Page 96 - FINAL CFA II SLIDES JUNE 2019 DAY 5.2

BUSINESS COMBINATIONS—ACQUISITION READING 18: EVALUATING QUALITY OF FINANCIAL REPORTS
METHOD ACCOUNTING

MODULE 18.1: QUALITY OF FINANCIAL REPORTS

Mergers and acquisitions often provide opportunities and motivations to manage financial results. For example:
• Stock acquisitions provide an incentive to by pass cash flow statement and pursue aggressive accounting so as to inflate their stock price prior to
acquisition.
• Target company could inflate stock price to fetch an attractive price at acquisition.

Acquirers may wish to hide pre-acquisition accounting irregularities; acquire targets with dissimilar operations or with less publicly available information to
reduce the comparability and consistency of their own financial statements.

Because IFRS requires that acquirer allocates the purchase price to fair value of identifiable net assets of the subsidiary and the balance to goodwill,
acquirers often underestimate the value of identifiable net assets—thereby overestimating goodwill on acquisition. Fair value adjustments for identifiable
assets typically result in excess depreciation which reduces profits for future reporting periods.

Since goodwill is not amortized, the effect of overestimating goodwill (and underestimating the value of identifiable assets) is to increase future reported
profits. Such inflated goodwill will eventually have to be written down as part of impairment testing but such losses can be timed. In addition, impairment
losses can be downplayed as a one-off, non-recurring event.

GAAP ACCOUNTING BUT NOT ECONOMIC REALITY

Sometimes, an accounting treatment may conform to reporting standards but, nonetheless, result in financial reporting that does not faithfully represent
economic reality.

• Restructuring provisions and impairment losses provide opportunities to time the recognition of losses (i.e., earnings management). Typically,
recognition of impairment or restructuring losses in a period reflects overstatement of income in prior periods.
• Conversely, impairment or restructuring provisions may be strategically timed to shift future expenses into the current period. For example, impairment
losses on long-lived assets recognized in the current period will reduce future depreciation expense. Similarly, restructuring provisions allow managers
to effectively set aside profits in the current period to be used in the future. Provisions are non-cash expenses charged in the current period; future
expenses from such provisions bypass the income statement. In such cases, losses recognized in the current period will boost income in the future
when reversed.