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How Companies Use Acquisitions to Boost Financials: Unmasking the Illusion

Updated: Feb 14

Corporate acquisitions can stimulate growth, bring new talent, consolidate market power, and provide numerous other strategic benefits. However, acquisitions can also be used as a tool to manipulate financial metrics, artificially boosting the acquiring company's financial performance. This 'financial engineering' can potentially mislead investors who rely heavily on these numbers to make informed decisions. This article will explore how companies use acquisitions to 'fake' numbers and provide examples to illustrate these practices.

Revenue Boosting Through Acquisitions

A common method of using acquisitions to bolster financials is revenue boosting. When Company A acquires Company B, Company B's revenues are typically added to Company A's top line in subsequent financial reporting periods. This can result in a significant jump in revenue for Company A, making it appear as though the company is experiencing a dramatic growth, even if its organic growth (i.e., growth not derived from acquisitions) is sluggish or declining.

Example: Imagine Company A, which had stagnant growth for several years, decides to purchase Company B, a smaller yet profitable firm. Post-acquisition, Company A reports a 30% revenue increase, which could mislead investors into believing that Company A's operations have significantly improved. However, on closer examination, one might find that this growth primarily resulted from incorporating Company B's revenues.

Earnings Manipulation through Purchase Price Allocation (PPA)

Purchase Price Allocation is another way acquisitions can be used to inflate earnings. When a company is acquired, the purchase price is allocated among the assets and liabilities acquired. Goodwill, a type of intangible asset, is often a significant part of this allocation. Depreciation and amortization of these assets can have substantial effects on reported earnings.

Example: Consider Company C, which acquires Company D for $1 billion. If $400 million is allocated to tangible assets, $200 million to identifiable intangibles, and the remaining $400 million to goodwill, only the first two categories will be amortized over their useful lives, reducing reported earnings. However, goodwill is not amortized. Consequently, by allocating more of the purchase price to goodwill, a company can reduce its depreciation and amortization expenses, artificially boosting earnings.

Leveraging Pro Forma Financial Statements

Acquiring companies often present pro forma financial statements that depict what the combined entity's financials might have looked like had the acquisition occurred at the beginning of the reporting period. While this can provide useful information, it can also be manipulated. For instance, one-time costs related to the acquisition might be excluded, portraying a rosier financial picture than reality.

Example: If Company E acquires Company F and incurs substantial transaction costs and restructuring expenses, it might present pro forma statements excluding these costs. This gives the impression of higher profitability, potentially misleading investors.

Cost Reduction Claims

Often, companies justify acquisitions by claiming significant future cost reductions (termed 'synergies'). While synergies can be a valid strategic rationale for an acquisition, these claims should be scrutinized as they are future-oriented and often optimistic.

Example: Company G acquires Company H, promising $100 million in cost synergies. These anticipated savings are factored into analysts' models, leading to higher future earnings estimates. If these synergies fail to materialize, investors relying on these inflated earnings forecasts could be misled.

While acquisitions can provide strategic advantages and create shareholder value, they can also be used to manipulate reported financials. Investors should be mindful of these tactics and scrutinize financial statements and company disclosures diligently. Performing comprehensive due diligence and seeking the advice of financial experts can further help in making informed investment decisions. Understanding the nuances of financial reporting in the context of acquisitions can equip investors with the skills to separate genuine growth from financially-engineered growth, fostering more successful investment strategies.

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