts Receivable Commonly involved in fraud Current nature of accounts Discretionary nature of reserves
- 30. Other Supplemental Representations Earnings related Sellers Circumstances Leading Indicators
- 31. Earnings Confusion among similar terms Pro-forma earnings Operating earnings Net earnings Net income Problem is widely recognized U.S. Congress SEC AICPA FASB
- 32. Sellers Circumstances Not uncommon to add back certain Seller expenditures Often, these are not itemized in financial statements Example
- 33. Revenue $30,000,000 Cost of Goods Sold ( 25,000,000 ) Gross Profit 5,000,000 Administrative Expenses ( 3,500,000 ) Net Income $1,500,000 Automobile Leases $50,000 Aircraft Costs 400,000 Lease for Shared Office 50,000 Net Savings to Buyer $500,000 20x Earnings Value Increase $10,000,000 Value without Add-Backs $30,000,000 Value with Add-Backs $40,000,000
- 34. Showing Value of Add-backs $40,000,000 $30,000,000 Value without Add-Backs Value with Add-Backs
- 35. Leading Indicators Not typically covered in financial statements Examples Same-store sales Number of customers/subscribers Sales per square foot (retail) Unit sales by product
- 36. Conclusion Financial Statement representations need to be tailored for: Type of business Type of valuation method Attorneys must engage accountants and appraisers