It’s no secret that a substantial percentage of acquisitions fail to deliver expected synergies.

That risk increases if the companies are comparable in size or if the acquired business is material to the acquiring company. For example, the 2001 merger of Hewlett-Packard and Compaq Computer arguably led to the end of industry dominance for both companies.

That doesn’t mean we can predict whether a particular acquisition will fail. But what if we could?

A recent academic paper, “Costs and Benefits of Internal Control Audits: Evidence from M&A transactions” (accepted for publication in Review of Accounting Studies), provides some insight into acquisitions that may generate negative returns to investors.

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The authors, Kravet et al., found evidence that excluding acquired companies from the assessment of internal controls — as permitted by Sarbanes-Oxley (SOX) Section 404 in the first year after an acquisition  — generated statistically significant negative stock returns of 0.8% at the time of the exemption announcement. (Typically, such announcements come months after the acquisition news hits the market.)

More notably, the authors also identified statistically significant negative returns of 8.8% and 12% for the periods of two and three years after the exemption announcement, respectively. That indicates negative outcomes are not fully priced at the announcement date.

(Note that the authors focused on acquisitions where the target had at least 20% of the acquirer’s market capitalization. Additionally, only companies subject to auditor attestation on internal controls were included.)

In addition to negative stock returns, Kravet et al. identified other negative outcomes for acquiring companies that elected to exclude acquisition targets from control assessments. Those included higher likelihood of goodwill impairments, lower return on investment, higher probability of a financial restatement, and overall lower quality of financial reporting.

This analysis is interesting from a practical perspective, because it allows for an early warning that certain companies may need more scrutiny on a going forward basis.

Based on that idea, we performed an analysis to identify a list of cases where assets or revenue of the target company were around 20% of the acquirer and where an acquisition-related exemption was reported in 2017 financial statements.

We started from a population of about 3,700 audited Sarbanes-Oxley 404 reports issued for fiscal 2017. About 390 reports (10.5% of the population) noted an acquisition-related exemption. Among those, companies issued slightly more than 100 reports where the target’s assets or revenue were around 20% of the acquirer’s.

Backing up the academic paper, companies that selected acquisition-related exemptions were statistically more likely to experience negative outcomes than companies that did not select such an exemption. 

To further illustrate how investors and analysts may use this model, let’s look at a case study: FTD Companies.

FTD acquired Provide Commerce in 2014 and elected to exclude the acquired company from its assessment of internal controls over financial reporting. Consistent with the model, FTD subsequently experienced negative outcomes related to the acquisition.

According to FTD’s 2014 annual report, it acquired Provide Commerce for $430 million. Its assets represented 52% of the consolidated total assets of FTD as of Dec. 31, 2014.

The 10-K stated, “Since we excluded the Provide Commerce acquisition from our evaluation of internal control over financial reporting, our evaluation does not include the material weaknesses identified by Provide Commerce’s external auditor related to the audit of the December 31, 2013 financial statements.”

 So, even though FTD took the exemption, it disclosed the control issues. That is not a common disclosure, but it’s required when companies discover control issues during the integration process. In our opinion, such disclosure may further increase the chances of a negative outcome, as discussed by Kravet et al.

In March 2016, less than two years after the acquisition date, FTD recorded an $85 million goodwill impairment related to its Provide Commerce unit, consistent with the academic model.

Additional red flags in FTD’s accounting quality matrix included the resignation of its CEO in November 2016, followed by the CFO’s resignation the following month.

In the quarterly earnings release and annual report issued in March 2017, FTD identified a material weakness in its internal controls over financial reporting relating to control over the assessment of cross-border indirect taxes.

In the same 10-K, the company identified the need to restate previously filed financial statements for 2014, 2015, and the first three quarters of 2016. Errors in cross-border taxes that reduced aggregate net income by about $15 million caused the restatements.

Additionally, in the same annual filing, the company announced an $84 million impairment of the Provide Commerce unit, bringing the unit’s total impairment to $169 million — a clear sign that the acquisition did not work out as planned.

After the filing, FTD stock declined sharply. That prompted numerous legal actions on behalf of shareholders. Plaintiffs alleged, among other things, false and misleading financial statements, lack of effective internal controls, and overstatement of the benefits of the Provide Commerce acquisition.

The stock slide continued into 2018, and as of August 28, the stock was trading at around $3.8. It had lost more than 80% of its value, even compared to the March 2017 low of about $20.

The accounting issues culminated in February 2018 with a material restatement related to errors in goodwill impairment calculations. The errors reduced September 2017 net income by $23 million.

From an investor’s perspective, the key question is whether the acquisition’s failure could have been predicted.

It’s hard to say whether any particular restatement documenting material errors will signal that all the bad news is finally out and that therefore a potential turnaround might be just around the corner. However, at the time of this article’s writing, FTD stock was still trading around a 52-week low of about $3.8.

To summarize, under SOX 404, companies are allowed to exclude newly acquired businesses in the first year following the acquisition. There is nothing inherently wrong with using regulatory leeway permitted by the accounting rule.

Yet, the research suggests selecting the exemption may increase the probability of negative stock returns following an acquisition.

This article was first published by FactSet.

Olga Usvyatsky is vice president of research for Audit Analytics. Kati Manyak and Nicole Hallas are research analysts with the firm.

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