The impact of the historical variation in accounting standards is evident with Choi and Lee’s (1991) examination of the effects on the market for takeovers and mergers with reference to whether national differences in the treatment of purchased goodwill are associated with differences in premia offered by U.K. as opposed to U.S.
acquirers of U.S. targets. They found that merger premia associated with U.K. acquisitions to be consistently higher than those for U.S. acquisitions. Moreover, higher premia offered by U.K. acquirers appear to be associated with not having to amortize goodwill to earnings and this was demonstrated to affect managerial behavior. This is in line with the U.S. research by Robinson and Shane (1990) that presented qualified results of an association between acquisition accounting method and bid premia for target firms. In particular, the researchers found bidders were willing to pay for the benefits derived from the accounting method of pooling in comparison to the purchase method which generally led to goodwill amortisation and reduced future earnings.
Australia adopted International Financial Reporting Standards (IFRS) in 2005 (AASB, 2004) and financial statements became comparable across many countries leading to increasing investment confidence by North American and European investors. Global companies such as BHP Billiton and Rio Tinto could now produce a single set of accounts rather than presenting a series of accounts compliant with various standards, e.g. US GAAP.
With respect to M&A activity, the adoption of IFRS led to significant changes in the accounting for goodwill. Prior to the adoption of IFRS, Australian Accounting Standards Board (AASB) standard (AASB 1013 Accounting for Goodwill) required
goodwill on acquisitions to be recorded as an asset and amortised on a straight-line basis over a period not exceeding 20 years (c.f. early UK standards). Under IFRS (AASB 3 Business Combinations), goodwill with an indefinite life is not written off. However, companies must undertake annual impairment tests of the value of this goodwill. Like the annual impairment test for other assets, the recoverable amount is the higher of either the fair value less cost to sell; or value in use (i.e. the present value of future cash flows including disposal value).
Bugeja and Gallery, (2006) report that the change to Australian and international goodwill accounting follows in the footsteps of changes made by the Financial Accounting Standards Board to US standards. However, the UK Financial Reporting Standard 10 Goodwill and Intangible Assets continues to require amortization of purchased goodwill, with a maximum amortization period of 20 years. The useful life may be determined as greater than 20 years if it is expected that the durability of the acquired business will exceed 20 years and the value of goodwill can be regularly measured. This has a bearing on resource acquisitions by U.K. domiciled companies with Australian and other non-U.K. targets.
Ernst & Young (2009) conducted an international study of over 700 transactions completed by IFRS compliant companies in Europe, Americas and Asia. Figure 17 summarizes the allocation of the acquisition price to net tangible assets, identifiable intangible assets and goodwill in 13 different sectors. Apart from the oil and gas sector, resource companies are excluded from the survey. However the survey does provide an interesting and not surprising comparison with higher goodwill
allocations in technology and consumer products while oil and gas companies had the lowest goodwill allocation percentages across the reviewed sectors.
Figure 17. The allocation proportion of goodwill, intangible and tangible assets in acquisitions across various sectors.
From Ernst & Young (2009).
In times of significantly decreasing commodity prices as recently experienced with the global financial crisis, annual impairments tests in resource companies are resulting in numerous impairment charges as evident in many resource company financial statements (e.g. BHP Billiton 2009, Rio Tinto 2009).
Prior to the adoption of the IFRS, goodwill amortisation was a significant consideration in M&A activity because of the impact of amortisation charges on earnings. To compensate for amortisation and other non-operating aspects of earnings, analysts often estimated ‘adjusted earnings’. This process is designed to standardise reported net operating profit after tax and include adjustments to (Oliver 1998):
• Abnormal gains/losses net of tax
• Foreign exchange gains/losses net of tax • Gains/losses from asset sales net of tax • Excess or inadequate depreciation • Amortisation of intangibles • Tax effect adjustments
• Adjustments for different reporting periods (eg. Adjust 31st December year end reporting years to years ending 30th June)
Interestingly, Bugeja and Gallery, (2006) actually found that after studying goodwill of different ‘ages’, firm value is positively associated with goodwill purchased in the observation year and in each of the preceding two years, but not with goodwill acquired more than two years previously. They believe their findings suggest that only recently acquired goodwill is associated with the market value of equity, which indicates that the market rationally perceives ‘older’ goodwill as not having future economic benefits.
Under the current IFRS regime the market appears to have increasing confidence in asset values reported each year and company management usually ‘flag’ material impairments prior to results reporting. Hence, the market focuses on ‘underlying earnings’ to reflect the operating performance of the company and ignore significant items unless they reflect unexpected and material asset write downs. Resource companies also typically provide earnings sensitivities to movements in commodity prices and exchange rates. This highlights a company’s earnings leverage to
particular commodities and exchange rates as well as providing analysts and
investors with a method of estimating short-term earnings based on these commodity price and exchange rate trends or expectations. This contrasts with the alternative of developing complicated company models to forecast earnings.
Prior to the implementation of IFRS, it is interesting to note the potential impact of increasing globalization of markets as Land and Lang’s (2002) research led them to conclude that average earnings/price ratios (also known as earnings yield) across the countries analyzed in their paper (Australia, Canada, France, Germany, Japan, the U.K., and the U.S.) had moved closer together from the 1987–1992 time period to the 1994–1999 time period.
The inverse of the earnings yield is the price/earning (P/E) ratio and is the most ubiquitous ratio used in share price analysis. This thesis highlights the importance of the prospective earnings timeframe with regards to P/E ratios as these can be
long-term P/E ratios which are deemed to reflect more sustainable earnings levels and are often capitalised to proxy for NPV valuations by overseas investors.
In bull markets there is a tendency for the market to focus on increases in short term earnings and hence, short-term P/E ratios on the back of increases in contemporary commodity price and often irrespective of the perceived sustainability of these commodity prices. In less bullish markets, sustainable P/E ratios based on medium and longer term forecast earnings levels become more important in a similar manner to NPV valuations (particularly given their potential similarity). An old axiom in the resource sector was to Buy the sector at high P/E ratios and then Sell at low P/E ratios with earnings increases from rising commodity prices. However, it also highlights the expectations of contracting short-term P/E ratios.