In this workout, we've been told that company A has acquired 100% of the equity of company B on the last day of their financial year, and the purchase consideration is 50 of equity and 5 in contingent consideration relating to a one year earnout. We've been asked to calculate the consolidated balance sheet at the date of the acquisition and the consolidated operating profit in the year after the acquisition. In addition, we've been asked how these numbers change if company B'S inventory is stepped down in value by 5 at acquisition and the earnout target is subsequently missed. Now, let's start off by calculating the consolidated balance sheets. And if you see here we've got the balance sheets of company A and company B, and we're going to consolidate these in the usual way. We start off by zeroing out the equity in the target. We then add in the purchase consideration, and that's 50 of equity and 5 of contingent consideration, and that's a liability. Next, we're gonna calculate the goodwill. We calculate this by taking the total consideration, that's the 50 of equity plus the 5 of contingent consideration, and we deduct from this the equity value of the target, giving us 15 of goodwill. We can now consolidate these numbers just by adding across the columns.

And now we have the consolidated balance sheets for companies A and B. Let's have a look at the income statement. And for simplicity here, we're now going to assume that there's no consolidation adjustments at this point and no synergies. So we'll just add together the income statements of company A and company B, and that's the revenues and operating costs. So now we've calculated the estimated consolidated operating profits for the first year after acquisition. However, the question asks us to show how the numbers change if company B's balance sheet is stepped down by five at acquisition and if the earnout targets are missed in the year after acquisition. Let's start off with inventory. The first thing we need to do is to adjust the acquisition balance sheets, and we're going to do this by reducing the value of current assets by 5. We're also going to need to adjust the goodwill balance because if the targets assets are lower at acquisition, that's going to increase the amount of goodwill.

So we now have goodwill of 20.

But let's have a think about what happens to the income statement. If we assume that inventory is sold in the year after the acquisition. This lower value for inventory will then translate into lower cost of goods sold for B in the year after acquisition. So let's show that here and now we can calculate a new operating profit figure.

This results in a reduction in cost of good sold 5, and an Increase in operating profit of fi. So whenever a company steps down the value of the target's assets, particularly working capital assets, this will give rise to additional operating profit in the early years after an acquisition as well as increased goodwill. Now, let's tackle with a contingent consideration. This was estimated as at the point of acquisition, so the acquisition balance sheet doesn't change even if the earnout target is subsequently missed. However, the liability that was recognized at acquisition needs to be released, which will result in an additional gain in earnings in the year after acquisition. Let's show that here, and we're gonna show that as a negative 5 in SG&A. So this contingent consideration acts a bit like a provision that's being released, and even worse, although missing an earnout target is a bad thing for the combined group because it shows profits have disappointed it's actually having a positive effect on earnings. This highlights two major risks associated with M&A accounting. The estimates used to calculate the fair value of the target's balance sheet and any deferred consideration can be used to inflate post-acquisition earnings. And this is a really tough thing for auditors to challenge. So how can we spot it if management are manipulating M&A balances? Any manipulation would be shown in three ways. Firstly, we'll see large step downs in the targets assets at acquisition. Step ups and step downs do have to be disclosed by companies, so we should definitely scrutinize these disclosures. Secondly, we'll see abnormally high levels of goodwill arising from acquisitions. And then finally, we'll see low levels of operating cash flows relative to profit in the early years after an acquisition as the additional earnings that arise from these estimates on non-cash items.