International Financial Reporting Standards_guide.pdf

70 Chapter 6 Business Combinations (IFRS 3)
6.6.4 In applying the acquisition method, the Statement of Comprehensive Income and the
statement of cash flows will include the operating performance of the acquiree from the date
of the acquisition going forward. Operating results prior to the acquisition are not restated
and remain the same as historically reported by the acquirer. Consequently, the financial
statements of the acquirer will not be comparable before and after the combination, but will
reflect the reality of the combination.
6.6.5 Despite the sound principles incorporated in IFRS 3, many analysts believe that the
determination of fair values involves considerable management discretion. Values for intangible
assets such as computer software might not be easily validated when analyzing purchase
acquisitions.
6.6.6 Management judgment can be particularly apparent in the allocation of excess consideration.
If, for example, the remaining excess consideration is allocated to goodwill, there will
be no impact on the firm’s net income, because goodwill is not amortized (but is tested for
impairment). If the excess were to be allocated to fixed assets, depreciation would rise, thus
reducing net income and producing incorrect financial statements.
6.6.7 Under the acquisition method, the acquirer’s gross margin usually decreases in the
year of the combination (assuming the combination does not occur near the end of the year)
because the write-up of the acquiree’s inventory will almost immediately increase the cost of
goods sold. However, in the year following the combination, the gross margin might increase,
reflecting the fact that the cost of goods sold decreases after the higher-cost inventory has
been sold. Under some unique circumstances, for instance, when an entity purchases another
for less than book value, the effect on the ratios can be the reverse of what is commonly
found. Therefore, there are no absolutes in using ratios, and analysts need to assess the
calculated ratios carefully to determine the real effect.
6.6.8 This points to an important analytical problem. Earnings, earnings per share, the
growth rate of these variables, rates of return on equity, profit margins, debt-to-equity ratios,
and other important financial ratios have no objective meaning. There is no rule of thumb
that the ratios will always appear better under the acquisition method or any other method
that might be allowed in non-IASB jurisdictions. The financial ratios must be interpreted in
light of the accounting principle that is employed to construct the financial statements, as
well as the substance of the business combination.
6.6.9 One technique an analyst can use in reviewing a company is to examine cash flow.
Cash flow, being an objective measure (in contrast to accounting measures such as earnings,
which are subjectively related to the accounting methods used to determine them), is less
affected by the accounting methods used. Therefore, it is often instructive to compare companies,
and to examine the performance of the same company over time, in terms of cash
flow.
6.6.10 Over the years, goodwill has become one of the most controversial topics in accounting.
Goodwill cannot be measured directly. Its value is generally determined through
appraisals, which are based on appraiser assumptions. As such, the value of goodwill is subjectively
determined.
6.6.11 The subject of recognizing goodwill in financial statements has found both proponents
and opponents among professionals. The proponents of goodwill recognition assert
that goodwill is the “present value of excess returns that a company is able to earn.” This
group claims that determining the present value of these excess returns is analogous to determining
the present value of future cash flows associated with other assets and projects.