In a speech in December 2018, Hans Hoogervost, chair of the International Accounting Standards Board (IASB), raised the topic of goodwill. With the IASB due to issue a Discussion Paper on the subject later in 2019, this blog outlines the debate behind ‘one of the most controversial areas’ of accounting standards.
IAS 38 Intangible Assets states explicitly that internally generated goodwill must not be recognised as an asset, as it is not identifiable and cannot be reliably measured. Goodwill arising on acquisitions, however, ie, purchased goodwill, is recognised and capitalised in accordance with IFRS 3 Business Combinations. In simple terms, purchased goodwill is measured as the difference between the amount of consideration transferred to acquire the business and the fair value of the separable net assets acquired. Unlike many other intangibles, it is not amortised but is instead tested annually for impairment in line with IAS 36 Impairment of Assets. It is this impairment only approach to the subsequent measurement of goodwill that is under the spotlight.
The main criticism of the impairment only approach is that it can result in write downs of goodwill which some consider to be ‘too little, too late’. This can be particularly evident when a poorly performing acquired business is combined with a successful existing business. Subsequent impairment reviews will consider both businesses as a combined unit. The existing successful business can have high levels of internally generated goodwill. Since the internally generated goodwill is not recognised on the balance sheet, it essentially creates a buffer (sometimes referred to as ‘headroom’) between the balance sheet (or book) value of the combined net assets and the value of the businesses as a combined unit. In this context, the value of the business is often measured based on the present value of future cash flows. Despite the poor performance of the acquired business, the value of the combined businesses exceeds the balance sheet value of the net assets and no impairment loss is recognised.
Recent corporate collapses, including Carillion, have highlighted this issue. At the time of its collapse, Carillion’s balance sheet reported goodwill of £1.57bn with no impairment losses having been recognised since IFRS 3 became effective. Its net assets at the time were only £0.73bn, meaning that without goodwill, the balance sheet would have reported net liabilities of £0.84bn. By remaining, unimpaired, on the balance sheet goodwill was in some sense disguising an otherwise weak financial position.
A further criticism is that impairment reviews require significant amounts of judgement and estimates. Measuring the value of the business unit based on forecasts of future cash flows can be a costly and time-consuming exercise. Concerns have also been raised regarding the high levels of subjectivity involved and whether management’s discretion can influence the amount and timing of impairment recognition.
IFRS 3 and the impairment only approach to goodwill was introduced in 2004. Prior to this, IAS 22 Business Combinations applied, which required goodwill to be amortised with a rebuttable presumption that its life was not more than 20 years. This was combined with the requirement to review goodwill for impairment, but only when specific impairment indicators arose. Some IFRS stakeholders are keen to see a return to this combined amortisation and impairment approach.
Amortisation avoids the complexity and some of the subjectivity of impairment reviews, and results in a steady decline in the reported value of goodwill. This steady write-off can help to reduce the need to recognise impairment losses and thereby reduces volatility in reported profits. Supporters also argue that it better reflects the phenomenon of the gradual replacement of purchased goodwill by internal goodwill after an acquisition.
In their June 2015 response to comments on the post implementation review of IFRS 3, the IASB acknowledged the mixed views on the subsequent accounting for goodwill. The board committed to carrying out further research, but with a focus on looking at ways to simplify and improve the impairment test rather than necessarily a return to amortisation.
However, in July 2018 it was decided to explore whether to reintroduce amortisation of goodwill. This, along with other options, will be included in a Discussion Paper expected later in 2019. In his recent speech Hoogervost was keen to emphasise that it is not a foregone conclusion that there will be a return to amortisation. There were good reasons why it was withdrawn, after all. The debate looks set to continue.
The Financial Reporting Faculty will be monitoring developments on this topic and will respond to the planned Discussion Paper in due course. Keep up to date with this, and other financial reporting news, via our financial reporting community pages and follow us on Twitter @ICAEW_FRF
It is a well written blog. Accounting for intangibles including goodwill is a complex and challenging area. IAS 38 is older than the advent of digital and disruptive technologies, therefore it does not reflect true value of business on the balance sheet.