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Module 7ModuleModuleModule 777 Emerging and Controversial Issues in International Financial ReportingInternational Financial Reporting Omar ElKheshen – kheshen@gmail.com 1
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Learning Objectives By the end of this module you should understand: 1. The difficulties involved in accounting for an acquisition and how goodwill arises 2. How goodwill differs from intangible assets and how both are accounted for 3. What impairment means and how to account for it 4. How share options are accounted for and their impact on bottom-line profits 5. How corporate pension obligations are making an impact of both profit and balance sheets 6. The basic principles of financial instruments and how these are captured in corporate financial statements 7. The difference between provisions and contingencies and when companies should account for them 8. Why new topics such as management commentaries and corporate financial reporting are currently under development in the field of financial reporting. Omar ElKheshen – kheshen@gmail.com 2
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Agenda 7.1 Introduction 7.2 Business Combinations and Goodwill 7.3 Intangible Assets and their Impairment 7.4 Share-based Payments 7.5 Pension Benefits 77..66 Financial InstrumentsFinancial Instruments 7.7 Provisions, Contingent Liabilities and Contingent Assets 7.8 Management Commentary 7.9 Reporting on Corporate Social Responsibility Review Questions Case Studies Omar ElKheshen – kheshen@gmail.com 3
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To discuss the controversial issues that attract news headlines, we must first understand the pressure under which the modern company director is operating Companies to grow annually/ quarterly Growth Entire Economy EPS & Capital& Capital Profit Markets either Organically More sales, More profit, More assets Profits Acquisition Taking over other companies or Neither type of growth is easy to achieve Omar ElKheshen – kheshen@gmail.com 4
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It is difficult for managers to steer their companies towards more and more growth, thus driving them towards adopting the short-termism phenomenon Difficulties Facing Managers Uncertainties ofUncertainties of Vagaries ofVagaries of Actions ofActions of the marketthe market consumerconsumer competitorscompetitors conditionsconditions preferencepreference Create a turbulence That create:That create: Temptations for management to adopt the set of generally accepted accounting principles which give the appearance of an upward trend in performance This pressure on profits or earnings per share is a phenomenon referred to as short-termism Omar ElKheshen – kheshen@gmail.com 5
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The investment analyst community is accused of being responsible for this outlook Relation Between Investment Analyst and Investors gives advice Investment Analyst Investors Visit the company concerned and talk Have neither time nor knowledge to to management study corporate performance Study past performance, make On the basis of analysts’ advice they reasonable assumptions about the buy, sell or hold shares future influences Prediction about Earnings Share Price Omar ElKheshen – kheshen@gmail.com 6
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On the other hand management stands by and watches the company’s share price being ‘talked up’ by the analyst community in advance of published accounts 2 Scenarios If the company fails to achieve If the company meets the the predicted profit level predicted profit level Share price will be marked Best the company can usuallyBest the company can usually down instantlydown instantly hope for is price stability Press managers to adopt: Short-Term View Arranging their financial affairs that higher profits are reported sooner rather than later The following sections of this module gives readers a flavor of some of the more controversial issues being addressed by the IASB Omar ElKheshen – kheshen@gmail.com 7
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Agenda 7.1 Introduction 7.2 Business Combinations and Goodwill 7.3 Intangible Assets and their Impairment 7.4 Share-based Payments 7.5 Pension Benefits 77..66 Financial InstrumentsFinancial Instruments 7.7 Provisions, Contingent Liabilities and Contingent Assets 7.8 Management Commentary 7.9 Reporting on Corporate Social Responsibility Review Questions Case Studies Omar ElKheshen – kheshen@gmail.com 8
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There are 2 types of accounting practices concerning group accounts, choosing between them depends on the terms of the business combination "How a company"How a company Accounting Practices Depends on business becomes a subsidiarybecomes a subsidiary combinations: of a holding company"of a holding company" Acquisition Accounting Merger Accounting "Purchase Method Accounting" "Pooling of Interests" Hawkish behavior of predatorHawkish behavior of predator Concept of harmony &Concept of harmony & and prey agreement The predator company Agreement between the two (Holding) acquires more than parties to pool their respective 50% of the equity share capital interests rather than for the one of the target (Subsidiary) for to hand over its assets to cash, or shares in the holding another company, or a combination of cash and shares Omar ElKheshen – kheshen@gmail.com 9
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We now introduce an example of a takeover using acquisition accounting Example Forth Ltd offers to acquire the entire share capital of Clyde Ltd. The terms are: one Forth share worth €5 for each of Clyde’s one million ordinary shares. The offer therefore values Clyde at €5 million. Clyde has net assets shown in its balance sheet of €4 million. Before the offer, which was accepted by all shareholders in Clyde, the summarized balance sheets of the two companies are as follows: Omar ElKheshen – kheshen@gmail.com 10
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We use the same mechanics as in module 5 Acquisition accounting would produce a balance sheet for Forth Group Ltd as follows: Difference between €5 m paid by Forth Share capital is doubled & €4 m Clyde’s due to the share issue to assets in B/S Clyde’s shareholders Difference between The distributableThe distributable acquisition valueacquisition value €€55 mm reserves of the and the €1 m ordinary group are those of shares issued by Forth the holding company, Forth Omar ElKheshen – kheshen@gmail.com 11
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Now let’s consider the same transaction using merger accounting The combined balance sheet would read: Comprises €1m original plus €1m newly issued Distributable reserves ofDistributable reserves of the 2 companies are added together Neither goodwill nor share premium appears on the balance sheet Accounting statements in merger accounting restates both companies’ accounts as if the two companies had always been one Omar ElKheshen – kheshen@gmail.com 12
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The managerial issues are clear when the two balance sheets, acquisition & merger, are compared, thus leading to merger accounting being favored over acquisition Feature in Both Accounting Practices Worthy of Managerial Attention Acquisition Accounting Merger Accounting Goodwill arises on B/S Combined nature of distributable reserves Goodwill should not be carried as an asset on the balance sheet beyond its perceived Management would have access to useful lifeuseful life considerably more free reserves thanconsiderably more free reserves than under acquisition accounting Writing off goodwill systematically has a negative impact on profits and/or reserves Merger accounting gives the management of the group more flexibility than acquisition accounting Omar ElKheshen – kheshen@gmail.com 13
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IFRS 3 Business Combinations has outlawed merger or pooling of interests accounting and requires managers to adopt acquisition accounting Reason Too many acquisitions were being structured under the former standard in such a way as to permit pooling even though the combination was clearly a takeover of one company by another; the amount actually paid by the acquirer was conveniently obscured from view IFRS 3 All business combinations should be accounted for by applying "Purchase method" requires the acquirer to: Recognize the acquiree’s assets, Recognize goodwill (the amount paid liabilities and contingent liabilities at over the fair value of the net assets their fair values at the acquisition acquired) date Omar ElKheshen – kheshen@gmail.com 14
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