The University of Hong Kong

Faculty of Business and Economics

Academic Year 2018 - 19

Advanced Financial Accounting

ACCT4104 Subclass C – E
Group Project

Students are required to apply the knowledge learned from this course to analyze issues on
business combinations. Group members are to meet, work together and contribute jointly to
complete the project. Students are required to make an oral presentation to discuss the important
issues of the project.

Format of the Oral Presentation

The oral presentations will be held during the lecture time according to the schedule below.

April 4 Presentation Team Questioning Team

1030 – 1220 C1 – 3 C4 – 6
1330 – 1520 D1 – 3 D7 – 10
1630 – 1820 E1 – 3 E4 – 6

April 11 Presentation Team Questioning Team

1030 – 1220 C4 – 6 C1 – 3
1330 – 1520 D4 – 6 D1 – 3
1630 – 1820 E4 – 6 E1 – 3

April 18 Presentation Team Questioning Team

1330 – 1520 D7 – 10 D4 – 6
1630 – 1820 E7 – 10 E11 – 14

April 25 Presentation Team Questioning Team

1630 – 1820 E11 – 14 E7 – 10

Each team has to work on the following:

(1) Make a 15-minute presentation (every member has to speak up). Then, answer questions
raised by the teacher and other teams (budgeted time: 10 minutes). You have to submit the
PowerPoint slides (and any other relevant materials) to the teacher before the presentation.
(2) Prepare questions for other teams and raise the questions after their presentations. You have
to submit (via email to the teacher) your questions and feedback (in a document of no more
than 300 words) by end of that presentation week.

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Marking Scheme

For your own presentation:

Quality of presentation content (e.g. research, analyses, etc.) 50%
Presentation skills and teamwork 10%
Answers to questions raised by the teacher and other teams 20%

For other teams’ presentations:

Quality of questions raised to other teams 10%
Feedback to the questions and answers 10%

Total: 100%

Please refer to the course outline for the detailed scoring criteria.

Case Questions

(1) Discuss the issues in the case article (adopted from Applying IFRS Standards, by Picker,
Clark, Dunn, Kolitz, Livne, Loftus, van der Tas, 4th Edition (2016), EY & Wiley). Support
your explanations and analyses with real examples and/or numerical examples.

(2) With the knowledge that you have learnt so far in Advanced Financial Accounting, explore
and discuss other consolidation accounting issues that have led / may lead to earnings
management / other ethical concerns.

CASE ARTICLE
One of the interesting questions about business combinations is whether earnings management
plays a role in the acquisition price. One context where earnings may play a role is when the
acquisition is funded by stock-for-stock swap. Here managers of the acquiring firm may attempt
to inflate earnings to increase the price of their stock. This, in turn, can produce a more
favourable exchange ratio for the acquiring firm's shareholders. Erickson and Wang (1999)
examine this question for 55 stock-for-stock mergers that took place between 1985 and 1990.
Earnings management is captured by abnormal accruals and is shown to increase in the quarters
preceding the merger announcement, but decrease following the announcement. To enhance the
strength of the conclusion that earnings management is present mostly in stock-for stock
acquisitions, the authors also analyse 64 cash deals, but do not find similar results. Louis (2004)
extends this line of inquiry to mergers between 1992 and 2000 comprising 236 stock swaps and
137 cash deals. He finds that stock-swap acquirers experienced negative abnormal returns in the
2 years prior to the merger announcement. This poor performance may have exerted pressure

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on managers to manipulate earnings. Consistent with this, Louis (2004) finds strong evidence
of greater earnings management in the quarter preceding the merger announcement in stock
acquirers than cash acquirers. Additionally, he finds that abnormal stock returns in the 3 years
following the merger are negatively related to the measure of abnormal accruals in the quarter
preceding the announcement. This is consistent with successful earnings management by
managers of stock swap-acquirers. Moreover, the evidence suggests that market participants do
not fully understand the effect of pre-merger announcement earnings management.
As business combinations represent a major corporate event, investors would benefit from
additional disclosures that could help them form expectations about future performance. Shalev
(2009) assembles a sample of 297 acquiring firms involved in 1019 acquisitions between 1 July
2001 to 31 December 2004 to examine what determines the level of disclosure. He posits that
acquirers that are more confident about the acquisition outcome would tend to be more
forthcoming in their disclosures. He finds that disclosure levels are negatively related to the
amount of goodwill recognised. This is consistent with goodwill capturing overpayment and
hence bad news that acquirers would like to withhold. Acquirers that provide more disclosure
also tend to report higher ROA in the year of acquisition and the following year. Consistent with
Shalev's (2009) hypothesis, these acquirers also experience positive abnormal stock returns in
the year following the filing of the annual report for the acquisition year.
Another question is whether earnings management plays a role in the allocation of the purchase
consideration to net assets and goodwill. Under IFRS® Standards, the purchase consideration is
allocated to goodwill after the fair value of net assets acquired is determined. This implies a one-
to-one substitution effect between fair value adjustments and goodwill. For example, allocating
purchase consideration to higher fair value of depreciable assets would reduce goodwill as well
as future profits owing to higher depreciation. The opposite is also true since goodwill is not
amortised. Shalev et al. (2013) explore how managerial compensation affects this price
allocation. They examine 320 acquisitions between 2001 and 2008 and test for the association
between a CEO's cash bonus (which is typically based on accounting numbers) and the
percentage of the purchase price that is allocated to goodwill and intangibles with indefinite life.
Shalev et al. (2013) provide evidence that suggests that greater bonus intensity is positively
associated with the percentage of purchase price that is allocated to goodwill and intangibles
with indefinite life. This is consistent with managers of acquiring firms using discretion to
allocate a greater fraction of the purchase price to assets that are not subject to depreciation and
amortisation which, in turn, boosts future profits.
Since goodwill is the difference between price paid and fair value of net assets acquired it is not
clear what its economic meaning is. Furthermore, insofar as goodwill is manipulated, it is
interesting to see if it has any predictive value and whether its power to predict future
performance is moderated by managerial discretion. These questions are addressed by Lee
(2011). Lee (2011) first establishes that goodwill is positively related to 1 year ahead operating

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cash flows. This provides support to the view that goodwill is an asset. Importantly, this relation
is not found to be sensitive to the degree of managerial discretion.
The above-mentioned studies are based on US samples; not much academic research has been
conducted into IFRS 3. One of the few studies to do so is Glaum et al. (2013) who examine the
degree of compliance with the disclosure requirements of IFRS 3 and IAS 36, the latter
governing goodwill impairment rules. They examine compliance in a sample of 357 European
firms involved in acquisitions in 2005 — the year when IFRS became mandatory in the EU.
Glaum et al. (2013) develop a 100-item disclosure checklist that is based on the requirements of
the two standards. Compliance is found to vary across countries, industries and auditor type. For
example, Switzerland shows the highest level of compliance and Austria the lowest. Companies
audited by big audit firms tend to comply more than companies audited by smaller auditors.
Glaum et al. (2013) further find from a multivariate analysis that compliance increases with the
size of recorded goodwill. A second study of IFRS 3 is Hamberg et al. (2011) who examine
IFRS 3 adoption in a sample of Swedish firms. They find that goodwill-intensive firms
experience higher stock returns than no-goodwill firms upon adoption of IFRS 3. It is not clear,
however, if investors correctly interpret goodwill as a signal of better performance.

References
Erickson, M., and Wang, S. W. 1999. Earnings management by acquiring firms in stock for
stock mergers. Journal of Accounting and Economics, 27(2), 149–176.
Glaum, M., Schmidt, P., Street, D. L., and Vogel, S. 2013. Compliance with IFRS 3- and IAS
36-required disclosures across 17 European countries: Company- and country-level
determinants. Accounting and Business Research, 43(3), 163–204.
Hamberg, M., Paananen, M., and Novak, J. 2011. The adoption of IFRS 3: The effects of
managerial discretion and stock market reactions. European Accounting Review, 20(2), 263–
288.
Lee, C. 2011. The effect of SFAS 142 on the ability of goodwill to predict future cash
flows. Journal of Accounting and Public Policy, 30(3), 236–255.
Louis, H. 2004. Earnings management and the market performance of acquiring firms. Journal
of Financial Economics, 74(1), 121–148.
Shalev, R. 2009. The information content of business combination disclosure level. The
Accounting Review, 84(1), 239–270.
Shalev, R., Zhang, I. X., and Zhang, Y. 2013. CEO compensation and fair value accounting:
Evidence from purchase price allocation. Journal of Accounting Research, 51(4), 819–854.

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