Ways to Improve the Earnings Quality in Acquisitions and Mergers

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Ways to improve the earnings quality
in acquisitions and mergers
In recent years, acquisition and merger activities have boomed as result of improvement in economy and corporate earning. Along with the growing acquisitions and mergers, the risk of earnings manipulation and fraud embedded in related complicated transactions has also increased. From past experiences, three most common areas that have high risk of earnings management are research and development expenditure, restructuring costs and goodwill. During acquisition, companies will recognize cost of research and development, which should be capitalized, as expenditure, and take excessive written- offs on such expense to create “big bath”. As to restructuring charges, the company will account excessive amount on restructuring cost and classify the cost as extraordinary items in the income statement since users of financial report will not take account of one-time unpredictable extraordinary items into consideration when analyzing the profitability of the company. Last but not least, goodwill can be overvalued at the point of acquisition and take a huge written-off afterwards and thus companies can reduce the systematic drag on earnings by adopting different depreciation and amortization methods. In precedent high-profile scandals, such as Enron, WorldCom and Cisco, great losses were suffered by the investor, employees and the whole society, which draw great attention of the regulatory authorities and the public to avoid such tragedy to happen again. To increase the earning quality in acquisition and mergers, government have tries to set more severe requirements to restrict the behaviors of the companies. For example, the Sarbanes-Oxley Act required the SEC to analyze its enforcement activity and identify financial reporting practices that are susceptible to inappropriate earnings management and fraud. In addition, external auditors who act as independent professionals also attach more significance to...
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