Column
Acquisition accounting is the respectable way to hide a business that has stopped growing
Nothing in a serial acquirer's reporting is false. The convention that lets an acquired company become organic on its first anniversary does the work that a misstatement would otherwise have to do.
In this story
- VNTY
- SPX−0.81%
Illustrative. Bank Season is an editorial prototype. This story, its sources, the issuers named in it and every figure it quotes are invented to demonstrate the publication. Nothing here is reported fact or investment advice. Read the disclosure.
I want to be careful at the outset, because this column is about something legal. Nothing described below is fraud, nothing here would trouble an auditor, and the companies that do it most effectively are run by people I would describe as honest. That is exactly what makes it interesting. When a whole industry arrives at a reporting convention that systematically flatters it, and every participant applies the convention correctly, the problem is the convention and there is nobody to blame.
The convention is this. A serial acquirer reports an organic growth figure that excludes recently acquired businesses, and the exclusion lapses on the first anniversary of each deal. From the thirteenth month, an acquired company counts as organic. Applied to a firm that buys one company every few years, this is sensible and nobody should object. Applied to a firm buying nine a year, it produces an organic figure permanently populated by businesses in their second year of ownership, which is the year the integration benefits arrive.
Three devices, none of them improper
The first anniversary rule does most of the work and it has two companions. Together they can hold a reported growth line above zero for as long as the acquisition programme continues, regardless of what the underlying business does.
How the conventions combine in a company closing nine deals a year
| Device | What it does | Is it improper | Effect on reported organic growth |
|---|---|---|---|
| First anniversary rule | Acquired businesses count as organic from month thirteen | No, universal practice | Adds the integration uplift year to the organic line |
| Base restatement for divestitures | Prior year revenue restated to exclude businesses since sold | No, required for comparability | Removes the weakest units from the comparison |
| Synergy disclosure without follow-up | Expected savings stated at announcement, never reconciled | No standard requires the reconciliation | Supports the multiple paid without ever being tested |
| Fiscal period alignment | Acquired company's year end conformed to the parent's | No, ordinary | Creates stub periods that complicate any outside reconstruction |
| Purchase price allocation to intangibles | Amortisation excluded from adjusted earnings | No, disclosed clearly | Adjusted earnings per share rises with every deal |
Every device listed is standard practice and appropriately disclosed. The column's argument is about their combined effect rather than about any one of them.
Look at the last row for a moment, because it is the one that closes the loop. A deal that is dilutive on statutory earnings is frequently accretive on adjusted earnings, because the amortisation of the intangibles created by the deal is added back. The more a company pays, the more intangible value it creates, the more it adds back, and the better the adjusted number looks. A management team compensated on adjusted earnings per share growth is therefore rewarded for paying more, which is not what anybody intended when the adjustment was first permitted.
13 months
Point at which an acquired business becomes organic under standard practice
Applied to a company closing nine acquisitions a year, the organic revenue base is perpetually populated by businesses in their second year of ownership.
I have watched this cycle three times now and the ending is always the same. The programme slows, because the pipeline empties or the balance sheet tightens or a rating agency makes a phone call. The conventions then run in reverse. Organic growth has nothing new feeding it, the base stops being restated favourably, and the reported figure converges on the underlying business over about four quarters. Shareholders discover what they owned at precisely the moment the company has least ability to do anything about it.
- Reported growth stays positive throughout the programme and is not, in any individual period, misleading.
- The convergence when deals stop is fast, usually four to six quarters, because the population of second year businesses ages out together.
- The multiple compresses before the revenue line does, because the market prices the end of the programme rather than the arrival of the numbers.
- Management teams are rarely dishonest about any of this and are frequently surprised by it, because they were reading the same reported figure as everyone else.
I have asked for a fixed cohort series from about a dozen acquirers over the years. Two provided it, and both turned out to be the ones I should have been buying. The refusals were never hostile. They were always the same answer, which is that the systems do not produce it, and the systems produce anything a chief executive genuinely wants.
Ines Duarte, portfolio manager at Kestrel Asset Management
Where the board comes in
None of this is an accounting problem, which is why I am unenthusiastic about solving it with a new standard. It is a governance problem sitting in plain view. A board that sets incentives on adjusted earnings per share growth, and does not commission an independent view of the underlying business, has outsourced its judgment to a metric that the executive team's own strategy is designed to improve. That is not a subtle failure. It is the oldest one there is, dressed in an audit opinion.
4 to 6 quarters
Typical time for reported growth to converge on the underlying business after a deal programme stops
Because the population of businesses in their second year of ownership ages out of the organic calculation together.
The remedy available to a board is not complicated either. Ask for the fixed cohort number in the audit committee pack every quarter. Do not publish it if you would rather not. Simply have it, look at it, and notice if the two lines diverge for six periods running. A board that has been watching that number cannot be surprised by the convergence, and a board that has not been watching it will be surprised at the same moment as everybody else, which is the moment it is worth the least.
What I would ask on the call
- 01What was revenue, this period and the comparable period, for the businesses you owned throughout both.
- 02Of the synergies announced with deals closed three years ago, how much is in the current cost base, and how was that measured.
- 03How much of the increase in adjusted earnings per share over the last three years is amortisation added back on acquired intangibles.
- 04If the acquisition programme paused for a year, what would the organic growth figure be in the fourth quarter of that pause.
The fourth question is the one that produces silence, and the silence is the answer. Any management team running a programme of this kind has modelled it, because their lenders made them. The reason it does not get said out loud is that saying it converts a growth company into a distribution business in the space of a sentence, and nobody volunteers for that. They wait, correctly, for the arithmetic to do it for them, by which time the people who needed to know have already paid the multiple.