Question

Greenmount Ltd, an ASX listed consumer goods corporation aims to acquire a fashion business to generate new growth opportunities. Following a formal search process, external advisors have identified the following two businesses as best matching entitiesfor a potential take-over: Tallows Ltd and Bilgola Ltd. Only one will be selected. To move forward with the selection process, the external advisor has estimated that both firms have the same entity value of $2m based on a Discounted Cash Flow (DCF) model, i.e. acquisition price of $2 million (excluding advisor fees), which will be paid as cash consideration. The external advisor will charge $5,000 finder’s fee and $3,000 legal fees paid in cash to prepare all required due diligence.

You have been given access to the following information about the assets, liabilities, and shareholders’ equity for both potential target firms:

Tallows Ltd:

	Historical costs	Carrying amount	Remaining useful life
Cash and cash equivalents	$12,000	$12,000	$           -
Accounts receivable	$21,000	$21,000	$           -
Inventory	$250,000	$220,000	$           -
Property Plant and Equipment (net)	$2,000,000	1,200,000	5 years
Total Assets		$1,453,000	$           -
Accounts Payable		$145,000	$           -
Bank Loans		$200,000	$           -
Shareholder’s Equity		$1,108,000	$           -
Liabilities & shareholders’ equity		$1,453,000	$           -

Additional information for Tallows Ltd: Taking into account current market information and historical data of the firm, you determine the following fair values: Accounts receivables: $18,000, Inventory: $180,000, Property Plant and Equipment: $1,000,000.

Bilgola Ltd:
	Historical Costs ($)	Carrying Amount ($)	Remaining useful life
Cash and cash equivalents	6,000	6,000
Accounts receivable	230,000	230,000
Inventory	600,000	600,000
Property Plant and Equivalent (net)	3,500,000	1,000,000	10 years
Total Assets		1,836,000
Accounts Payable		200,000
Bond Payable		360,000
Shareholders' Equity		1,276,000
Liabilities and shareholders' equity		1,836,000

Additional information for Bilgola Ltd:

Considering current market prices and further historical information from the company, you determine the following fair values: Accounts receivable $200,000, Inventory $500,000, Property Plant and Equipment $2,000,000.

Nicholas Less, the CFO of Greenmount Ltd has been under pressure to increase the companies’earnings as soon as possible. He has to provide a recommendation on which firm to acquire at the next board of directors meeting in two weeks. In preparation for the meeting, Nicholas has asked you to prepare a fact sheet that evaluates the acquisition of the two potential target firms, Tallows Ltd and Bilgola Ltd from an accounting perspective.

1. You remember an in-class discussion from your studies about the use of fair value accounting versus historical cost accounting. Provide arguments for and against the use of both methods and explain the trade-off between the two methods in the context of the objective and fundamental characteristics of financial reporting.

Answer 1

Historical Cost Method

The historical cost accounting method suggests that the assets should accounted at the cost which was incurred at the time of purchase. This method is more reliable and can be have physical evidence to support its valuation. However, this method does not provide the correct picture when we compare it to the market rates.

Fair Value Method

Fair value accounting method suggests that assets should be accounted at the market price rather than the historical costs because at the time of sale one will not be able to recover the historical costs. Fair value of assets can be derived by market research or can be determined on the basis of method suggested in IFRS 9

In the above example, as per the discounted cash flow method the external advisor has valued both the companies at $ 2 million however comparing the balance sheet items with its current market price, we can determine the following:

TALLOWS LTD
	Historical Value	Fair Value	Change
Cash and cash equivalents	12,000	12,000
Accounts receivable	21,000	18,000	-3,000
Inventory	2,20,000	1,80,000	-40,000
Property Plant and Equipment (net)	12,00,000	10,00,000	-2,00,000
Total Assets	14,53,000	12,10,000
Accounts Payable	1,45,000	1,45,000
Bank Loans	2,00,000	2,00,000
Shareholder’s Equity	11,08,000	11,08,000
Liabilities & shareholders’ equity	14,53,000	14,53,000
LOSS IN VALUE			-2,43,000

Replacing the historical costs with current market value we can see that there will be loss in value by $ 2,43,000 if we buy the Tallows Limited business.

BILGOLA LTD
	Historical Value	Fair Value	Change
Cash and cash equivalents	6,000	12,000
Accounts receivable	2,30,000	2,00,000	-30,000
Inventory	6,00,000	5,00,000	-1,00,000
Property Plant and Equipment (net)	1,00,000	2,00,000	1,00,000
Total Assets	9,36,000	9,12,000
Accounts Payable	2,00,000	2,00,000
Bank Loans	36,00,000	36,00,000
Shareholder’s Equity	12,76,000	12,76,000
Liabilities & shareholders’ equity	50,76,000	50,76,000
LOSS IN VALUE			-30,000

Compared to Tallows there is loss of only $ 30,000 when we buy Bilgola Limited business. Hence as per the accounting principles and the current market value it is suggested that we should go for Bilgola Limited.