Holdings & Joint Ventures - Analysis of Implications - Essay Example

Holdings & Joint Ventures Analysis of Implications Introduction Companies, especially trans-national companies find it convenient to acquire, amalgamate or go in for a joint venture operation with a company or unit with a native origin in the country they wish to operate. Even inside a country it has been found to be beneficial to hold a smaller unit as a joint venture to improve reach in the market without incurring the cost and gestation time as it would be in the case of opening a new unit. In the case of software companies this trend is more pronounced as it involves skilled human capital which comes along with the acquisition. The proposal is seen to be, in the light of a business operation to be the most favorable method of expansion. It has its own pitfalls and dangers, and if the analysis of the company and its financial health is not done in a proper context, far from becoming an asset the new merger can create a liability that will far exceed the cost of setting up a plant. Therefore it is pertinent to analyze this practice in detail and the information to be disclosed. It also is relevant to note the underlying legal and financial guidelines that ought to be followed in all such mergers. This paper analyses the impact of the acquisition in the light of accounting parameters and will try by logical similes and examples to arrive at the proper perspective in relation to the type of dealings. Definitions & Rules We can define a merger where two individual companies become a single company and unify their entity. Strong companies seek out the less fortunate ones and then unify them into the company. Some times very strong and prospective companies also merge to create a bigger market or capture a foreign market. A company can also purchase another company and this is a purchase or consolidation. The stocks of the acquired company are sold for an agreed amount. Some tax benefits accrue. For example the buying company can write off the assets they acquire to the actual value paid for the company, and the difference between the book value and that purchase value for the assets can be charged off as depreciation over several years. An Acquisition of one company by another is a little different from a merger but not much. All of the above reasons for combining two companies apply, but instead of swapping stock or consolidating under a new corporate entity, one company simply buys another. In an acquisition, a company can buy another company with cash, with stock, or a combination of the two. The difference between the merger purchase and an acquisition depends on whether the purchase is friendly and announced as a merger or announced as an acquisition or the purchase is unfriendly. When it's unfriendly, it's always an acquisition. We are more concerned with a Holding company. The Encyclopedia Britannica defines a holding company as: "Corporation that owns enough voting stock in one or more other companies to exercise control over them. A holding company provides a means of concentrating control of several companies with a minimum of investment; other means of gaining control, such as mergers or consolidations, are more complicated legally and more expensive. A holding company can reap the benefits of a subsidiary's goodwill and reputation while limiting its liability to the proportion of the subsidiary's stock that it owns. The parent company in a conglomerate corporation is usually a holding company."i Why Have A Holding There are many business needs like expansion, new markets, new niche, and effective marketing and price control to name a few reasons other than more profits. The accounting reasons to create such a holding may be on account of tax saving, complimenting capability and resources, and share capital, technology, and risk. Important Factors to be considered The screening of prospective partners: This is done at all levels of management, not only the analysis of the company's financial history or capital. Analyzing factors like human resources, technical competency and machinery all form a part of the analysis usually overlooked in financial judgments. The business plan must elucidate the contributions of both companies in the proposed future venture clearly and in terms of figures and not a hap hazard projection. Facts of both parties ought to be verified by a third party or competent Auditor. We will examine the disastrous consequences of the failure in this respect when we consider the failure of Enron. With these, development of an exit strategy and terms of dissolution of the joint venture and the most appropriate structure are important. Tools for Analysis The most important tool to be used is the P/E ratios (price to earnings) Looking at the P/E for all the stocks within the same industry group will give a good guidance for what that P/E should be. PSRs (price to sales ratios) the fixed multiple of the acquired company's revenue based on the PSR of the industry. Asset evaluation. Valuation of the assets a target company owns, like gold deposits, real estate holdings, machinery, stakes in other companies, stocks etc. Market Cap. In a listed company, share to share comparison on the actual market price is done and the values that help buy the target's share at a lesser price are preferred. However this may not be the best indicator. Replacement Cost. The cost of investing in a company is weighed against starting a similar unit by the proposer. If the cost ratios say that starting anew venture is less costly and less risky to the acquisition, then the deal falls through. Accounting Practice The practice of using these methods alone was found to be obsolete and often resulted in frauds. Therefore new methods of evaluation have been suggested by the International Accounting Standards Board (IASB). According to the press note which highlights the need for a new accounting policy, the note says: "In recent years, the techniques used by entities for measuring and managing exposure to risks arising from financial instruments have evolved and new risk management concepts and approaches have gained acceptance. In addition, many public and private sector initiatives have proposed improvements to the disclosure framework for risks arising from financial instruments. The International Accounting Standards Board (IASB) believes that users of financial Statements need information about an entity's exposure to risks and how those risks are managed. Such information can influence a user's assessment of the financial position and financial performance of an entity or of the amount, timing and uncertainty of its future cash flows. Greater transparency regarding those risks allows users to make more informed judgments about risk and return."ii The board therefore recommends the evaluation of the significance of financial instruments for the entity's financial position and performance. Recommends the detailed study of risk from financial instruments to which the company was exposed hitherto, and the total capital. The board suggested "simplifying the disclosures now required by IAS 32 about concentrations of risk, credit risk, liquidity risk and market risk and deleting disclosures required by IAS 30, about contingencies and commitments and general banking risks."iii On 18 August 2005 IASB issued standards to improve disclosures about financial instruments and capital. "The IFRS requires disclosures about the significance of financial instruments for an entity's financial position and performance. These disclosures incorporate many of the requirements previously in IAS 32 (whose title has been shortened to reflect the change). The IFRS also requires information about the extent to which the entity is exposed to risks arising from financial instruments, and a description of management's objectives, policies and processes for managing those risks. Together, these disclosures provide an overview of the entity's use of financial instruments and the exposures to risks they create." The IFRS policy regarding the disclosure is made in their hand book as under: If an entity prepares a sensitivity analysis, such as value-at-risk, that reflects interdependencies between risk variables (e.g. interest rates and exchange rates) and uses it to manage financial risks, it may use that sensitivity analysis in place of the analysis specified in paragraph 40 of IFRS 7. IFRS 7.41(a) a) an explanation of the method used in preparing such a sensitivity analysis, and of the main parameters and assumptions underlying the data provided; and IFRS 7.41(b) b) an explanation of the objective of the method used and of limitations that may result in the information not fully reflecting the fair value of the assets and liabilities involved. IFRS 7.42 When the sensitivity analyses disclosed in accordance with paragraph 40 or 41 of IFRS 7 (see above) are unrepresentative of a risk inherent in a financial instrument (for example because the year-end exposure does not reflect the exposure during the year), the entity shall disclose that fact and the reason it believes the sensitivity analyses are unrepresentative. Adoption of Standard before effective date IFRS 7.43 If the entity has applied IFRS 7 for a period beginning before 1 January 2007, it shall disclose that fact. IFRS 7.44 If an entity applies IFRS 7 for annual periods beginning before 1 January 2006, it need not present comparative information for the disclosures required by paragraphs 31 to 42 of the Standard about the nature and extent of risks arising from financial instruments (Bulleted directives are verbatim from the bulletin). Legal Implications One bulletin we have to consider is the Special Advisory Bulletin issued by the legal authority regarding joint ventures being used for fraud. The circular says that "proliferation of arrangements between those in a position to refer business, such as physicians, and those providing items or services for which Medicare or Medicaid pays. Some examples of the items or services provided in these arrangements include clinical diagnostic laboratory services, durable medical equipment (DME), and other diagnostic services. Sometimes these Deals are called "joint ventures." A joint venture may take a variety of forms: it may be a contractual arrangement between two or more parties to cooperate in providing services, or it may involve the creation of a new legal entity by the parties, such as a limited partnership or closely held corporation, to provide such services". This is seen as a method of perpetuating fraud and is frowned upon in most countries. Overview of Successful Mergers Bayer AG was organized into a holding company. In December 2002 in order to provide for flexibility it adopted a holding company structure. Bayer, the German company based at Leverkusen, Germany, has a U.S. operations company - the Bayer Corp. at Robinson Township. According to the press release, "The holding structure gives us the flexibility we need to respond (to) altered operating conditions and implement the recent decision on a strategic alignment of our portfolio, including the separation of large parts of our industrial business into an independent company listed on the stock exchange. "The units of the company into crop science, health care and chemicals businesses into separate legal entities. The conversion of Bayer's material science, business services and industry services units into separate companies completed the reorganization. This is an example how the theory of efficiency with holding companies was put in practiceiv That was where a company converted its own units into a holding company. Now let us see an actual merger: On September 5 2006, Security Holding Corp acquired a Pennsylvania company Compass Technologies Inc., Exton, Pa., that makes access control and security management systems. Compass was projected to have $2 million in revenue in 2006. This was more of an acquisition for technology, because the principal aim was to incorporate the radio-frequency identification and digital video capabilities of Security Holding with Compass' access control technology. "The principal itself was a subsidiary of Arlington, Security Holding was formed for the purpose of the acquisition of SecurityInc, a Franklin manufacturer of radio-frequency identification access control systems, and affiliated companies CyberLynk Network Inc., Franklin, and AAID Security Solutions Inc., Peachtree City, Ga. The three companies had sales of $3 million in 2005 and expect $7 million in sales in 2007."v Homeland Security Capital focuses on acquiring, developing and consolidating homeland security-related businesses. With the purchase of Compass Technologies, it expects total revenue of $18 million a year. CISCO with Largest Mergers The networking giant Cisco Systems (Cisco), acquired 80 companies. The methodology adopted by Cisco included evaluating the target company, determining its compatibility with Cisco and integrating the acquired company's operations with Cisco. Cisco made revisions in its acquisition strategy for each of these companies that resulted in the most successful acquisitions of the decade. The Danger Trap Analysis There is a classic case that we can site and study for highlighting the hypothesis "There is a growing practice of companies conducting parts of their business through other companies in which they have a substantial but not a controlling interest. While consolidation is not appropriate for such holdings, it is also not efficient to disclose only the cost of investment and dividend income as this would lead to misstated EPS and P/E ratios of the investing company." Enron - An illustrative Example. Material for this research and application of this principle is primarily from the detailed research published by Robert E. Litan titled ' The Enron Failure and the State of Corporate Disclosure' in April 2002. According to Robert, the catastrophe at Enron resulted because the accounting and disclosure policies were not correct. " The immediate accounting problem exposed by Enron's failure was the weak consolidation rule prescribed for highly leveraged "special purpose entities" (SPEs), or partnerships that were formed to carry out various projects whose assets and liabilities were not shown in Enron's balance sheet. Enron failed in part because of losses arising out of the many SPEs that it had created." Further it is argued that "Leaving aside the fact that Enron appears to have misled its auditor, Andersen, about the amount of outside investments in SPEs (thus wrongfully avoiding consolidation), it is now clear that the 3 percent test was much too weak. FASB has since rightly raised the threshold to 10 percent."vi Improving the disclosure system is a complex task with few clear answers. According to former Federal Reserve Board Chairman Paul Volcker, the growing complexities of business-reflected in a dizzying array of new financial instruments and corporate organizational structures-pose increasingly difficult challenges for any system of disclosure. The fact is that for many kinds of transactions, there are no single "right" answers, which helps explain why the Financial Accounting Standards Board (FASB) often takes so long to set new standards or refine earlier ones, and why International Accounting Standards are framed in a more generic fashion. The lack of specifics allows accountants greater discretion in deciding how to justify various transactions. "Accounting standards should help investors understand all relevant financial facts that will enable them to make projections about future cash flows. Where the standards are altered or not implemented out of concern for affected firms rather than investors, the outcome may not be socially desirable. In theory, putting more investor or public representatives on FASB could help rectify the imbalance. In practice, however, if Congress wants the rules to benefit narrow interests, then there is little that even a more balanced FASB can do." According to Robert E. Litan. Auditors & Enforcement The Auditor has an important role to play in the proper conduct of the amalgamation and proper accounting. Auditors have a responsibility in enforcing the standards. "The failures with respect to audit of Enron, attention have been focused on verification of financial statements. Policymakers should concentrate on two basic approaches, which are not mutually inconsistent, but ideally should be reinforcing: improved monitoring or oversight of auditors and improved incentives for auditors to carry out their work properly." Says Robert E. Litan. Arthur Levitt points at the "..Trend toward earnings management-or the manipulation of quarterly earnings reports to achieve or exceed market expectations, which is evidenced by the significant increase in earnings restatements over the past few years." Probable Alternatives According to Mike Markowski, " Earnings per share figures too often deliberately conceal the truth whereas cash flow reveals it. Study the patterns of quarterly operating cash flow figures and you can discover a buy or sell signal." He further goes on to argue that "Operating cash flow per share (OPS) is the best leading indicator of future problems or positive changes in a company's financial health," Negative anomalies can spotlight stocks to sell or avoid while Wall Street research analysts maintain their buy or hold ratings because of investment banking conflicts. Today mergers and acquisitions have become the most effective way for businesses to achieve quick growth and enhanced market competitiveness. They are seen by many as a viable, valued, and necessary growth strategy for companies of all sizes worldwide. The era where an M&A transaction were done solely for quick financial gain is over. Today's deals are strategically driven. However, until recently the planning process known as marketing due diligence was not taken into consideration. Marketing due diligence examines the pre-merger planning and post-merger integration of companies to ensure that marketing and sales synergies exist between the companies. Through the use of this title, those considering M&As will be able to move quickly to realize strategic marketing and sales synergies in order to ensure the success of the merger. Art Detman gives an insight in to the working of The StockDiagnostics.com website dedicated to analysis of the cash flow. According to Detman, "One algorithm is a pattern of "positive" financial statement anomalies that can be used to identify low-priced emerging growth companies that are usually not recommended by Wall Street" He says that in the period for analysis from 2002 to 2003, companies like uDate.com, Lending Tree, were purchased by Barry Diller's US Interactive - for premiums of 150% and 40% respectively. Similarly " Multex.com (NASDAQ: MLTX) was acquired by Reuters for a 60% gain one week after appearing in The OPS Newsletter. Numerical Technologies (NASDAQ: NMTC) was bought out for a 90% gain six days after being selected. Ramsay Youth Services (NASDAQ: RYOU) appreciated 38% after a buyout offer came 10 weeks after being selected." Mike Markowski says that investors have their own formulas for cash flow, and the formula comprises of earnings before interest, taxes, depreciation and amortization. "The accounting scandals revealed it is not a defendable or reliable indicator, but a recently concocted and fashionable measurement," Conclusion The analysis of PSRs, Asset evaluation , Market Cap and the Replacement Cost remains the better forms of analysis. Since the success of the Operating (or operational) cash flow (OPS)must also be considered. To prevent Enron like fiascos, it is a better policy to see that accounts are made in the IFRS criteria to risks especially from financial instruments. Disclosures must provide an overview of a sensitivity analysis, financial risks, main parameters and assumptions underlying the data provided; and the viability of the project. Bibliography Economic Studies Program The Brookings Institution, 1775 Massachusetts Ave., NW, Washington, DC 20036 www.brook.edu/comm/policybriefs/pb97.pdf Bayer changes to holding company http://pittsburgh.bizjournals.com/pittsburgh/stories/2003/12/29/daily8.html Pittsburgh Business Times - December 30, 2003 The Business Journal of Milwaukee - September 5, 2006 http://www.iasplus.com/dttpubs/ifrs3.pdf holding company. (2007). In Encyclopedia Britannica. Retrieved June 12, 2007, from Encyclopedia Britannica Online: http://www.britannica.com/eb/article-9001857 Financial Institutions, Valuations, Mergers and Acquisitions: The Fair Value Approach Zabihollah Rezaee The Enron Failure and the State of Corporate Disclosure by Robert E. Litan April 2002 Full document in PDF (152KB) Winning at Mergers and Acquisitions The Guide to Market-Focused Planning and Integration Mark N. Clemente ISBN: 9780471190561 ISBN10: 047119056X Published: John Wiley & Sons Inc Publish Date: 1998-04-01 Joseph M. Morris ISBN: 9780471381877 ISBN10: 047138187X Published: John Wiley & Sons Inc International Financial Reporting Standards IFRS 7 Financial Instruments: Disclosures A disclosure checklist September 2005 OPS Not OOPS! EQUITIES MAGAZINE JANUARY-JUNE 2003 By Art Detman, Jr OFFICE OF INSPECTOR GENERAL SPECIAL ADVISORY BULLETIN CONTRACTUAL JOINT VENTURES (pdf) The Office of Inspector General (OIG) was established at the Department of Health and Human Services by Congress in 1976 to identify and eliminate fraud, abuse, and waste in the department's programs Audit IAS Plus. Published for our clients and staff throughout the world December 2005 - IFRIC Special International Accounting Standards Board Press Release 22 July 2004IASB publishes Exposure Draft on Financial Instrument Disclosures Read More