PROBLEM 3 AMI Limited was covered in a December 2009 Fortune article for its acquisition accounting practises. AMI's market value fell by 23% in mid-November 2009, following charges by an analyst that the business was inflating its growth image through accounting gimmicks, as well as rumours that AMI's auditors might leave. AMI has invested 30 billion in the last three years alone 23 billion in cash. It has concentrated on everyday technologies-security systems, electrical connectors, industrial valves, and health care devices, to name a few. AMI announced that its net income before special charges more than doubled to 2.6 billion in fiscal 2009, while revenues increased by 83% to 22.5 billion. AMI's market worth was almost 80 billion prior to the claims, up from just 1.7 billion in 2002. According to several analysts, AMI aggressively controlled its earnings by leveraging acquisitions to achieve eye-popping results. Short sellers on Wall Street have long talked about AMI's bookkeeping. AMI is a "rollup" company-one that leverages its high stock price to acquire businesses with lower PE multiples and its acquisition strategy is now jeopardised as a result of the stock price decrease. AMI's troubles stem from aggressive merger-related accounting, which includes restating acquired companies' earnings before the mergers happen in order to make future results appear better. Pooling accounting is used to account for the majority of AMI's largest acquisitions. This practically means that AMI restates its financial statements, implying that the purchased firm was a part of AMI long before the deal closed. These restatements make comparing one period to the next exceedingly difficult. To add to the uncertainty, AMI has recently taken 4 billion in merger-related costs, shifted its fiscal year-end from December to September, and relocated its headquarters from the United Kingdom to Bermuda to take advantage of a lower tax rate. According to one expert, AMI is amassing massive charges to fund "cookie jars" of reserves for future running needs. Indeed, once the huge charges are included in AMI's earnings appear anything but brilliant. AMI reported significant financial losses in fiscal 2006 and 2007, as well as an 83 percent decline in net income in the first nine months of fiscal 2009. London Stock Exchange practise, on the other hand, is to disregard such charges, claiming that Pro-forma results provide a more accurate representation of "normalised" earnings. AMI vigorously denies all charges. According to its CEO, the SEC performed comprehensive legal and financial reviews of AMI's three largest transactions over the last two years. Additionally, the CEO states that only six of the company's 120 recent transactions utilised pooling, despite the fact that it was used in some of the company's largest transactions. Apart from accounting concerns, AMI is an expert in cost-cutting. For example, following its 2008 acquisition of U.K. Surgical, AMI has reduced annual operating costs by 200 million. However, former UK Surgical executives and competitors believe AMI may have lost some of the ingenuity necessary to thrive in an evolving medical supply market. "They had a lot of great ideas in the pipeline," one executive explained, "but [AMI] pulled the plug on everything." Required: a. Describe how merger-related accounting impairs a user's ability to make period-to-period comparisons using accounting reports. Does this hold true for both the purchase and pooling methods? Explain. (10 Marks) b. Explain why a high price-to-earnings ratio is crucial to Tyco's acquisitions strategy. (5 Marks) c. How do merger-related charges potentially enable a company to inflate future operating earnings? How can a user of financial statements assess whether this is occurring? (10 Marks) d. Many short-term gains in acquisition come from cutting costs. What potential long-term harm can cost-cutting create? (5 Marks) e. Tyco's controversy is arguably a quality of earnings concern, where Tyco strategically used the discretion in GAAP. Why is the market's reaction to this alleged behavior so severe? (5 Marks) f. Many companies report pro-forma earnings that exclude one-time acquisition costs and, increasingly, goodwill amortization. Critique the use of pro-forma earnings for financial statement analysis. (5 Marks) (Total: 40 Marks) PROBLEM 3 AMI Limited was covered in a December 2009 Fortune article for its acquisition accounting practises. AMI's market value fell by 23% in mid-November 2009, following charges by an analyst that the business was inflating its growth image through accounting gimmicks, as well as rumours that AMI's auditors might leave. AMI has invested 30 billion in the last three years alone 23 billion in cash. It has concentrated on everyday technologies-security systems, electrical connectors, industrial valves, and health care devices, to name a few. AMI announced that its net income before special charges more than doubled to 2.6 billion in fiscal 2009, while revenues increased by 83% to 22.5 billion. AMI's market worth was almost 80 billion prior to the claims, up from just 1.7 billion in 2002. According to several analysts, AMI aggressively controlled its earnings by leveraging acquisitions to achieve eye-popping results. Short sellers on Wall Street have long talked about AMI's bookkeeping. AMI is a "rollup" company-one that leverages its high stock price to acquire businesses with lower PE multiples and its acquisition strategy is now jeopardised as a result of the stock price decrease. AMI's troubles stem from aggressive merger-related accounting, which includes restating acquired companies' earnings before the mergers happen in order to make future results appear better. Pooling accounting is used to account for the majority of AMI's largest acquisitions. This practically means that AMI restates its financial statements, implying that the purchased firm was a part of AMI long before the deal closed. These restatements make comparing one period to the next exceedingly difficult. To add to the uncertainty, AMI has recently taken 4 billion in merger-related costs, shifted its fiscal year-end from December to September, and relocated its headquarters from the United Kingdom to Bermuda to take advantage of a lower tax rate. According to one expert, AMI is amassing massive charges to fund "cookie jars" of reserves for future running needs. Indeed, once the huge charges are included in AMI's earnings appear anything but brilliant. AMI reported significant financial losses in fiscal 2006 and 2007, as well as an 83 percent decline in net income in the first nine months of fiscal 2009. London Stock Exchange practise, on the other hand, is to disregard such charges, claiming that Pro-forma results provide a more accurate representation of "normalised" earnings. AMI vigorously denies all charges. According to its CEO, the SEC performed comprehensive legal and financial reviews of AMI's three largest transactions over the last two years. Additionally, the CEO states that only six of the company's 120 recent transactions utilised pooling, despite the fact that it was used in some of the company's largest transactions. Apart from accounting concerns, AMI is an expert in cost-cutting. For example, following its 2008 acquisition of U.K. Surgical, AMI has reduced annual operating costs by 200 million. However, former UK Surgical executives and competitors believe AMI may have lost some of the ingenuity necessary to thrive in an evolving medical supply market. "They had a lot of great ideas in the pipeline," one executive explained, "but [AMI] pulled the plug on everything." Required: a. Describe how merger-related accounting impairs a user's ability to make period-to-period comparisons using accounting reports. Does this hold true for both the purchase and pooling methods? Explain. (10 Marks) b. Explain why a high price-to-earnings ratio is crucial to Tyco's acquisitions strategy. (5 Marks) c. How do merger-related charges potentially enable a company to inflate future operating earnings? How can a user of financial statements assess whether this is occurring? (10 Marks) d. Many short-term gains in acquisition come from cutting costs. What potential long-term harm can cost-cutting create? (5 Marks) e. Tyco's controversy is arguably a quality of earnings concern, where Tyco strategically used the discretion in GAAP. Why is the market's reaction to this alleged behavior so severe? (5 Marks) f. Many companies report pro-forma earnings that exclude one-time acquisition costs and, increasingly, goodwill amortization. Critique the use of pro-forma earnings for financial statement analysis. (5 Marks) (Total: 40 Marks)