Navigating Common Challenges in a Business Combination: The Use of Specialists and Prospective Financial Information 

Business combinations in private or public companies can be complex and infrequent, leading to potential errors due to unfamiliarity. Unlike routine transactions, companies may lack established procedures or controls, which complicates the work of those in technical accounting and financial reporting roles. Additionally, manual intervention in accounting for these combinations increases the risk of human error.  

At a time when the PCAOB continues to identify numerous audit quality issues and areas of improvement, companies must place greater emphasis on business combination procedures and controls in their financial statement audits. These transaction events require significant estimation and judgment, making well-designed and effectively implemented procedures and controls crucial to their success. 

Use of a Specialist 

It’s common for companies to use third-party valuation specialists in business combinations. These specialists provide expertise in valuing intangible assets acquired during the transaction and navigating the complex requirements of purchase price allocations and fair value measurements, which are critical for accurate financial reporting.   

While third-party valuation experts bring significant knowledge and technical skills, company management must properly oversee, review, and evaluate the specialist’s work. Unsurprisingly, errors are often found in the work produced by valuation specialists. Below are a few reminders when reviewing the work of a specialist:  

Clerical Accuracy Check

All schedules, exhibits, or analyses prepared by the specialist should be checked for clerical accuracy. Valuation reports, for example, often involve complex calculations and large amounts of data, increasing the likelihood of clerical errors. Many valuation tasks are performed manually in Excel, which can lead to mistakes such as data entry errors or miscalculations. As part of your review procedures, test the clerical accuracy of all calculations performed by the specialist.  

Understand the Valuation Methodology

Valuation specialists often employ unique methodologies or practices specific to their firms. While the fundamental principles of valuation are generally consistent across the industry, each firm may develop proprietary models, techniques, and approaches to address specific valuation challenges. For instance, a specialist might calculate the Internal Rate of Return (IRR) at 13.6% but round it up to 14.0%. Although common practice for that firm, rounding up the IRR could materially affect the fair value of a recorded intangible asset. 

Additionally, a specialist might use a range (e.g., 13% – 15%) to determine the weighted-average cost of capital (WACC). This range accounts for inherent uncertainties and variations in the inputs used to determine the WACC. Companies should understand the valuation firm’s methodology in selecting a point within the range (often the midpoint) and evaluate the potential variability in the fair value of recorded intangibles when using a discount rate at the high or low end of the range. By understanding the valuation specialist’s methodology, company management can better assess whether the specialist’s practices could result in potential accounting issues. 

Company-Specific Data

Specialists often include company-specific data in their valuations. For example, historical attrition rates are crucial in customer relationship valuation, especially with methods like the Multi-Period Excess Earnings Method (MPEEM). These rates help estimate future customer retention and forecast revenue streams. However, the specialist doesn’t test this company-specific data. Therefore, company management should design procedures to verify the accuracy and completeness of the data used by the specialist, often involving detailed testing back to source documents. In situations in which there is limited historical data, it might be necessary to benchmark attrition rates with other similar businesses. 

Although an assembled workforce (“Assembled Workforce”) is not recognized as a separate intangible asset apart from goodwill, its value impacts the valuation of other intangible assets. Determining the fair value of an Assembled Workforce involves using company-specific data such as salaries, wages, benefits, and other compensation. Additionally, productivity levels and workforce efficiency are considered. Company management must design procedures to test the company-specific data used in valuing the Assembled Workforce. 

Selection of Discount Rates

Often, valuations don’t include sufficient quantitative support from the specialist for the discount rate selected. Reconciling the internal rate of return (IRR), weighted average cost of capital (WACC), and weighted average return on assets (WARA) is a common analytical tool in valuation. Ideally, these rates should be closely aligned. This comparison provides insights into transaction economics and potential biases in prospective financial information (PFI). Valuation specialists might often include a company-specific risk premium (CSRP) to reconcile the WACC to the IRR. Adjustments to the CSRP should be quantitatively supported and not arbitrary. Company management should work with the specialists to fully understand and document the rationale behind CSRP adjustments, including specific risks and methodologies used. 

Additionally, it’s not uncommon for specialists to use the same discount rate for all intangible assets and for discount rates to be arbitrarily reduced by 100 or 200 basis points (bps) to the WACC. This might be done, for example, to ensure the implied return on goodwill in the WARA is higher than on intangible assets. While it could be expected that the goodwill’s return should be higher than the intangible assets, subjectively adjusting discount rates by 100 or 200 bps to achieve that outcome is inappropriate. Company management should work with the specialist to understand and document the risk differences between assets and validate that the implied return on goodwill is reasonable, supportable, and consistent with the company’s growth profile.  

Selected Royalty Rates

Typically, a valuation specialist selects the royalty rate based on a comparable set of licensing agreements. However, the resulting data points can produce a large range of possible royalty rate assumptions. The valuation specialist often calculates the minimum, average, median, and maximum selected range of royalty rates. Potential issues arise when the valuation specialist selects a royalty rate using subjective methods or the specialist might improperly weight the comparable agreements, giving undue influence to certain transactions that aren’t representative of the specific characteristics of the trademarks being compared.

It’s essential for valuation specialists to use a rigorous and transparent methodology, ensure the comparable agreements are truly comparable, and thoroughly review all calculations and assumptions. Company management should review the selected royalty rates, understand the specialist’s methodology for the selection of the rate, and determine if another selected rate within the range would be more comparable.  

Prospective Financial Information 

Prospective Financial Information (PFI) often relies on assumptions about future events and conditions. Auditors critically evaluate and challenge these projections to ensure they’re reasonable. PFI could involve complex calculations and significant judgment, and errors or misjudgments in these areas can lead to material misstatements. Proper execution of well-designed procedures and controls over PFI is essential.   

As company management prepare to review PFI, don’t forget to implement these common procedures or controls:  

Defining Expectations

An important first step in reviewing prospective financial information is to establish quantitative and qualitative expectations and thresholds for each significant assumption (see further discussion below). Reviewers should apply these metrics to identify results that are unusual or unreasonable. For example, setting a 5% revenue growth rate for the next five fiscal years based on historical growth, industry projections, and materiality considerations can guide the review process. If revenue growth in these periods exceeds this threshold, it would require further investigation and explanation. By defining expectations for each assumption, reviewers can address and resolve discrepancies before concluding on the reasonableness of the projection.   

Determine Significant Assumptions

Significant assumptions in prospective financial information require the most scrutiny due to their materiality, sensitivity to variations, and high estimation uncertainty. Reviewers often focus on revenue growth rates or EBITDA margins, but all significant assumptions should be identified and individually reviewed. The identification of significant assumptions is performed in the context of materiality to the company’s financial statements. Assumptions that when changed or sensitized produce a material change to the recorded fair value are considered significant assumptions. Specific procedures or controls should be designed for each significant assumption. Start by listing all significant assumptions in the PFI model. For example, typical significant PFI assumptions may include:  

• Annual revenue growth rates. 
• Annual gross profit margins. 
• Annual selling and marketing as a percentage of revenues. 
• Annual general and administrative expense as a percentage of revenues. 
• Annual EBITDA/EBIT margins. 
• Annual depreciation and amortization as a percentage of revenues. 
• Annual effective tax rate. 
• Annual capital expenditures as a percentage of revenues. 
• Annual debt-free net working capital requirements as a percentage of revenues. 

Review Each Time Period Separately

Reviewers of PFI models often focus on immediate-term cash flow projections (1 to 5 years), which typically align with deal models or other forecasts. However, greater attention is needed for the later years of the cash flow period (years 5+ into the terminal year), which have higher estimation uncertainty and less scrutiny from management and typically are forecasted or normalized by the specialist into the terminal period. Understanding the method used for this normalization and the basis thereof is crucial, as a manual (e.g., not straight-line) normalization can sometimes lead to unusual volatility or unstable cash flow patterns in the terminal period. Additionally, terminal period assumptions, carried into perpetuity, often drive a large component of the overall value and require robust review procedures to ensure accuracy and reasonableness. 

Reconcile the PFI Used in the Valuation to the Deal Model

Aligning the PFI with the deal model ensures consistency and accuracy in financial projections. Differences are common, as the deal model may include aggressive growth assumptions for strategic decision-making, while the PFI for valuing intangibles is more conservative and adheres to accounting standards. Reconciling these differences is crucial for a robust and defensible PFI, with clear documentation and understanding of assumptions and methodologies used in both models.    

Careful Selection of Guideline (Peer Group) Public Companies

Company management will identify selected guideline (peer group) public companies in a business combination. The peer group provides a basis for comparison, helping to ensure that the forecasted projections align with industry expectations and reflect relevant market participant assumptions. Using an inappropriate peer group can result in misleading financial projections and inaccurate valuations.     

Typical Procedures to Review PFI Assumptions

When reviewing the PFI in a business combination, reviewers should assess the company’s ability to accurately forecast and execute its business plans. It’s crucial to ensure projections align with peer group and industry expectations. Robust review procedures must be in place to conclude financial projections are reasonable. Here are some example procedures that should be performed for each significant assumption:  

• Compare the assumption to historical experience of the company. For instance, comparison of revenue growth rates in the immediate-term (e.g., 1-5 years) cash flow projections to historical average or median growth rates of the company. 
• Compare the assumption against the peer group historical actuals or projected trends, such as forecasted EBITDA margins in the PFI to projected EBITDA margins of the peer group.  
• Compare assumptions to current industry and economic trends, both historical and projected. For example, compare projected revenue growth rates to industry growth rates within the company’s sector.  
• Evaluate any changes to the company’s business model, product mix, or customer base that may impact projected cash flows. 
• Evaluate management’s ability and intention to carry out any specific actions (e.g., expansion plans) embedded in the underlying assumptions.  

When assessing the reasonableness of financial projections, reviewers should clearly document why assumptions are (or are not) reasonable compared to evaluated information (e.g., peers, industry trends, economic trends, historical performance). Reviewers should also obtain and evaluate underlying information (e.g., copies of new contracts) supporting management’s assumptions. 

Synergies Identified

Management often includes company-specific synergies in the deal model to justify the acquisition’s purchase price and demonstrate potential financial benefits, making the transaction more attractive to investors and stakeholders. However, cost or revenue synergies in the PFI model must reflect market participants’ perspectives and provide a realistic view of the acquisition’s benefits. One common procedure to evaluate the estimate of synergies could be reviewing management’s ability to forecast synergies in previous acquisitions. Comparing forecasted synergies to actual synergies achieved in previous acquisitions provides a basis for management’s track record for forecasting. In addition, reviewing actual synergies identified and realized post-acquisition will help support the estimate.  

Evaluate the Assumptions Collectively

Lastly, take a step back and evaluate the assumptions collectively and in conjunction with one another. Significant revenue growth projections in the discrete period may be inconsistent with the assumption of selling and marketing expense reductions. Also consider the level of risk in the PFI and related discount rate. If the estimates appear to have a degree of risk, is there a company-specific risk premium incorporated into the calculation of the discount rate? For example, if a 1% CSRP is included in the discount rate, quantify what that compares to in terms of dollars or percentage revenue growth.   

As a final reminder, for those companies subject to internal controls, given that PFI involves significant judgment and is inherently subjective, auditors frequently find that the documentation supporting the review of PFI, known as management review controls (MRCs), is often insufficient. Simply having a signature or a brief note is not enough; detailed documentation of the review process for each significant assumption and the resolution of any issues identified is required. The standards and expectations for MRCs have evolved, and what was considered adequate in the past may no longer meet current expectations. This can lead to control deficiencies, including material weaknesses if companies have not updated their controls documentation to align with relevant requirements.  

Maximize Enterprise Value, Minimize Risk 

By addressing these matters during the valuation process, financial preparers can minimize unwanted surprises and create a strong foundation for business combination success. For expert support in overcoming business combination challenges and generating audit-ready financials, contact CrossCountry Consulting.