Advance Finance Solution

a)

IASB should have permitted a choice of accounting treatment in IFRS 3 because at times, it is very difficult to measure the amount of goodwill using a particular method. Under IFRS 3, accounting for business combination is done by following acquisition method or purchase method. Under this method, fair value all identifiable net assets are determined to calculate the amount of goodwill or gain on bargain purchase. There are two methods for the calculation of goodwill i.e.,

Full Goodwill Method: Under this method, the net identifiable assets are measured at fair value and non-controlling interest is measured at fair value i.e., it means non-controlling interest includes goodwill also.

Proportionate Goodwill Method: Under this method, the net identifiable assets are measured at fair value but non-controlling interest is measured at proportionate share on net identifiable assets of the acquiree company i.e., no goodwill is recognized for non-controlling interest.

The choice of accounting method for business combination makes a difference only when the business is not acquired wholly or less than 100% of the business is acquired.Determination of fair value of NCI can sometimes be very complicated and time-taking. The fair value of NCI can be measured simply if the shares of the company are publicly traded and listed on stock exchange. However, if the shares of the company are not listed on any of the stock exchanges, then fair value of NCI cannot be determined reliably. There are other techniques which help to determine the fair value of NCI but are not reliable and dependable like:

1. Using discounted cashflow analysis.
2. Using market price of share of the similar firms that are publicly traded and listed on stock exchange.

Under US GAAP, there is no such provision as it only provides for full goodwill accounting method. However, under IFRS 3, a company can choose any option for accounting purpose i.e., full accounting method and partial accounting. If a company is taking over a private company, then it is difficult to measure the fair value of non-controlling interest as the shares of the company are not publicly traded and listed on any of the stock exchanges. Thus, in such case, it is advisable to opt for proportionate goodwill method and calculate the value of NCI accordingly. Here, non-controlling interest is calculated by multiplying share of non-controlling interest with the fair value of net identifiable assets of the company.

c)

Purchase consideration includes amount paid in cash, amount paid after some periods, market value of shares issued but should not include contingent consideration. In this case, Expander plc will pay £5,000 million of cash at the date of acquisition as well as £2,000 million in two years’ time. In deferred payments, the payment to be made after some period should be discounted at appropriate rate to reflect its present value.

With the identification of brands, trade names and internet domain names, the fair value of net identifiable assets increases from £1760 to £5260. Since the company did not recognise such item in the financial statement, it should be considered while calculating the fair value of net identifiable assets.

Method 1. Full goodwill method:

Under this method, the amount of goodwill increases from £7,554.06 to £4,054.06. The difference is £3,500 which is fair value of brands, trade names and internet domain names. It can be said that if full goodwill accounting method is followed, then difference in the amount of goodwill in above two cases will be exactly equal to the fair value of brands, trade names and internet domain names.

Method 2. Proportionate goodwill method:

Under this method, the amount of goodwill increases from £5,582.06 to £3,132.06. The difference is £2,450 which is controlling portion of fair value of brands, trade names and internet domain names. It can be said that if partial goodwill accounting method is followed, then difference in the amount of goodwill in above two cases will be exactly equal to the controlling portion of fair value of brands, trade names and internet domain names.

Controlling portion of fair value of brands, trade names and internet domain names

= Fair value of brands, trade names and internet domain names * Controlling portion

= 3,500*70%

= £2,450

c) The board of expander should adopt full goodwill accounting method in measuring non-controlling interest. The fair value of Target Plc is already determined and thus more reliable. Since, the shares of Target Plc are listed on stock exchange as well as publicly traded, fair value of NCI us calculated easily by multiplying market price of shares with the number of shares held by NCI. It is always advisable to go for “Full goodwill accounting method” if shares are publicly traded and listed on stock exchange due to following reasons:

1. Under this method, the value of non-controlling interest also includes the amount of goodwill. Under partial goodwill accounting method, the value of non-controlling interest does not also include the amount of goodwill. As a result, NCI and goodwill are underestimated to the extent of goodwill allocated to NCI.

Method 1. Full goodwill method: Method 2. Proportionate goodwill method:

In the above case, it is seen that NCI and goodwill have been underestimated by £922 due to adoption of proportionate goodwill method. In proportionate goodwill method, goodwill allocated to NCI is taken into consideration and thus, the value of NCI has been underestimated. The amount of goodwill allocated to NCI is £922 i.e., the difference between fair value of NCI and proportionate share on net identifiable assets. Similarly, the amount of goodwill has been reduced as it does not take into consideration the amount of goodwill allocated to NCI.

1. Consolidated Financial statement will not show the correct financial position as many items i.e., NCI, Goodwill etc. are underestimated. The investors will not be able to assess the true position of the company due to misleading financial information.

• Impairment of goodwill is comparatively easy under full goodwill method as there is no need for grossing up of goodwill for partly owned subsidiaries or subsidiaries which are not wholly owned.

Part 2

a) Financial information disclosed by firms can lead to capital markets’ reactions. There are several types of voluntary information that has been shown to affect capital markets’ reactions. In the recent periods, the outburst of “Covid-19” is an eye-catcher. The disclosure of such information in the financial statement hasn’t comprehensive global economic effects but global capital markets have affected significantly. NASDAQ, S&P 500 have recorded their largest drop in a decade and financial markets have also collapsed. Due to such disclosure, the behavioural finance has become important in assessing investment opportunities and thus, investors start to ignore the fundamental principles of investment theory as market become unpredictable to make any decision related to investment strategy. They are driven by other factors in making their investment strategy which are quite different from fundamental principles of making sound investment strategy.

The efficient market hypothesis suggests that no unfair advantage can be made by trading on securities in the market as all the information relevant in determining the share price are already being considered. It means stacks are quoted at fair value where no one is in unfair advantage. There are three form of market hypothesis i.e.,

1. Weak form of efficient market hypothesis: Under this hypothesis, current share price reflects all the past data in terms of price of shares and no technical analysis can help them in making unfair advantage. However, profit can be made through fundamental analysis.
2. Semi-strong form of efficient market hypothesis: Under this hypothesis, current share price also includes the effect of public information and thus no analysis i.e., technical or fundamental helps the investors in making undue profit. However, profit can be made by using insider information which are not incorporated in the current market price of the share.

• Strong form of efficient market hypothesis: Under this hypothesis, current share price includes the effect of public as well as insider information and no analysis i.e., technical or fundamental helps the investors in making undue profit.

Efficient market hypothesis suggests that capital market would react or being affected by any new information. The disclosure of Covid-19 has a significant impact in the capital markets. Behavioural theory helps the investors in understanding different market circumstances. There are various theories related to it. One of such theory is Over-under reaction hypothesis where fundamental analysis has been made to understand the behaviour of shareholders in the capital markets i.e., why they become optimistic when market goes upward and become pessimistic when market goes downwards. Such incident leads to high market volatility which results in dropping of market price of share on bad or negative news and rising of market price on good or positive news. If the news turn out to be bad or negative, then investors would try to sell as much shares they have which further decreases the market price of shares in the capital market and the loop goes on and on.

b) It has affected the capital markets negatively due to the outburst of Covid-19 both in terms of models used and impact expected.

Model used:

Constant Mean Return model: The constant mean return model assumes that average return for a specified stock is equal to mean return of daily yield of stock which vary regularly. Here, abnormal return is calculated by subtracting normal return from return of security in given period.

Under such model, abnormal return is calculated to very high as the daily yield of stock vary vigorously and normal return on the stock is said to be fixed. It increases the unpredictability of the stock return in the capital markets and investors has to be cautious in taking appropriate measures in making investment decisions.

Market Return Model: In this model, normal return on stock is equal to the return on market measured by stock exchange i.e., S&P 500. Here, abnormal return is calculated by subtracting market return on specified day from return of security in given period.

Under such model, abnormal return is calculated to very high as the return on market vary significantly and normal return on the stock is said to be fixed. It increases the unpredictability of the stock return in the capital markets as the market performs surprisingly and investors has to be cautious in taking appropriate measures in making investment decisions.

• Market Model: This model calculates the normal return on stock by applying an equation i.e.,

E_it = α_i + β_iR_{mt +} Error term

E_it = Expected Return

α_i and β_i = Model parameters

R_mt = Market Return at period i

From the above equation, the expected return is appeared to be normal rate of return on stock and thus be reduced from return of security in given period to calculate the abnormal return on the stock.

Under such model, abnormal return is calculated to very high as the market return, and error term vary vigorously and normal return on the stock is said to be fixed. It increases the unpredictability of the stock return in the capital markets and investors has to be cautious in taking appropriate measures in making investment decisions.

All of the models discussed above said that abnormal return is very high in the capital markets. The abnormal rate of return indicates that the capital markets is very unpredictable and it is very difficult to make correct decisions regarding the operations of market. According to efficient market hypothesis, no one can make undue advantage as the current share market indicates that all the information have been already taken into consideration while determining such price. But, in such case, no one predict the impact of such pandemic upon the current market price of the shares but it is also important that no analysis can help the investors in estimating the change in market price of the shares.

c) Disclosures are essential to understand the financial statement to the fullest and without making assumptions. Disclosure should be framed in such a way that it would serve the needs of the investors and thus increases the disclosure effectiveness from the point of view of investors. Following aspects/variables one needs to take into consideration when measuring the impact of disclosure:

How recent the economic events are: The investors should ensure that the economic events for which disclosures have been made by the company should belong to the present time and thus relevant for the present circumstances. If the economic events for which disclosures have been made is still relevant, then due consideration should be given to such disclosures while making decision related to the investment purpose. On the other hand, if the economic events for which disclosures have been made is not relevant within present reference, then such disclosures shall be ignored while making decision related to the investment purpose.

Trends in technology and connectivity: In the era of technology and innovations, technology is rapidly changing and thus more efficient methods are applied in increasing the efficiency of the business operations. If the nature of business is such that it is required for the regular business activity of the business, then it should not be given due importance but on the other hand, Due considerations should be given to such disclosures while making decision related to the investment purpose.

Inability of existing accounting model: If the existing model of accounting is inadequate, then disclosures made for change in accounting model should not be given due importance but on the other hand, due considerations should be given to such disclosures while making decision related to the investment purpose.

Transparency: If the nature of business is such that it provides high degree of transparency, then disclosures might not be given due importance but on the other hand, due considerations should be given to such disclosures while making decision related to the investment purpose if the nature of business is such that it provides low degree of transparency.

Economic conditions: If the economic condition is such that it stays for a short span of time, then it should not be given due importance but on the other hand, due considerations should be given to such disclosures while making decision related to the investment purpose if such economic conditions will stay for a long time.