IFRS 3 and Information risk associated with business combinations.

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Master Thesis

IFRS 3 and Information Risk

Associated with Business

Combinations

Programme: MSc Accountancy and Control, Accountancy Track

Student name: Pengyu Lai

Student number: 10394389

Supervisor: Dr. Sanjay Bissessur

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Abstract

This thesis attempts to study the effects of IFRS 3 on information risk associated with business combinations, by studying the association between the level of goodwill and the cost of capital in several years around the year of IFRS adoption. As IFRS was mandatorily adopted in EU in 2005, this research focuses on a group of 30 Mergers and Acquisitions transactions completed by companies listed in a number of European Union countries between 2000 and 2012. The results show that the amount of goodwill has no statistically significant relation with the cost of capital after controlling the market capitalisation and year effects, and hence this research finds no evidence of the influence of IFRS 3 on information risk related to business combinations.

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Introduction

Background

The adoption of International Financial Reporting Standards (IFRS) for listed companies in a large amount of countries all over the world seems to be one of the most noteworthy regulatory changes in the accounting history (Daske, Leuz and Verdi, 2008). Over 100 countries have switched to IFRS reporting or decided to require the introduction of these standards in the near future, and even the U.S. Securities and Exchange Commission (SEC) is considering allowing U.S. firms to prepare their financial statements according to IFRS (SEC [2007]). Since 2005, over 7,000 listed firms in the European Union have to or will have to adopt IFRS, as the mandatory adoption of IFRS has been motivated by the need to ensure greater comparability, transparency and quality of financial reporting across the EU member states. Moreover, the quality of financial reports has significantly increased with the adoption of IFRS in European countries like Austrian, German and Switzerland, not only for firms that have voluntarily introduced IFRS or U.S.GAAP but also for firms that mandatorily adopted such standards in response to the requirements of some particular stock market segments. (Daske and Gefbhardt, 2006). In response to IASB framework, it seems self-evident that financial statement amounts which reflect current economic conditions and up-to-date expectations of the future will be more useful for users to make economic decisions (Barth, 2006).

Among a few measurement attributes that have been considered for financial statements, fair value appears to be most preferable because fair value accounting constitutes the only comprehensive and internally consistent approach the IASB has identified, particularly in terms of relevance, comparability, consistency, and timeliness (Barth, 2006). As a single method approach, it would promote consistency as well as comparability within accounts i.e. help avoid mismatches and allowing more meaningful aggregation (Whittington, 2008). It is claimed that fair value also has the property of objectivity to reflect the market’s view rather than the entity-specific views of managers (IASB, 2005, Discussion Paper, Ch. 4). In recent

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years, historical cost has been substituted with fair value measures in accordance with several accounting standards including IFRS 3, and this therefore provide managers with increased discretion to determine fair value without an actual market for the asset (Hamberg, Paananen and Novak, 2011).

IFRS 3 Business Combinations refers to the accounting employed in cases such as acquisition or merger where an acquiror obtains control of a business. In order to account for such business combinations, the 'acquisition method' is used. This method requires one to measure the acquired assets and assumed liabilities at their fair values at the acquisition date (a revised version of IFRS 3 was issued in January 2008 and applies to business combinations occurring in an entity's first annual period beginning on or after 1 July 2009) (IFRS 3, Deloitte). The objective of this IFRS is to improve the relevance, reliability and comparability of the information that a reporting entity provides in its financial statements about a business combination and its effects. To achieve such an objective, IFRS 3 establishes principles and requirements for acquirors, including how to recognize and measure the goodwill acquired in the business combination or a gain from a bargain purchase.

After the adoption of IFRS 3, the amount of capitalized goodwill has been substantially increased. This is attributed to significantly low goodwill impairments under IFRS relative to goodwill amortizations and impairments made under local GAAP, which consequently increased reported earnings. A remarkable interpretation for this is that the adoption of IFRS 3 results in more unspecific intangible assets that make future earnings more dependent on managers’ discretionary decisions (Hamberg, Paananen and Novak, 2011). Despite the desirability of fair value measurement as the single ideal measurement basis, such focus on subsequent fair value measurement in accordance with IFRS 3 may have a negative impact on reliability (Whittington, 2008). In the sense of information asymmetry, this arguably increases information risk associated with business combinations (Lambert, Leuz and Verrechia, 2007). In order to investigate the effectiveness of IFRS 3 in accounting for business combinations, it is interesting to find out the capital markets effects of the change in the information flow from

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financial reports to users after the introduction of the IFRS. Accordingly, the research question of this thesis is as follow:

Research question

Does the adoption of IFRS 3 increase information risk associated with business combinations?

Motivation of my study

By addressing the research question, my thesis contributes to prior literature in two ways. Firstly, there have been a few studies that document the influence of the adoption of IFRS in general on financial disclosure of companies from all over the world, while my study based on the listed companies in European Union countries testifies the transferability and generalizability of some of those prior findings. More importantly, Hamberg, Paananen and Novak’s (2011) work is regarded as the only one research that has shed a light on the effects of the adoption of IFRS 3 in particular (some accounting consequences of IFRS 3 and the reaction of stock market), while my study supplements theirs by identifying the potential correlation between the adoption of IFRS 3 and information risk related to business combinations in order to ascertain the effectiveness of IFRS 3.

From the societal perspective, this research is also expected to make a contribution in a several ways. To start with, the accounting authorities could learn some imperfections of the current IFRS 3 and the potential impacts on the ultimate quality of financial reporting so those authority organizations may therefore in the future come up with certain policies regarding the next modification for the standards in order to improve them. Secondly, investors could gain an insight in the problematic issues underlying financial statements regarding business combinations with the adoption of IFRS 3, so some possibly mistaken views caused by information asymmetry could be corrected. For example, many investors have perceived the accrual-based increase in earning stemming from IFRS 3 as an indication of higher future cash flow. After all, managers are incentivised to avoid revealing potential overpayment and thus to provide more comprehensive information on an acquisition about which they expect to

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create added value (good news) and less information on an acquisition about which they are less confident (bad news) (Verrechia, 1983; Dye, 1985; Shalev, 2009). This leads to my next point. With respect to companies, the potential inappropriateness of the high level of managerial discretion in business combinations in accordance with IFRS 3 would be discovered and highlighted. This may not directly reduce the information asymmetry or information risk but at least help draw attentions to them. In other words, some ways in which the companies could have possibly taken advantage of IFRS in mergers or acquisitions (e.g. earning management) may be exposed, thus those companies would have to deal with it in some sense so they can maintain the creditability of the financial reports.

Literature Review and Hypothesis

In order to set forth the dynamics between the two key concepts of this thesis, the cost of capital and information asymmetry, it is constructive to first understand the notion of each of them. To begin with, the cost of capital can be considered as the borrowing rate of a firm at which it acquires funds to finance projects or the lending rate at which the firm could have earned if the firm invested elsewhere (Berk, J. and P. DeMarzo, 2010). In other words, the cost of capital is a combined cost of each type of source by which a firm raises funds. Alternatively, it could be described as the minimum rate of return equity owners or investors demand in return for the capital they provide to the firm. As the return provided by a share may be interpreted as the sum of the dividends it pays out to shareholders, it could be deemed as the cost a firm needs to pay in order to absorb capital from investors. Given that the P/E ratio of a firm is defined as the ratio between its current share price and earnings per share (EPS), the reciprocal of it may constitute an efficient reflection of the cost of capital (which will be further presented in the methodology part).

Prior literature suggests that the interaction between information asymmetry and quality heterogeneity of the information leads to the need for information disclosure. When bad investments (such as “lemons” which represent bad cars in the typical American example) claim to be equally good as the good investments (good cars), both of them will be valued at an average level ultimately. For financial reporting, this implies that the risk of investment is

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lower if the good investments disclose more information so as to show higher quality to the market, and consequently the cost of capital will be lower i.e. the “lemons” phenomenon will be lessened (Akerlof, 1970). It is also suggested that higher information disclosure increases liquidity by decreasing the information asymmetries between managers and investors and hence results in lower cost of capital (Diamond and Verrecchia, 1991). Furthermore, Healy and Palepu (2001) illustrates that investor’s required rate of return is positively related to the degree of private information relative to public information because insiders are perceived by outsiders as advantageous regarding investment decisions making.

As suggested in the first section, a few studies have testified the desirability of adoption of IFRS to a considerable number of countries around the world, but there still are hesitations in making such a big move as switching from own local accounting regime to IFRS (Daske and Gebhardt, 2006). Despite the general considerations for the lost congruence between local accounting standards and the needs of a particular institutional environment (e.g., Schildbach, 2004), there is still substantial debate about the quality of financial disclosure according to IFRS, both in practice and academia IFRS (Daske and Gebhardt, 2006). To address the issue concerning whether IFRS is desirable, some evidence from proponents have been presented in the first paragraph of this paper, highlighting some positive influences IFRS may have on disclosure. That is, Daske and Gebhardt (2006) indicate that the quality of financial reports has significantly increased with the adoption of IFRS in European countries like Austrian, German and Switzerland, not only for firms that have voluntarily introduced IFRS but also for firms that mandatorily adopted such standards in response to the requirements of some particular stock market segments. Furthermore, Daske, Leuz and Verdi’s (2008) research based on 26 countries around the world suggests that on average market liquidity and equity valuations increase around the time of the introduction of IFRS whereas firms’ cost of capital decreases. According to their findings, nevertheless, those capital-market benefits occur only in the countries where the firms have incentives to be transparent and where legal enforcement is strong, underscoring the central importance of firms’ reporting incentives and countries’ enforcement regimes for the quality of financial reporting. On the other hand, counterexamples against IFRS could be also found as follows. Prominently, the French

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Premier Jacques Chirac expressed firm resistance to the adoption of IFRS (AccountancyAge, 2003). In addition, four East Asian countries (Ball et al., 2003) constitute another notable counterexample from the academics’ point of view. In the setting of these countries, adopting ‘IAS-type’ accounting standards do not necessarily contribute to higher disclosure quality because of the lax enforcement mechanisms and strong adverse reporting incentives.

To interpret IFRS 3, one of the key terms is Business Combinations, since the standard outlines the accounting that is applied for an acquisition or merger where an acquiror obtains control of a business. The 'acquisition method' is used to account for such business acquisitions. This method suggests the measure of the acquired assets and assumed liabilities at their fair values at the acquisition date (a revised version of IFRS 3 was issued in January 2008 and applies to business combinations occurring in an entity's first annual period beginning on or after 1 July 2009) (IFRS 3, Deloitte). The IASB chooses fair value because the board concludes that it is the most relevant attribute for assets acquired and liabilities assumed in a business combination and provides information that is more comparable and understandable than measurement at cost or on the basis of allocating the total cost of an acquisition (BC198, IFRS3). The objective of this IFRS is to improve the relevance, reliability and comparability of the information provided by a reporting entity in its financial statements regarding a business combination and its effects. In order to achieve this objective, IFRS 3 establishes principles against acquirors, including how to recognize and measure the goodwill acquired in the business combination or a gain from a bargain purchase.

Goodwill can be considered as an asset that leads to future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognized. Given the unidentifiable and inseparable nature of goodwill, the academic opinions about the recognition of such particular intangible are somewhat mixed. That is, a number of researchers question the notion of goodwill being recognized as an asset (Johnson, 1998). While goodwill generally consists of a number of distinct elements which include the reputation of a business corporate, the reputation of a product, the trademark, the custom, the rights in the goodwill etc., it makes the assessment of goodwill complex. One of

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the biggest concerns relates to the recognition of goodwill in the asset section of the statement of financial position (Munteanu et al. 2012). The difference between the purchase price consideration for a business combination and the net assets of the target firm is recognized as goodwill until the adoption of IFRS 3, which furthermore mandates the recognition of all unidentified assets that meet the criteria for recognition of assets. As prior literature indentifies considerable difference between the book value and the market value of public firms (Quilligan, 2006), typical explanations involve a variety of elements including customer relationships, innovations, brands etc. After all, the amortization of goodwill becomes another central issue when goodwill is recognized as an asset (Munteanu et al. 2012).

With the adoption of IFRS, several accounting standards including IFRS 3, have recently substituted historical cost with fair value measures. This switch potentially provides managers with increased discretion to determine fair value without an actual market for the asset, according to Hamberg, Paananen and Novak (2011). These authors document a substantial increase of the amount of capitalized goodwill after the adoption of IFRS 3 in January, 2005. The reported earnings were dramatically increased, which is considered partly because of a higher acquisition activity during the period and partly because of the abandonment of goodwill amortizations. That is, goodwill impairments under IFRS are considerably lower than goodwill amortizations and impairments made under Swedish GAAP. Moreover, they conclude that firms with substantial amount of goodwill yielded abnormally high returns despite abnormally low earnings, whereas investors may have incorrectly viewed the accrual-based increase in earnings stemming from IFRS 3 as an indication of higher future cash flows.

While IFRS 3 is in favour of fair value measurement, there is some evidence of the deficiencies of fair value. As implied in the first part of this paper, fair value is deemed the single method approach, which promotes consistency within accounts as well as comparability across entities, avoiding mismatches and allowing more meaningful aggregation. In standard setters’ deliberations, the fair value method moreover has the property of relevance because it measures the market’s expectation of future cash flows (see

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Barth, 2006, 2007; Hague, 2007). It is also claimed that fair value approach has the property of objectivity, reflecting the market’s view rather than the entity-specific views of managers (IASB, 2005, Discussion Paper, Ch. 4). However, fair value does not always appear to be most effective. To be more specific, the market prices under fair value measurement are not entity-specific as they fail to reflect the specific circumstances and economic opportunities towards the entity. Even though proponents of fair value view this in the positive sense that entity-specific measurement may be employed as a sort of subjective estimates of management, this does contradict the underlying assumption that markets are perfect and thus fully informed. In practise, in order to fulfil the accountability function to users who are barely fully informed, financial statements are generally expected to report the state of a specific entity. Therefore, disclosure of the opportunities available to the specific entity tends to be more helpful than reporting the hypothetical opportunities available in a theoretically constructed market. Furthermore, fair value’s reliance on the assumption of perfect market sometimes inevitably comes with deficiencies. In particular, the focus on selling price rather than net realizable value (selling price less cost to sell) neglect to consider the circumstances where entry (purchase) price may be more relevant. For example, in case of a going concern business where replacement is the norm, replacement costs may better capture the cost of acquired assets and hence more properly measure profit margins. In that case, fair value does not well measure the subject in terms of cash flow. Another alternative measure against fair value is value in use, which is generally regarded as an entity-specific measure of the present value of the realizable cash flows. This measure is considered to be particularly informative where financial markets are so illiquid that the most profitable way in using an asset like a loan portfolio is to hold it to maturity. Overall, fair value measurement under the introduction of IFRS 3 is arguably problematic.

While the disclosure theory suggests that higher information disclosure decreases the information asymmetries between managers and investors (Diamond and Verrecchia, 1991), precise accounting information proves to play an important role in reducing the cost of capital by decreasing the systematic risk of shares to uninformed investors (Easley and O’Hara ,2004). The changes in accounting for business combinations introduced by IFRS 3 are

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consistent with the disclosure theory. That is, the most important issues IFRS 3 changed in accounting for business combinations, compared to its predecessors IAS 22 and FRS 10, include the increased disclosure and the emphasis on fair value measures for subsequent valuation of identified intangibles and goodwill resulting from business combinations. From investors’ perspective, the expectation of future net cash flows of the combined firm is a central issue in a merger or acquisition, while IFRS 3 is of high economic significance not only to acquirors (because of the expected influences of the business combinations on their operations), but also to investors (because financial reporting concerning such transactions may be regarded as indicators for acquiror’s future performance and thus its future earnings and cash flows) (Johnson and Petrone, 1998). On the other hand, because managers have incentives to avoid revealing potential overpayment, they may provide more ‘good news’ (i.e. comprehensive information on an acquisition about which they expect to create added value) and less bad news (i.e. information on an acquisition about which they are less confident), resulting in information asymmetry (Verrechia, 1983; Dye, 1985; Shalev, 2009).

In light of these findings and consistent with prior literature, IFRS 3 should be associated with enhanced transparency and comparability. Thus, IFRS 3 adoption should lead to higher liquidity and thus lower cost of capital. Though a wide stream of research has focused on investigating the economic consequences of IFRS adoption, the findings are mixed (Hail, Leuz and Wysocki, 2010).

With respect to business combinations, low disclosure by the acquiror results in financial reports not faithfully representing assets, and/or liabilities of the acquisition. Theoretical work suggests that financial reporting of low quality increases market participants’ assessed variances of a firm’s future net cash flows and the assessed covariances with other firms’ cash flows, resulting in greater information risk to shareholders, as reflected in the firm’s cost of capital (Jorgensen and Kirschenheiter, 2003; Hughes and Liu, 2007; Lambert et al., 2007). Furthermore, the information asymmetries introduce adverse selection into capital markets, resulting in increased unwillingness of less informed investors to trade, which indirectly affects

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cost of capital through market liquidity (Diamond and Verrecchia, 1991; Verrecchia, 2001; Easley and O’Hara, 2004).

Increased disclosure under IFRS 3 should lower the information asymmetry in the market, yet Hamberg et al. (2011) express concerns related to the level of discretion afforded to managers in the process of allocating the purchase price. These concerns are related to the fair value approach and the firm specific (or business combination specific) nature of intangibles that must be recognized upon acquisition. This means that fair value measures are likely to be not observable in the market and that the amounts allocated to the intangibles will depend heavily on managerial estimates. Thus, managerial incentives could result in less reliable disclosure, and therefore higher information asymmetry.

In light of the literature review presented above, there could be an increase of information risk associated with business combinations with the adoption of IFRS 3. Upon the basis of the information asymmetry theory, accordingly, my Hypothesis is: Information risk associated

with business combinations will increase with the adoption of IFRS 3.

Research Methodology

This thesis relies on a quantitative empirical analysis of accounting data in relation to market data. Based on the literature review, I attempt to study cost of capital in order to measure the theoretical construct information risk. While the cost of capital is such an elusive concept that has been arguably measured by prior research in multiple ways, one common and simple approach among them is to use the earnings yield of a share (which is the reciprocal of the well-known P/E ratio) as the empirical proxy (C. Firer, 1994). As the return provided by a share may be interpreted as the sum of the dividends it pays out to shareholders, it could be deemed as the cost a firm needs to pay in order to absorb capital from investors. Given that the P/E ratio of a firm is defined as the ratio between its current share price and earnings per share (EPS), the reciprocal of it may constitute an efficient reflection of the cost of capital. However, the use of this ratio may contain some deficiencies especially when the firm does not pay dividends but retained its earnings, because the EPS approach ignores the importance

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of dividend policy. Therefore, this research uses the ratio between EPS and share price as well as the ratio between dividends per share and share price to measure the cost of capital, respectively. Both of EPS and dividends per share are found in the annual report of each acquiror firm from the sample at the year of the business combination. With respect to the share price, this research collects the acquiror’s closing share price at the effective date of every M&A selected in the sample, partially from the firm’s official website and partially from either finance.yahoo.com or finance.google.com.

As discussed in the last section, one of the most significant issues IFRS 3 has specifically changed in accounting for business combinations is the emphasis on fair value measures for subsequent valuation of goodwill resulting from business combinations. Given this particular relation between goodwill and IFRS 3, this research thus examines the level of acquiror

goodwill derived from the business combinations in the sample. More specifically, a ratio of

the acquiror goodwill to the purchase price (total cost of the acquisition) is utilized to measure the disclosure of goodwill. Both of the goodwill and purchase price related to each M&A in the sample are found in the annual report of the corresponding acquiror firm at the year. Amongst all the selected business combinations in the sample, it is noticeable that the goodwill resulting from the acquisition of Roche Holding by DSM in 2003 turns out to be negative. By definition, negative goodwill occurs when the fair value of the acquired net assets exceeds the price paid for the acquisition, and this hence implies a bargain purchase to the acquiror firm or a distress sale to the target firm (Ma and Hopkins, 1988).

In addition to the independent variable goodwill/purchase price, a control variable firm size is included in the model in order to assess the goodwill’s relative ability to capture the effect on the change of the cost of capital. Prior research has testified that large firms are likely to disclose more information since they will benefit most from attracting increased demand of large investors due to increased liquidity of the firm’s securities (Diamond and Verrecchia, 1991). Furthermore, firm size proves to be positively correlated to disclosure quality, which is one of the most important determinants of the cost of capital (Daske and Gebhardt, 2006). Therefore, the model includes firm size defined as the log of acquiror’s market capitalisation

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at the year of the acquisition (LogMCAP), following Daske and Gebhardt’s (2006) approach. Unlike their model, however, the market capitalisation in this model is calculated by multiplying the weighted average number of shares by the acquiror’s closing share price at the effective date of the acquisition.

To start with the data search, I used the database Thomson One (formerly known as SDC Platinum), which brings together company information from a variety of sources that are produced by Thomson Reuters. This includes company financials and filings, deals data, ownership data and private equity data (former VentureXpert). I accessed this database with computers inside the Pierson Revesz Library, University of Amsterdam. To collect a relevant sample, the search criteria is set up aiming for the Merger and Acquisition (M&A) deals completed by public firms listed in European Union countries from 1st January 2000 to 31st December 2012. In total, 49,421 Merger and Acquisition (M&A) deals are identified in the database. Moreover, I narrowed the sample down to 30 by first filtering out the transaction records that do not contain all the necessary information to this thesis (e.g. no disclosure of the goodwill because the acquisition is not material from the acquiror’s perspective), and also by randomly selecting the acquisitions in each sample year in the way that the amounts of selected M&A per year are as close as possible. With regard to the time range of this sample, this research focuses on the time period between 1st January, 2000 and 31st December, 2012 as IFRS was mandatorily adopted in EU in 2005. Thus the selected cases are evenly divided at year 2005 (i.e. the numbers of cases before 2005 and after are equal), although the number of cases per year prior to 2005 varies more.

The acquirors’ countries include United Kingdom, France, Netherlands, Italy, Sweden, Belgium, Germany, Switzerland and Republic of Ireland. Table 1 presents the number of each of the nations from the sample. This geographical composition of sample can mainly be interpreted as follows: compared to firms listed in countries where the adoption of IFRS is merely permitted or optional (such as United States and China), the desired information about M&A by EU acquiror firms is abundant and thus easier to reach because most of the EU listed firms have mandatorily adopted IFRS since 2005. Moreover, the countries like United

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Kingdom, France, Netherlands and Germany are most noticeable and commonly seen in the sample, as they are the biggest economies in EU and hence likely to have the largest amount and frequency of transactions. Besides, a number of prior studies suggest that earnings management is more common in Europe than in United States since the abolishment of goodwill amortizations has a large effect on reported earnings of European firms, so it is more relevant to base the research on EU firms since earning management implies higher likelihood of information asymmetry (Leuz et al., 2003; Lang et al., 2006).

Table 1

Acquiror Nation Number

United Kingdom 9 Belgium 1 France 4 Germany 5 Ireland-Rep 1 Italy 2 Netherlands 5 Sweden 2 Switzerland 1 Total 30

As mentioned above, this research collects the data that corresponds to all the variables within the time period from 1st January, 2000 to 31st December, 2012. With respect to this time range of sample, this research attempts to study the multiple years around the year of IFRS adoption (2005, as mentioned in the last paragraphs). Also, the relevant information or data about M&A prior to 2005 is relatively limited to obtain.

In order to capture cross-sectional difference in the cost of capital that is not related to goodwill but year effects instead, I include fixed year effects as a dummy variable. Hence, the main regression model is conducted as follows:

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COC = β0 + β1*GW/PP + β2*LogMCAP+ β3*YEAR + ε, where COC stands for the cost of capital, GW/PP the ratio of goodwill to purchase price i.e.

the level of goodwill, MCAP the control variable i.e. market capitalisation, and YEAR the fixed year effects. As discussed above, the cost of capital is further measured by the ratio of earnings per share to purchase price (E/P) and that of dividends per share to purchase price (D/P), respectively. Then the main model is formed in two versions as follows:

E/P = β0 + β1*GW/PP + β2*LogMCAP+ β3*YEAR + ε, (1) D/P = β0 + β1*GW/PP + β2*LogMCAP+ β3*YEAR + ε. (2)

Empirical Findings

Descriptive Statistics

Table 2 presents the descriptive statistics for all the indirect and direct variables used in the regression models, while Table 3 presents the general information about the collected M&A deals (such as company name and country of the acquirors and targets) per year within the examined period. Given the large gaps between the means and the medians as well as between maximums and minimums for the market capitalisation, it is apparent that the acquirors vary strikingly in firm size. Similarly, the business combinations vary considerably in terms of resulting goodwill as well as total cost of the acquisition. Therefore, the sample may fairly cover a variety of transactions during the time period despite the limited sample size.

There are a several conspicuous points when looking into the table or, to be more precise, the last column. First, there are a few negative figures. The minimum acquiror earnings per share is EUR -40.89 reported by Vivendi Universal SA from France in 2002. In total, there are actually six acquiror firms that disclose earnings per share below zero in the sample. The negative earnings per share could be explained by those firms’ depression at the time, which

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helps define the cost of capital, and thus are included for this research (so are the negative E/Ps).

In addition, there are negative acquiror goodwill and GW/PP in the sample. Specifically, DSM NV (from Netherlands) disclosed negative goodwill of EUR 49 million related to the acquisition of Roche Holding AG-Vitamins in the former’s annual report 2003. This appears to be the only one business combination of negative goodwill among the 30 M&A transactions. As mentioned in the last section, negative goodwill generally implies a bargain purchase to the acquiror or/and a distress sale to the target (Ma and Hopkins, 1988), but the accounting standards for business combinations (i.e. requiring goodwill amortization, etc.) cannot be surely ruled out as an explanation of such goodwill disclosure. So this deal is also taken into account for my research to help study whether such goodwill too affects the cost of capital, although historically negative goodwill does not occur very frequently (Higson, 1998).

Besides, the minimum figure for dividends per share is zero (hence so is the corresponding D/P). In fact, there are two null dividends per share records in the sample. Specifically, COLT Telecom Group SA (from UK) did not pay any dividends to the shareholders in 2001; neither did Elan Corp PLC (from Ireland) in 2000. This could be the result of the firms’ depression at the time to the extent that they could not have the money or capital to pay out (which might be justified by their negative EPS at the time, -0.48 pounds and EUR -2.64 respectively), or because of their particular investment plans at the year such that they invested the earnings in projects instead of paying dividends. Anyway, such D/P is therefore in relation with the cost of capital, as the D/P ratio plays the alternative to E/P to measure the cost of capital in this research.

Table 2

Variable N Mean Median Q3 Q1 Max Min

Acquiror earnings per share

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Dividend per share 30 6.40 1.10 5.18 0.43 45.00 0.00 Acquiror closing stock

price at the effective/unconditional

date

30 265.79 50.68 292.63 21.09 1,846.00 2.58

Acquiror goodwill (mil) 30 4,874.83 937.00 5,478.25 123.25 28,524.00 -49.00 Total cost of acquisition (mil) 30 9,396.61 1,683.35 11,266.75 270.75 56,527.00 17.00 E/P 30 0.03 0.05 0.08 0.01 0.65 -1.41 D/P 30 0.05 0.03 0.05 0.01 0.43 0.00 GW/PP 30 0.60 0.57 0.79 0.42 1.11 -0.03 Market Cap 30 460,588.24 46,513.58 306,437.72 14,804.55 8,236,114.32 4.63 Weighted average

number of shares (mil)

30 2,415.14 910.89 1,459.09 465.31 16,016.71 0.27

Log of Market Cap 30 4.62 4.66 5.44 4.17 6.92 0.67

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Table 3

Date Effective/

Unconditional Target Name

Target

Nation Acquiror Name Acquiror Nation

11/30/2012 Embanet-Compass Knowledge Grp United States Pearson PLC United Kingdom

01/09/2012 Indal Spain Koninklijke Philips Netherlands

09/09/2011 Technokolla SpA Italy Sika AG Switzerland

05/23/2011 Tegro GmbH Germany Rexel SA France

07/16/2010 AOB SAS France Seco Tools AB Sweden

02/09/2010 Chattem Inc United States Sanofi-Aventis SA France 11/16/2009 Solel Solar Systems Ltd Israel Siemens AG Germany 07/27/2009 Saeco International Group SpA Italy Koninklijke Philips Netherlands 11/18/2008 Anheuser-Busch Cos Inc United States InBev NV Belgium 10/29/2008 Taylor Nelson Sofres PLC United Kingdom WPP Group PLC United Kingdom

02/21/2007 Rosno Russian Fed Allianz SE Germany

01/01/2007 SanPaolo IMI SpA Italy Banca Intesa SpA Italy

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01/31/2006 Boots Healthcare International United Kingdom Reckitt Benckiser Group PLC United Kingdom 11/28/2005 Kryvorizhstal Ukraine Mittal Steel Co NV Netherlands 05/31/2005 Liberty Surf Groupe SA France Telecom Italia SpA Italy 08/20/2004 Aventis SA France Sanofi-Synthelabo SA France 08/16/2004 Aerosystems International Ltd United Kingdom BAE Systems PLC United Kingdom

02/18/2004 Bank of Bermuda Ltd Bermuda HSBC United Kingdom

09/30/2003 Roche Holding AG-Vitamins Switzerland DSM NV Netherlands 05/27/2003 ThyssenKrupp Sofedit SAS France ThyssenKrupp AG Germany 03/31/2003 Pfizer Inc-Adams United States Cadbury Schweppes PLC United Kingdom 03/28/2003 Household International Inc United States HSBC United Kingdom

12/09/2002 Sonera Oyj Finland Telia AB Sweden

05/07/2002 USA Networks Inc-Ent Asts United States Vivendi Universal SA France 01/31/2002 Niagara Mohawk Holdings Inc United States National Grid Group PLC United Kingdom

07/13/2001 Dresdner Bank AG Germany Allianz AG Germany

07/03/2001 Fitec SA France COLT Telecom Group SA United Kingdom 11/10/2000 Dura Pharmaceuticals Inc United States Elan Corp PLC Ireland-Rep 09/02/2000 ReliaStar Financial Corp United States ING Groep NV Netherlands

Regression Analysis

Table 4 below displays the results from the regression analysis for the Hypothesis, derived from STATA. The column (1) and column (2) present the results from the regression analysis regarding model (1) and model (2), respectively. Contrary to the expectation, the coefficient of LogMCAP on E/P turns out to be positive (0.115) but that on D/P is negative as expected, although it is considerably small (-0.00240). More surprisingly, the coefficients of GW/PP on E/P is negative (-0.373) while that on D/P is positive as expected (0.0447). The negative coefficient of GW/PP seemingly implies that there is a negative association between the amount of goodwill and the cost of capital after controlling the market capitalisation and the year effects, and is therefore inconsistent with the Hypothesis to the extent that goodwill grows with the adoption of IFRS 3; nevertheless, none of the coefficients is statistically significant. With respect to year effects, this table shows that none of the years from 2001 to 2012 significantly contributes to the cross-sectional difference in the cost of capital relative to the year 2000 as the reference group. As a result, the Hypothesis is rejected since no significant relation is identified between the dependent variable and independent variables whatsoever. Given the assumed correlation between goodwill raise and IFRS 3 adoption, this

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outcome differs from the findings of prior research (as presented in the literature review) to a large extent. For example, Daske, Leuz and Verdi’s (2008) research shows a significant decrease of ﬁrms’ cost of capital around the time of IFRS introduction.

Table 4 (1) (2) VARIABLES E/P D/P GW/PP -0.373 0.0447 (0.341) (0.0541) LogMCAP 0.115 -0.00240 (0.0964) (0.0157) 2000b.year 0 0 (0) (0) 2001.year -0.261 -0.0222 (0.222) (0.0376) 2002.year -0.750 0.00610 (0.522) (0.0344) 2003.year -0.0632 0.131 (0.299) (0.134) 2004.year -0.381 -0.00107 (0.238) (0.0376) 2005.year -0.0418 0.00389 (0.178) (0.0329) 2006.year -0.312 0.00948 (0.266) (0.0336) 2007.year -0.112 0.0226 (0.211) (0.0407) 2008.year -0.00918 -0.00535 (0.182) (0.0353) 2009.year -0.0903 0.00277 (0.181) (0.0320) 2010.year -0.0302 0.0212 (0.221) (0.0385) 2011.year 0.135 -0.0113 (0.313) (0.0511) 2012.year -0.146 0.00853 (0.180) (0.0395) Constant -0.105 0.00978 (0.318) (0.103)

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Observations 30 30

R-squared 0.482 0.322

Robust standard errors in parentheses *** p<0.01, ** p<0.05, * p<0.1

Additional Analysis

An additional test is conducted to compare the impact of high goodwill on the cost of capital to that of low goodwill by evenly dividing the sample into two groups. More specifically, the sample is divided at the median of GW/PP (0.57), into two groups and hence each of them consists of 15 M&A deals. In other words, all the mergers from the first half are of higher goodwill level than the other group. Then I run the regression analysis with the model (1) and (2) again, for the two groups of sample separately. Table 5 and Table 6 respectively display the outputs of the low goodwill group and the high goodwill group. Accordingly, the coefficients of GW/PP from the low goodwill group (0.900 on E/P and 0.591 on D/P) are particularly higher than those from the high goodwill group (-0.271 and 0.0418). The coefficient of GW/PP on E/P from the high goodwill group is even negative. Nevertheless, none of the coefficients of GW/PP from the two groups is statistically significant again.

Table 5 (1) (2) VARIABLES E/P D/P GW/PP 0.900 0.591 (0.440) (0.337) LogMCAP 0.0261 -0.00469 (0.0673) (0.0400) 2001b.year 0 0 (0) (0) 2002.year -0.241 -0.0971 (0.179) (0.110) 2003.year 0.281* 0.183 (0.116) (0.100) 2004.year -0.318** -0.146 (0.0992) (0.0880) 2005.year 0.177* -0.0234

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20 (0.0576) (0.0352) 2006.year -0.114 -0.0676 (0.109) (0.0559) 2007.year -0.104 -0.0472 (0.0823) (0.0623) 2010.year -0.130 -0.0839 (0.127) (0.0874) 2011.year -0.214 -0.181 (0.207) (0.141) 2012.year -0.206 -0.105 (0.144) (0.101) Constant -0.315 -0.109 (0.277) (0.170) Observations 15 15 R-squared 0.880 0.830

Robust standard errors in parentheses *** p<0.01, ** p<0.05, * p<0.1 Table 6 (1) (2) VARIABLES E/P D/P GW/PP -0.271 0.0418 (1.180) (0.207) LogMCAP 0.168 0.0107 (0.440) (0.0770) 2000b.year 0 0 (0) (0) 2001.year -0.262 -0.0553 (0.483) (0.0846) 2002.year -1.521 -0.00453 (0.476) (0.0834) 2003.year -0.359 -0.0322 (0.756) (0.132) 2004.year -0.406 -0.00748 (0.602) (0.105) 2005.year -0.0508 0.0117 (0.482) (0.0844) 2007.year -0.0488 -0.00863 (0.450) (0.0788)

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21 2008.year -0.0540 -0.0118 (0.452) (0.0791) 2009.year -0.101 0.00206 (0.483) (0.0845) 2010.year 0.196 0.0395 (0.774) (0.135) 2011.year 0.525 0.0366 (1.583) (0.277) 2012.year -0.244 -0.0291 (0.475) (0.0832) Constant -0.407 -0.0455 (1.212) (0.212) Observations 15 15 R-squared 0.971 0.627

Robust standard errors in parentheses *** p<0.01, ** p<0.05, * p<0.1

Limitations

The results are nonetheless subject to certain limitations underlying the methodology. To start with, the model built to testify the influence of IFRS 3 on the information risk is fundamentally based on the key assumption that the amount of goodwill derived from business combinations increases with the adoption of IFRS 3 i.e. the higher level of goodwill is theoretically a reflection of the appliance of IFRS 3, as prior research indicated (Diamond and Verrecchia, 1991; Huges, Liu and Liu, 2007). However, there are more potential causes that could contribute to a large amount of goodwill when it comes to a business combination, for examples, the economy-wide rise in the valuation ratio. Some other explanations for growth of goodwill are related to progressive depletion of the equity of acquirors, industrial characteristics and the effects of writing-down net assets. (Higson, 1998).

The second limitation is the sample size. Due to the adverse selection effects, it is possible that the sample conducted in this research fails to cover more comprehensive transactions that capture the overall relation between goodwill and cost of capital whereas includes the deals that suggests otherwise. For example, United Kingdom and Netherlands are two of the most common acquiror nations in the sample not only because the acquiror firms from these two

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countries are most active in the market, but also because the desired information about those firms’ acquisitions is easier to identify as they disclose their acquisitions more manifestly in the annual reports. In other words, the figures for the necessary variables used in the models (EPS, total cost of capital, etc.) can be more conveniently found when the acquiror is a British or Dutch firm. Yet comparable firms from some other countries like France and Finland are somehow more challenging for the data search. Consequently, this small sample size may indicate a biased sample subject to national or regional influences.

Last but not least, the effectiveness of E/P ratio to measure the cost of capital has been questioned. In particular, C. Firer (1994) argues that a firm’s earnings yield (EPS/P) will equal its cost of capital only if the firm remains unchanged in size and pays out 100% of its earnings in dividends but raises no new capital. This author furthermore lists a few problems associated with the use of EPS, including that earnings figures do not adequately reflect risk, do not take into account the working capital and fixed investments needed for anticipated sales growth, and EPS approach ignores the importance of dividend policy. Nevertheless, the deficiencies of the use of E/P might be compensated by the analysis with the second measure, D/P.

Case Studies

To gain a deeper insight of business combinations in relation to the accounting issues, three particular acquisitions out of the sample will be further discussed in detail. As two representatives of business combinations under IFRS 3, the first two cases are the acquisition of Tegro by Rexel in 2011, and the acquisition of Boots Healthcare International by Reckitt Benckiser in 2006. As the “counter” example before the adoption of IFRS, the third case is the acquisition of Bank of Bermuda by HSBC in 2004.

Rexel is a French group founded in 1967, with the headquarters in Paris. Rexel specializes in the distribution of electrical products and services in the areas of automation, technical supply and energy management to professional users. The offerings cover a wide range, including lighting, security, automation, climate control, communication, building automation and

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renewable energies. The group, as a global leader in its market, has 2,200 sales outlets (branches) in 37 countries and 28,000 employees, and presents annual revenue of EUR 12.7 billion and annual net income of EUR 319 million in 2011. It is traded on Paris stock exchange. As the counterparty of the acquisition, Tegro (Technische Elektro-Großhandels) GmbH distributes electrical products too. This target company was based in Freudenberg, Germany.

As part of Rexel’s external growth policy, which aims to strengthen its presence in emerging markets, increase its market share in mature countries and improve the offering of its high value-added services, the Group acquired a number of foreign companies in 2011 including Tegro. Rexel acquired Tegro on May 3, 2011. The latter company booked sales of approximately €10 million in 2010, and this entity has been consolidated as of May 1, 2011. The table below, which is derived from annual report of Rexel in 2011, shows the consideration allocated to identifiable assets and liabilities of the acquired entities in 2011 and entities acquired in 2010 consolidated as of January 1, 2011, estimated on a provisional basis as of December 31, 2011:

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This table highlights that the net assets of Tegro acquired by Rexel (EUR 63.3 million) is merely less than a half of the total consideration or purchase price (EUR 155.4 million), whereas the goodwill acquired amounts to EUR 92.1 million. The GW/PP ratio is therefore 0.543. This implies that the goodwill contributes to the majority of the acquisition cost. As a matter of fact, the most extreme GW/PP ratio amongst the sample relates to the acquisition of Taylor Nelson Sofres (UK) by WPP Group (UK) in 2008, in which case the goodwill (EUR 1132.7 million) amounts even higher than the total consideration (EUR 1105 million). This is explained by the negative net assets due to the extraordinarily high liabilities of the acquired firm.

For the second case, the acquiror Reckitt Benckiser plc is a British-Dutch multinational consumer goods company headquartered in Slough, Berkshire. It is a major producer of health, hygiene and home products. It was formed in 1999 by the merger of the UK-based Reckitt & Colman plc and the Netherlands-based Benckiser NV. It has operations in around 60 countries and its products are sold in almost 200 countries. Reckitt Benckiser is listed on the London Stock Exchange and is a constituent of the FTSE 100 Index. It had 35,900 employees in 2012 and a market capitalisation of approximately £31.6 billion as of February 13, 2013. As the acquired company, Boots Healthcare International was a pharmacy chain founded in 1849 in Nottingham, United Kingdom, with outlets in most high streets throughout the country and also in the Republic of Ireland.

On January 31, 2006, Reckitt Benckiser acquired 100% of the issued share capital of a number of companies plus business assets comprising the Boots Healthcare International business (BHI), by a consideration of £1,871 million. This transaction has been accounted for by the purchase method of accounting. All assets and liabilities were recognised at their respective fair values. The residual excess over the net assets acquired is recognised as goodwill in the financial statements (see the table below).

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Similarly, this table is derived from the annual report of Reckitt Benckiser plc in 2006. As we can see in this table, the goodwill is EUR 796 million, which amounts to 42% of the total cost of acquisition EUR 1,888 million.

With regard to the background of the case before 2005, HSBC Holdings plc is a British multinational banking and financial services company headquartered in London, United Kingdom. It is also one of the largest banks in the world. It was founded in London in 1991 by the Hongkong and Shanghai Banking Corporation to act as a new group holding company. HSBC has around 7,200 offices in 85 countries and territories across Africa, Asia, Europe, North America and South America, and approximately 89 million customers. As of December 31, 2012, it had total assets of $2.693 trillion, of which roughly half were in Europe, the Middle East and Africa, and a quarter in each of Asia-Pacific and the Americas. As of 2012, it was the world's largest bank in terms of assets and sixth-largest public company, according to a composite measure by Forbes magazine. HSBC is organised within four business groups: commercial banking; global banking and markets (investment banking); retail banking and wealth management; and global private banking. HSBC has a dual primary listing on the Hong Kong and London Stock Exchange and is a constituent of the FTSE 100 Index.

The Bank of Bermuda Limited was a financial services company in Bermuda providing fund administration, trust, custody, asset management and banking services to institutions and

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individuals. The Bank of Bermuda grew to span 17 of the world's key financial and offshore centers including Bahrain, Cayman Islands, Cook Islands, Dublin, Guernsey, Hong Kong, Isle of Man, Japan, Jersey, London, Luxembourg, New York, New Zealand, Singapore, South Africa and Switzerland prior to joining the HSBC Group's network in February 2004.

On February 18, 2004, HSBC acquired the entire share capital of the Bank of Bermuda for a cash consideration of US$ 1,224 million. Goodwill of US$ 651 million arose from this acquisition. This event took place before the adoption of IFRS, but the GW/PP is still higher than 0.5. In other words, the goodwill is still considered relatively high, just like the two previous acquisitions under IFRS 3. In fact, the acquisition of Fitec (France) by COLT Telecom Group (UK) in 2001 even contributes the second highest GW/PP ratio (0.989) within the sample, in which case the net acquired assets seems to be rather insignificant.

Conclusion

This thesis attempts to study whether the adoption of IFRS 3 leads to higher information risk associated with business combinations, by studying the association between the level of goodwill and the cost of capital in several years around the year of IFRS adoption. As information asymmetries increases the cost of capital (Diamond and Verracchia, 1991), the earnings yield (E/P ratio) and the dividends yield (dividends per share/share price) are separately used to measure the cost of capital. Likewise, the goodwill relative to the purchase price is used to measure IFRS 3, as the amount of goodwill will increase with the adoption of IFRS 3 (Hamberg, Paananen and Novak, 2011). Given that IFRS was mandatorily adopted in EU in 2005, the research collects a dataset of 30 Mergers & Acquisitions deals completed by public companies listed in a variety of European Union countries from 2000 to 2012. Besides multiple limitations underlying the methodology, the results from the regression analysis show that the amount of goodwill has no statistically significant relation with the cost of capital after controlling the market capitalisation and year effects. Hence, this research does not identify any negative influence of IFRS 3 on information risk related to business combinations.

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The adoption of International Financial Reportin g Standards (IFRS) for l isted com panies in a large am ount of countries all o ver the world seem s to be o ne of the m ost no teworthy regulatory changes in the accounting h istory (Daske, Leu z and Verdi, 2008). Over 100 countries have recently switched to I FRS reporting or decided to require the introduct ion of t hese standards i n the near future, and even the U. S. Securit ies and Exchange Com m ission ( SEC) is cons idering allow ing U. S. firm s to prepare their financial statem ents according to I FRS (SE C [200 7]). From 2005, over 7,000 listed f irm s in the Europea n Union have t o or wil l The adop tion of In ternational Financial Reportin g Standards (IFRS) for li sted com panies in a large am ount of countries all o ver the world seem s to be o ne of the m ost no teworthy re gulatory changes in the accounting h istory (Daske, Leu z and Verdi, 2008). Over 100 countries have r ecently switched to IFRS r eport ing or decided t o require the in troductio n of these s tandards in the near future, and even

the U.S. Securities and E xchange Com m ission ( SE C) is cons idering all owing U. S. firm s to prepare their financial statem ents ac cording to IFRS I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. I l ove y ou. I love y ou. V I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. I y ou. I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. V I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. I love y ou. I

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IFRS 3 and Information risk associated with business combinations.

Master Thesis