Accounting for Goodwill: Time for a Change?
Goodwill, the difference between the amount paid for a business and the fair value of the net assets acquired, has long caused problems for accountants and has recently been the focus of media attention.
Commentators on the collapse of Carillion have criticised the apparent lack of goodwill impairment in the financial statements, despite the declining financial performance of the underlying subsidiaries. It’s been suggested that the current accounting rules allow management to hide the fact that acquisitions have gone bad, and therefore produce overly optimistic accounts.
Goodwill is most commonly found in the group accounts although it can also be found in the individual accounts of an entity. So, what does this goodwill represent? Well, it arises on the acquisition of a business and is calculated as (in simple terms) the difference between the price paid for the business and the identifiable assets and liabilities acquired. Essentially, it consists of:
- the going concern element of the acquired business; and
- the expected synergies and other benefits from combining businesses.
In the 1980s, UK Statement of Standard Accounting Practice 22 ‘Accounting for Goodwill’ required that this difference was immediately written off against reserves. This meant there was no charge through the profit and loss account. After numerous entities including Saatchi and Saatchi, which had gone on a buying spree, ended up with negative reserves (1991) there was pressure to move to a different approach for accounting for goodwill.
Eventually, Financial Reporting Standard (FRS) 10 ‘Goodwill and Intangible Assets’ was issued in 1997 and took the view that despite not satisfying the definition of an asset, goodwill was to be capitalised on the balance sheet and written down over a number of years.
The logic of the UK’s Accounting Standards Board was that goodwill formed a bridge between the cost of an investment shown as an asset in the acquirer's own financial statements and the values attributed to the acquired assets and liabilities in the consolidated financial statements.
Therefore, rather than accounting for it as a deduction from shareholders' equity, goodwill formed part of a larger asset, the investment, for which management remained accountable. The current UK standard Financial Reporting Standard 102 retains this amortisation approach.
However, listed companies preparing their accounts under International Financial Reporting Standards (IFRS) are required to follow a different approach under IFRS 3 Business Combinations. This standard prohibits an amortisation approach to purchased goodwill and instead requires that goodwill is tested annually for impairment.
As a result of its Post-implementation Review (PIR) of IFRS 3, completed in 2015, the International Accounting Standards Board (IASB) decided to undertake a new research project looking at certain aspects of accounting for goodwill. Initially, the focus was to be on ways to improve the impairment approach but has recently been widened to consider a re-introduction of amortisation as well.
When the IASB originally outlawed amortisation of goodwill, it was justified on the following grounds:
- it can be very difficult to make an objective assessment of the time period over which goodwill should be amortised, and in some cases, the goodwill may have an indefinite life;
- some investors report that they ignore amortisation as it has no cash impact and will add it back when making their assessment of an entity’s financial performance.
But the PIR and wider research identified concerns with the requirement for an annual impairment review as well. The process is seen as costly and subject to management discretion, therefore impairment losses tend to be recognised too late. Because goodwill does not generate independent cash flows, its impairment is assessed as part of a cash generating unit (CGU) or group of CGUs.
This means that the goodwill on a newly acquired subsidiary may be assessed as part of a wider CGU which includes well-established existing businesses. The value of such businesses for the purposes of assessing impairment will be significantly higher than their book value due to unrecognised internally-generated goodwill.
Therefore, there will be no impairment at the level of the CGU, even if the newly acquired business is performing poorly. The result is that inflated goodwill balances may remain on the balance sheet indefinitely.
Of course, some may question whether, since goodwill is a residual figure, it really meets the definition of an asset at all. It can be seen instead as the amount of an overpayment to acquire a new business – as in the recent goodwill write-down by GE on their 2015 acquisition of Alstom.
It’s unlikely that we will see a return to an immediate write-off of goodwill to reserves, but a review of the impairment and amortisation approaches will hopefully lead to a better understanding of what goodwill is, and a more robust and timely recognition of any write-downs.