When corporate regulators periodically publish their "hit list" of focus areas for surveillance activities around financial reporting practices, one item appears time and time again - the adequacy of impairment testing of goodwill. It is also a frequent cause of friction between those preparing financial statements and those auditing them.
At a glance
- Significant global growth in mergers and acquisitions has raised the profile of goodwill accounting associated with such economic activities.
- Management optimism over the expected future performance of business acquisitions sometimes contributes to delayed recognition of impairment.
- While the debate over impairment vs amortisation of goodwill continues, improving disclosures around business combinations remains a key priority.
By Ram Subramanian and Nadee Dissanayake
Expanding merger and acquisition activity has contributed to the prominence of goodwill on group balance sheets, with recent estimates from the International Accounting Standards Board (IASB) placing a value of US$8 trillion (A$10.4 trillion) on the worldwide goodwill value recorded in financial statements.
According to an overview of China’s domestic listed companies, the number of companies with goodwill recorded in their financials has grown from 29 per cent in 2007 to 55 per cent in 2019.
Technology giant Apple has acquired about 100 companies over the past six years – that’s a new business acquisition every three to four weeks, on average. Noteworthy among these is the acquisition of Beats Electronics in 2014 for a sum of US$3 billion (A$3.9 billion), with goodwill arising from this acquisition amounting to US$2.2 billion (A$2.8 billion).
Goodwill makes up a major portion of the value attributed to other companies’ notable acquisitions as well. When Microsoft bought social networking platform LinkedIn in 2016, according to statutory filings at that time approximately US$16 billion (A$20.7 billion) was allocated to goodwill from the purchase consideration of about US$27 billion (A$35 billion).
Bridging the gaps
When companies acquire other businesses, goodwill is recognised in group balance sheets as the difference between the purchase consideration and the fair value of identifiable net assets acquired.
In other words, goodwill is the premium paid by the acquirer that represents the acquiree’s future potential to generate cash flows and other economic benefits.
“It is essentially a bridge between what is paid and what is acquired when a company acquires another business,” says Ian Mackintosh FCPA, past vicechair of the IASB and member of the CPA Australia External Reporting Centre of Excellence.
Although internally generated intangible assets – such as trademarks, customer lists and brand names – are generally not allowed to be separately recognised on company balance sheets, IFRS 3 Business Combinations (IFRS 3) does allow these to be recognised separately from goodwill when there has been a business acquisition.
Goodwill, therefore, is a residue – “all the assets that do not meet the criteria for recognition and measurement, and a premium that the buyer is willing to pay for the acquisition”, says Mackintosh.
This would include an acquired company’s workforce, the going concern element of the acquiree’s existing business and the value attributed to the synergies and other benefits from combining the acquirer’s and acquiree’s net assets and businesses.
Calls for change
When IFRS 3 was issued by the IASB in 2008, the previous amortisation model for goodwill was replaced with an annual impairment test model.
In arriving at this major shift in accounting approach, the IASB observed that the useful life of acquired goodwill, and the pattern in which it diminishes, is difficult to predict. As a result, the amount amortised in any given period is an arbitrary estimate at best.
It was felt that a rigorous and operational impairment test would provide more useful information that better reflects the consumption of goodwill and the assets and liabilities associated with it.
Although this annual impairment test approach to writing down goodwill remains in place today, calls to reintroduce amortisation of goodwill have been growing in number in recent years.
Supporters of reintroducing goodwill amortisation claim that goodwill is not written off soon enough or by the right amount. There are a few reasons why this occurs.
One commonly acknowledged issue with goodwill impairment is the “headroom” or “shielding” problem.
When a business is acquired, the purchaser often incorporates it into their own business activities, and the net assets of the acquired business are merged with the net assets of the acquirer.
Goodwill is not directly tested for impairment, but is tested as part of a basket of assets and liabilities (a cash generating unit) to which it has been allocated.
Because of this approach, any unrecognised internally generated goodwill, other unrecognised intangible assets or recognised assets that have a fair value higher than their book value could all act as a “shield” when the net assets of the cash generating unit to which the acquired goodwill has been allocated are tested for impairment.
Even if the acquired business is kept separate, a similar “shielding” effect can arise from postacquisition internally generated goodwill and other unrecognised intangibles.
This means that any increase in value of other assets and internal goodwill could potentially compensate for any decrease in the value of acquired assets and associated goodwill.
Although attempts have been made to address this complex aspect of goodwill accounting, no costeffective solution has been developed so far to address the “shielding” or “headroom” challenge.
CPA Australia resource:
Submission on disclosures, goodwill and impairment
Management optimism over future cash flows and profitability of an acquired business can also lead to delays in goodwill impairment.
A business acquisition is almost always based on a number of assumptions and estimates around the synergies as well as other benefits the acquired business can bring to the acquirer.
These predictions do not always bear fruit, and an impairment loss is booked against goodwill when the valuation of the acquired business does not pass the impairment test.
Goodwill write-offs can arise due to unpredictable external circumstances as well. Last year was a particularly challenging period due to the COVID-19 pandemic.
It is possible that many companies, including those with a stake in the travel, retail, and oil and gas industries, may have had to take an impairment charge against goodwill carried in their books as the result of the pandemic-induced economic downturn.
From time to time, even if there is a diminution in goodwill value, those responsible for the business acquisition decision may try to justify their position through somewhat optimistic estimates and judgement calls. Supporters of goodwill amortisation argue that a systematic write-down of goodwill will avoid this problem.
Amortisation vs impairment
There is also a school of thought that maintains that not all elements of goodwill represent a wasting asset that is consumed systematically over a period of time.
A paper published by the International Valuation Standards Council explores this very notion, arguing that the identified tangible and intangible assets broadly represent the finite lived assets of the acquired business, while the goodwill represents going concern or the perpetual growth portion of the acquired business.
This argument is premised on the fact that any acquisition is based on the assumption that the business is a going concern and, therefore, that element of the business holds its value into the foreseeable future.
While the amortisation versus impairment debate rages on, Mackintosh says that it really does not matter whether goodwill is impaired or amortised.
“Analysts write back goodwill anyway when drawing up their valuations and recommendations. Whether goodwill is impaired, amortised or something else is done with it, it does not matter to them. I am not sure it’s all that important a question whether goodwill should be impaired or amortised,” says Mackintosh.
What is much more important are robust disclosures about business acquisitions.
“Good disclosures need to shine a light on acquisition decisions made by the management of the company and say something meaningful about the stewardship of that company and its business acquisition decisions,” Mackintosh says.
“Disclosures around management expectations for business acquisitions may not be restricted to the financial statements.
Readers should look to the directors’ report or management commentary sections of the annual report for information on how management expects to benefit from their business acquisition decisions.”
A divided future
In 2020, the IASB published a consultation that explores options to simplify the impairment accounting of goodwill and proposed disclosures to complement business acquisitions.
Although the IASB proposes to retain the current goodwill impairment model, when the paper was finalised, support for this from the IASB members was marginal, with only eight of the 14 members voting in favour of retaining the impairment model.
Preliminary analysis of feedback received on the IASB consultation indicates views remain divided on the amortisation versus impairment question.
The IASB consultation also suggested the impairment test be simplified, by moving away from the current annual impairment requirement to requiring an impairment test only when indicators of impairment are identified.
Most respondents to the IASB consultation appear not to be in support of this proposal, suggesting the current annual impairment test is the better option.
While it is currently expected that the IASB will retain the goodwill impairment model as proposed in its consultation, improvements may need to be considered through better disclosures and addressing issues such as the shielding challenge.