We aim to highlight companies at risk of manipulating their profits through acquisition accounting. As highlighted in our report, GOODWILL HUNTING: Using Acquisition Accounting to Inflate Earnings
(1 Nov 2016), companies can write-down the value of assets at acquired companies at the time of consolidated, such as fixed assets and/or inventory, thereby lowering depreciation and/or cost of goods sold, in order to inflate profits. Asset write-downs lead to the creation of deferred tax assets as there will be a timing difference between the reported financials and tax financials (the tax authorities do not recognise asset write-downs). As such, we use a combination of three red flags to highlight companies at risk:
- A material acquisition (1 point). Companies which make material acquisitions are more likely to be manipulating their profits. Around 26% of all listed companies made a material acquisition or disposal (with consideration in excess of >5% of sales) between 2013 and 2015.
- Large or material rise in deferred tax assets (1 point). A rising deferred tax asset suggests that there is a timing difference between reported financial statements and tax records. This could be evidence of asset write-downs. Companies are awarded 1 point if deferred tax assets are in the largest 80th percentile relative to industry peers, or the rise in deferred tax assets over the past one or three years is in excess of the 80th percentile.
- Large or material rise in intangible assets (1 point). Large and rising intangible assets are often the by-product of material acquisitions. However, should companies write-off depreciable assets as part of acquisition accounting, this will be offset by higher intangibles.