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Accounting for Goodwill Under IFRS 3

In this essay I will be discussing the underlying problems with accounting for goodwill as a result of business combinations, which will include the comparison between the requirements of FRS 10 and IFRS 3 and also how this International standard affects the preparers and shareholders.

IFRS 3 defines goodwill as: “future economic benefits arising from assets that are not capable of being individually identified and separately recognised”. The definition effectively confirms that the value of the business overall is more than the sum of the accountable and identifiable net assets. Goodwill can occur either internally or as a result of business acquisition that therefore results in purchased goodwill. It is relevant to note here that self generated goodwill is not recognised as an asset under IAS 38 as it would allow such companies to have unfair advantage by valuing their own assets and thus producing more favorable balance sheet. Where as the purchased goodwill is recognised as it has an identifiable “cost”, being the difference between the fair value of the total consideration for the business and the fair value of all the other accountable and identifiable net assets. This difference can be attributed to factors such as business reputation, managerial ability, an established customer base and so on.

The treatment of goodwill differs between UK GAAP and IFRS in a number of respects, both regarding the initial measurement of goodwill and its subsequent treatment. First, the definition of goodwill and other intangible assets differs from the FRS 10,

Goodwill and Intangible Assets, (ASB, 1997) treatment in the UK. IFRS 3 requires that “all the acquiree’s intangible assets at the acquisition date should be recognised separately in the consolidated financial statements if they satisfy the IAS 38,

Intangible Assets, (IASB, 2004) definition of an intangible asset.” UK GAAP however is not as narrow in identifying intangibles and does not rule out the likelihood of many intangibles being subsumed within goodwill. The likely effect of this would be that on the adoption of IFRS, goodwill would be smaller, and other intangibles will be greater, than was the case under UK GAAP.

Secondly, in terms of the following treatment of goodwill after initial measurement, there is a main difference between UK GAAP and IFRS. “IFRS require that goodwill should be subject to annual impairment reviews, but should not be amortized. Under

FRS 10 there is a rebuttable presumption that that the useful life of goodwill does not exceed 20 years with amortization over the useful life.” An infinite useful life is only permitted under exceptional circumstances. As a result, the expectation is that profit under IFRS will normally be larger (e.g. Vodafone profits increased by 6.8 billion) than under UK GAAP as there it is unlikely that impairment charges will arise in most years, but amortization will arise under UK GAAP systematically (annually), which in turn allowed managers to predict with greater accuracy the impact on earnings. In contrast, impairment losses will arise at irregular intervals, which mean profit for the year figure will become more volatile. This in turn will prevent management and shareholders to make decision in advance.

Furthermore, as intangibles are normally amortised, but goodwill is not, there is an incentive for directors, in areas of “classificationary uncertainty”, to recognise goodwill rather than an intangible as this avoids the need to recognise annual amortization changes and therefore improves profit.

The new IFRS 3 standard, which is mandatory on all new transactions from 31 March 2004 for all quoted companies in the EU, has bought greater transparency to the acquisition process by disclosing the details of acquisitions including all the assets acquired and liabilities assumed, including contingent liabilities, to the companies shareholders. Under UK GAAP, the directors could talk generally about their “valuable customer base”, “excellent technology” and “world-class brands” in justifying the premium paid for a purchase. IFRS has changed the rules. IFRS 3 is introduced due to the rising significance of intangible assets as an economic resource. As businesses in the UK turn into increasingly service-orientated, intangible assets will make up a growing percentage of the value of many acquired businesses. Nevertheless IFRS 3 is much more than an accounting convention. The transparency promoted by this standard will allow analysts extraordinary insight into the performance of the purchased business. Shareholders will be in a better position to understand what they have actually got for their money. The implications for preparers are that they must understand and be ready to meet the challenges that IFRS 3 signifies, by making sure they have the necessary provisions in place such as training and equipment.

One of the main concerns is that measuring intangibles is not simply a one-off process. When a business is purchased, a process known as a purchase price allocation is necessary to assign the purchase consideration across the assets of the business. Only once the fair values are calculated for the intangibles, the preparers can determine the extent of the goodwill. Business will now as a result have to carry out impairment tests to check and, if necessary, correct the value of goodwill and long-life intangibles. For example, if a brand name has not performed well in the previous 12 months, the management could possibly face a big hit to both their income statement, in terms of impairment loss, and balance sheet, by having written down the value of the brand. Impairment check takes place at the level of what is known as cash generating units, often at a level below an operating unit. This means that small units of poor performing goodwill will be difficult to mask or subsidise by better performing goodwill from elsewhere, unless part of the business is included in a significantly larger CGU in which case poor performing transaction would be difficult to isolate. This in turn could increase the risk of considering such accounts for future investors.

Interestingly, although the treatment of impairment appears to be correct according to the framework, it could be argued that the impairment approach is not correct as the charge occurs at the wrong time (i.e. when there is a loss in value, rather than when profits are being made). It is very difficult to estimate future economic benefit of the goodwill as it depends on future sales and profitability of sales and it is probable the those estimates are likely to be over optimistic (e.g. introduction of a new car model) and therefore increasing FEB and avoiding an impairment charge. In addition it means that the treatment of goodwill for IFRS 3 transactions is inconsistent from its treatment in IAS 38. Therefore they should only use one of the treatments.

The other main challenge of IFRS 3 is choosing appropriate amortisation periods for each finite-life intangible asset. While some assets, such as a strong brand name, may have a relatively long or even indefinite life span, others, such as customer relationships or technology, may be written down over few years. Evidently, where different intangible assets have varying life duration, the likelihood to manipulate the amortisation impact on earnings could be seen as attractive to management. It is suggested that “in attempting to soften the short-term blow to earnings, companies may attempt to shift some of the value of short-lived assets to those with longer lives.” However, regulators could be suspicious of such an activity and due to the rigid nature of the IFRS 3 would ask the preparers to readjust asset lives. The result could be negative not only for the senior management but also for the reputation of the business as a whole. For shareholders, despite this may being a disadvantage, it could also be an advantage as they can be satisfied that the information audited is accurate. Another concern for the management when making a strategic decision on acquiring a decent business is the unpredictability of earnings (EPS), and could be negative as a result of IFRS 3. The management would needs to make the market aware that it is not an indication of poor purchase (in showing positive cash flow) as otherwise share price could well take a tumble as EPS rule is more supreme for shareholders than any other rule.

Other advantages for investors/shareholders include IFRS promise more accurate, comprehensive and timely financial statement information, relative to the national standards they replace for public financial reporting in most of the countries adopting them, including Europe. To the extent that financial statement information is not known from other sources, this should lead to more informed valuation in the equity markets, and hence lower risk to shareholders. In addition, by eliminating many international differences in accounting standards, and standardising reporting formats, IFRS eliminate many of the adjustments analysts historically have made in order to make companies’ financials more comparable internationally. IFRS adoption therefore could reduce the cost for management and shareholders of processing financial information. However, these advantages are possible provided standards are implemented by the management consistently. On the other hand, increased transparency causes managers to act more in the interests of shareholders. In particular, timelier loss recognition in the financial statements increases the incentives of managers to attend to existing loss-making investments and strategies more quickly, and to undertake fewer new investments with negative NPVs, such as “pet” projects and “trophy” acquisitions.

Finally, we would also need to consider the implementation IFRS 3 to see how effective it has been in reality. “IFRS 3 was designed to demonstrate to investors how their money was being spent on acquisitions”. However, recent research appears to indicate that “UK’s major companies are systematically failing to comply with IFRS 3. As a result the accounting for business acquisitions is still opaque, and creative accounting is still occurring.” “The specialist skills needed to undertake the implementation of IFRS 3 has cost these companies an estimated 80 million GBP.” As this provision is still in early stages, I think it will take some time for companies to catch up with this provision. I agree with the article that the large amount of money spent is largely wasted costs given the information is directly opposed to the spirits of IFRS 3 and therefore this opportunity should used to consider how resources should be deployed in future that would ensure equal benefits to cost incurred. In addition, for IFRS 3 to have any significant effect on company reports then it will require input not from standard setters but also academics and industry.

In contrast it is evident that extraordinary success has been achieved in developing a comprehensive set of “high quality” standards and in persuading almost 100 countries to adopt them. In time people will appreciate that IFRS 3 focuses purchasers on what they are really buying and ultimately this should lead to the creation of shareholder value.

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