Once every decade or so accountants fret over goodwill and reconsider how best to report it in financial statements – should it be amortised, impaired, amortised and impaired, or something else? There is no obvious right answer, positions are entrenched, and debate usually gets nowhere.
The problem is that neither amortisation nor impairment provides much help for investors. The debate needs to move on to what really matters – reporting about business value. There are already encouraging moves in this direction. It is time to apply similar innovative thinking to goodwill.
The accounting for goodwill has been a problem ever since the financial statements of a group of companies have been consolidated. Because goodwill is the difference between the price paid for a business and the value of its individual assets and liabilities, it is more the product of a different measurement perspective than it is an asset in its own right. This makes accounting for goodwill as if it were an asset for accounting purposes unsatisfactory, irrespective of how that accounting is structured.
Acquired businesses can be thought of as investments. They could be measured at fair value and performance evaluated considering changes in that fair value, just as we do for minority equity stakes.1In some limited cases, majority stakes in subsidiaries are not consolidated and instead accounted for at fair value. This applies to certain investments by investment entities. For example, a private equity fund may have both minority and some majority equity stakes within its investment portfolio. Accounting for all these assets at fair value, without consolidating the majority owned businesses, makes sense. However, focusing only on this ‘business value perspective’ would generally fail to provide investors with the most relevant information, particularly considering that acquired businesses are usually integrated with existing operating activities.
In consolidated financial statements we look through the acquired business to the individual assets and liabilities. Presenting financial statements where the parent and subsidiary are treated as a single economic entity generally provides the best basis for investors to evaluate that economic activity. This ‘accounting perspective’ considers the revenues, expenses, assets and liabilities of the acquired business, not the value of the business as a whole.
Goodwill arises when reporting moves from a business value perspective (the purchase price) to an accounting asset and liability perspective of an acquired company. As such it is difficult to rationalise goodwill as a separate accounting asset. It is for this reason that the accounting used for other balance sheet assets just does not seem to work for goodwill, and why we therefore question whether goodwill should be reported as an accounting asset in the first place.
Accounting for goodwill in the same way as other assets does not work
The present accounting for goodwill under IFRS and US GAAP is to treat it as an intangible asset of indefinite life, regularly test it for impairment and to write down the asset to the extent it is deemed irrecoverable. Goodwill is not amortised.
Many do not like this impairment-only approach. They argue that the lack of regular amortisation fails to reflect the consumption of purchased goodwill and its gradual replacement by internally generated goodwill, and that impairments are frequently inadequate. However, supporters of the impairment-only approach point to the arbitrary nature of amortisation and the greater relevance of impairment losses to investors.2 Investors also take different positions over the appropriate treatment of goodwill in financial statements. However, we believe that the majority of those providing views to the IASB and FASB, as part of their recent outreach and consultations, think that the existing impairment approach has more relevance for equity analysis than would a return to amortisation. This is also our view; given a choice between impairment only and amortisation plus impairment we would choose impairment only.
In our view, neither approach has much merit.
Goodwill impairments are useless
When companies calculate that a goodwill asset is impaired, write down the asset and report a goodwill impairment charge, they do not mean it literally. Goodwill cannot be measured directly, only the business, or cash generating unit (CGU) to use the accounting jargon, to which that goodwill is attributable, can be measured. If the value of a CGU is lower than the sum of the balance sheet carrying values of the assets less liabilities of that CGU, it is assumed that the loss relates to the goodwill. But this may not faithfully reflect the actual loss of goodwill itself.
An impairment loss may not mean that goodwill itself is impaired and, conversely a lack of impairment does not mean that goodwill has not been impaired. The problem is one of measurement and particularly of shielding.
Shielding refers to the understatement of the non-goodwill assets of a CGU that is subject to an impairment test. Although an impairment test may show that the value of a CGU is higher than the reported net assets (indicating that no impairment has occurred), if the recognised net assets of that CGU had not been understated, a loss may well have been apparent.
Shielding can arise for several reasons:
- Combining acquired businesses into larger CGUs: When a business is acquired, it often becomes part of a larger CGU. If the value of the other business activities in the CGU is greater than the carrying value of the related net assets, the difference ‘shields’ the acquired goodwill from impairment. Only if the value of the CGU falls by at least this difference (the unrecognised internally generated goodwill), would a loss be reported. This shielding effect is sometimes called ‘pre-acquisition headroom’ as it results from pre-existing unrecognised internally generated goodwill.3We discussed and provided a numerical illustration of pre-acquisition headroom in our article ‘Goodwill impairments may not identify impaired goodwill’. At one stage, adjustments to the impairment test to remove this headroom effect (which we explain and gave our support to in our article) were being considered by the IASB, but it seems that this has now been abandoned.
- Unrecognised intangibles: Although intangible assets acquired in a business combination are recognised in the consolidated financial statements, the same cannot be said for internally generated intangibles that arise after an acquisition. Most expenditure that results in internally generated intangibles is expensed.4For more about the accounting for intangibles and the implications of not recognising internally generated assets see our article ‘Missing intangible assets distorts return on capital’. Because the acquired intangibles are progressively amortised, if replacement intangibles are not recognised, the net assets amount of the CGU falls (or at least rises by less than it would have done). This creates an additional and increasing shielding effect in the goodwill impairment test. The value of a CGU must additionally fall by the amount of post-acquisition unrecognised intangibles for the impairment test to fail.
- Unrecognised goodwill: Where a business combination involves the purchase of less than 100% of a subsidiary, under IFRS (for US GAAP this is not an issue), companies can choose between two ways to measure goodwill. It all depends on whether NCI is measured at fair value on the date of acquisition or at the NCI share of recognised net assets. The difference is goodwill relating to the NCI. If the book value approach is used, additional headroom equal to the unrecognised goodwill attributable to NCI is available to shield the acquired goodwill from impairment.
- Historical cost measurement: Certain aspects of financial reporting are inherently conservative. For example, many assets are measured at historical cost5Although assets and liabilities arising from a business combination are mostly measured at their fair value on the date of the transaction, these values are not kept up to date if the subsequent measurement basis for that item is historical cost. This means these value changes after the date of the acquisition (excluding some negative changes which are reported as impairments) go unrecognised. which may be less than their fair value. If assets arising in a business combination have increased in value after the date of an acquisition, and that increase is not recognised in the financial statements, this provides an additional shield or headroom in the goodwill impairment test. Only if the value of the CGU has additionally fallen by at least the unrecognised increase in value of other assets would an impairment loss be triggered.6The two-step impairment test approach under US GAAP mitigates this shielding effect – although we note that there is a proposal to simplify the test which would make it less effective.
The result of these multiple shielding effects is that, in practice, so-called goodwill impairments say little about whether goodwill is actually impaired, and even less about the success or otherwise of the acquisition decisions that resulted in the goodwill.
Although shielding destroys the usefulness of the goodwill impairment test regarding goodwill itself, the impairment test does arguably have some merit in at least ensuring that the carrying value of the net assets of a CGU is expected to be recovered. This may in some (limited) situations serve as a signal that an acquisition was unsuccessful.
But we question whether this partial reporting of a business value change really helps, considering that it is only brought to the attention of investors when the value change trips a somewhat arbitrary line that varies depending on the nature of the business, its historical development, and the granularity with which it determines CGUs. Even if an impairment is triggered, the amount recognised is almost certainly less than the business value lost and shielding means that plenty of bad acquisitions never result in an impairment being reported.
Goodwill amortisation is useless
Goodwill is very difficult to rationalise as a separate asset. At worst it is conceptually impossible given that it is the product of different measurement perspectives for a business. At best it comprises many different and potentially offsetting contributory factors.
This inability to pin down precisely what goodwill is makes it very difficult to identify a suitable amortisation basis or useful economic life. We can see how certain aspects of purchased goodwill may diminish over time but identifying which bits, when and how, is impossible. As a result, any goodwill amortisation is essentially arbitrary and devoid of economic meaning.
Most investors will be familiar with the generalised description of purchased goodwill as the difference between the fair value of the consideration paid for a business and the fair value of the individual assets and liabilities acquired. On this basis goodwill seems to mean something, being the fair value on the date of acquisition of what is not recognised as a separate (non-goodwill) asset for accounting purposes. This might include different contributing factors but at least it is the fair value (and purchase price) of something.
However, all is not what it seems. Although most acquired assets and liabilities in business combinations are measured at fair value, this does not apply to everything, including, for example, deferred tax and pension obligations.
- Deferred tax: In a business combination deferred tax is measured at the normal IFRS7We have written this based on IFRS – similar issues arise under US GAAP. (IAS 12) balance sheet value rather than fair value. The balance sheet value for deferred tax can be higher or lower than the fair value of the future incremental tax payments or savings the deferred tax balance represents. This can result in either an over or understatement of goodwill. A good example, and a situation where the impact can be particularly significant, concerns tax losses. Deferred tax assets in the balance sheet for tax losses are based on an assessment of whether realisation is ‘probable’ and does not take into account the time value of money. As a result, the contribution of tax losses to business value can be very different from the balance sheet amount.8We discuss the overstatement of deferred tax assets relating to tax losses in our article ‘Deferred tax fails to reflect economic value’.
- Pension liabilities: A pension obligation assumed as part of a business combination is measured at the IFRS (IAS 19) balance sheet carrying value; it is not adjusted to fair value. Because the purchase price of a business with a defined benefit pension obligation would consider the purchaser’s assessment of the economic value of pensions, the resulting goodwill balance incorporates the difference between this economic (or fair) value and whatever is reported in the balance sheet. We think that the IAS 19 liability generally understates the fair value of the obligation. There is plenty of evidence for this when transactions involve just the pension scheme, such as in pension buyouts. The result is that goodwill is understated.
The impact of not measuring all acquired separate assets and liabilities at fair value is that, in effect, the reported goodwill amount is a combination of: (1) the value arising from factors that are not recognised as separate assets (including those we list below) and (2) the positive and negative value differences for those items that are recognised but not measured at their acquisition date fair value. It is difficult to see how the resulting goodwill balance means anything, and how a basis for its amortisation can be anything other than arbitrary.
Even if recognised goodwill were to be measured in a consistent manner, we still do not think an amortisation charge has any relevance. Goodwill is made up of many contributing factors. In our view, it is impossible to fully identify each of these factors, their relative contribution to goodwill, their useful life, and how all of this should be combined into a single useful life to determine goodwill amortisation.
For example, goodwill may include:
- Employees: Value may arise from the culture, training, and abilities of employees. Rarely would any component of this be recognised as a separate asset. Furthermore, if a business has an ongoing share-based payment incentive scheme, the deferred cost and future benefits of this would also, in effect, be a component of goodwill.
- Growth opportunities: Business value is not just determined by current business activities but also by options to expand and develop new business activities in the future. These ‘real options’ may not be available to others and hence contribute to the price paid by a purchaser and the resulting goodwill.
- Restructuring: Poorly performing businesses may be acquired with a view to restructuring, in which case the purchase price is likely lower due to the anticipated cost of that business transformation. Such restructuring costs rarely qualify as a liability at the time of the acquisition, which results in a negative restructuring cost component of goodwill.
- Synergies: Business combinations are often justified based on anticipated cost and revenue synergies. Different synergy components of goodwill may provide benefits over different periods, and some may even be assumed to continue indefinitely.
- Overpayment: We all know that research shows that the average acquisition destroys value, which is often the result of overpayment. Theoretically this overpayment should result in an immediate impairment loss and not be added to goodwill; however, we cannot recall this ever happening – in part no doubt due to management hubris and in part due to the goodwill shielding we have described above. Clearly, ascribing a useful life to the overpayment component of goodwill is meaningless.
In our view, goodwill is so different in nature that it cannot be viewed in the same way as the separate assets and liabilities recognised in the balance sheet, which is why any attempt to determine a useful life will inevitably result in meaningless amounts.
The impairment only approach to goodwill accounting has been applied in IFRS and US GAAP for many years. However, most jurisdictions have at some point required or permitted amortisation over an estimated useful life, often subject to an upper limit for the amortisation period. But whenever an amortisation approach has previously been used, investors have mostly ignored the expense. Certainly, that was our experience (and our advice to clients) when we were involved in investment banking, and we have no reason to assume it will be different if amortisation were now to be reintroduced.
Eliminate goodwill and enhance reporting about business value
Financial statements would be more useful if goodwill were not included in the balance sheet. Eliminating goodwill through immediate write-off (generally expressed as a deduction from equity in the form of a consolidation adjustment, rather than reporting an expense) is not new. It was applied in several jurisdictions prior to their adoption of IFRS and was permitted under IFRS prior to 1993.
This does not mean that goodwill should be ignored – far from it. We think that information about goodwill and about business combinations is important and should be part of wider reporting about business value.
Most accounting is about recognising and measuring individual assets and liabilities, and the related revenues and expenses that are derived from changes in these balance sheet items. The insights this provides for investors are extremely useful and it facilitates analysis of key metrics, such as profit, cash flow, return on capital, and components of financial position. However, accounting data alone is not enough for investors to fully understand a business, even when supported by footnotes and the related explanations in management commentary.
Investors also need information that directly relates to business value. We are not necessarily saying that companies should provide management’s valuation of the business, but rather that transactions, activities, and risks that affect value, and for which normal accounting metrics do not suffice, are reported such that investors are able to make their own value judgements.
The value effects of acquisitions include the amount and type of consideration paid, the impact this has on equity dilution and enterprise value, the acquisition premium paid and the goodwill amount. We think that disclosures about the cumulative effects of business combinations, including a schedule of ‘goodwill’ arising on consolidation, should form part of reporting about business value and that this would be more useful than trying to account for goodwill as an accounting asset.
Business value is also affected by the strategy and objectives of business combinations and by the post-acquisition performance of the acquired business, including whether and how synergy and other benefits are realised.
The IASB has recently moved to enhance disclosure in exactly this way, with proposals included in a paper published last year. It is presently working on a draft accounting standard, and many of these ideas will soon be put forward for public comment. We support the proposed new value-related approach.
Other business value related disclosures
Disclosures about business value should not stop with business combinations; other transactions should be subject to similar reporting. Business value related disclosures, or perhaps a separate business value report, should also include:
- Restructuring: A major business transformation programme may involve significant investment and, similarly to a business combination, result in dilution from capital raising and generate value benefits through synergy-like cost savings.
- Sustainability: Climate change and other ESG factors may have particular relevance for business value. Indeed in a recent press release announcing the formation of the new International Sustainability Standards Board the IFRS Foundation explains that the focus of sustainability reporting will be on how ESG affects enterprise value … “Financial markets need to assess the risks and opportunities facing individual companies which arise from environmental, social and governance (ESG) issues, as these affect enterprise value”.
- Unrecognised intangibles: Many investors have called for better disclosure about intangible assets that do not qualify for recognition in the balance sheet. This is also closely related to reporting on business value and is sometimes linked to sustainability reporting.
We think that the move towards reporting about matters that affect business value, but which are not covered adequately by simply reporting assets, liabilities, revenues and expenses, is an opportunity to rethink the accounting for goodwill. Including goodwill in business value related reporting would facilitate better judgements about whether the change in business performance has justified the price paid (including the goodwill) and the resulting equity and enterprise dilution suffered by investors.
It is also important to note that immediate write-off of goodwill does not mean ignoring the financial effect of that part of the acquisition consideration. A higher price paid results in either an increase in equity, and hence an EPS dilution effect, or an increase in net debt and therefore additional finance charges. Disclosures about the annual and cumulative impact of financing business combinations should be part of business value reporting.
Views of the IASB and FASB
Both the IASB and FASB are currently discussing whether to change the accounting for goodwill. The IASB is still debating what to do while FASB has already taken a tentative decision to reintroduce amortisation. These decisions do not make change certain as both boards will need to issue an exposure draft of a new standard and consider feedback before making any final changes to accounting standards.
In its earlier discussion paper on goodwill accounting the IASB dismissed immediate write-off and does not seem to be presently considering this as a way forward. In our view it was dismissed too quickly, and we urge a rethink.
The four reasons why the IASB decided “not to pursue the idea of immediate write-off”9See page 74 of the IASB Discussion Paper Business Combinations – Disclosures, Goodwill and Impairment. and our responses are:
“Requiring an immediate write-off would be inconsistent with the Board’s conclusion in IFRS 3 that goodwill is an asset that should be recognised and with management’s view when deciding to acquire the business that it has paid for something that is expected to generate future economic benefits.”
We would argue that it is businesses that generate future economic benefits and that such benefits cannot be directly ascribed to goodwill. Some would question whether goodwill is an asset of a business given that it cannot be separated from that business. But even if it does meet the definition of an accounting asset, it does not necessarily follow that it must be recognised in the balance sheet. There are plenty of accounting assets that for one reason or another are not recognised.
“Recording a write-off directly in equity would not be a faithful representation, because it would inappropriately portray the acquirer as having made a distribution to its owners.“
We do not agree that a deduction from equity equates to a distribution. There are other cases where items other than transactions with owners and retained earnings affect equity, such as certain items relating to share-based payments and consolidation differences arising from some business combinations under common control.
“Investors would no longer receive the information, albeit limited, provided by the impairment test for cash-generating units containing goodwill.“
We believe that immediate write-off would facilitate the provision of better information through a greater focus on business value. But at least there is an acknowledgement that the information content of impairments is limited!
“Some investors use the carrying amount of goodwill in their analysis and in their assessment of management’s stewardship.“
Certainly, measuring invested capital and ROIC inclusive of goodwill adds an element of accountability for management’s acquisition decisions. However, we think that separate value focused reporting would be a better way to consider management stewardship. We also note that the stewardship argument is a reason not to amortise goodwill because the accountability arising from having the asset in the balance sheet would soon diminish through amortisation and, of course, the amortisation itself would be ignored by investors.
If the choice is between impairment only and amortisation plus impairment (which seems to be the IASB and FASB debate), we would choose impairment only. However, we think it is time to focus more on the wider business value effects of business combinations and not be distracted by the accounting for goodwill. We suggest immediate write-off of goodwill against equity, combined with enhanced reporting on business value as a way to achieve this.
Accounting for goodwill – Tell us what you think
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Insights for investors
- Goodwill impairment tests do not reliably measure impairments of goodwill. The value of business units must fall by at least the sum of multiple shielding effects to trigger an impairment.
- Goodwill impairments may be a signal of sorts but what is reported is essentially useless.
- If goodwill amortisation is ever reintroduced, ignore the expense. Goodwill is a mixture of various value factors and measurement differences, and any attempt to calculate amortisation will inevitably be arbitrary.
- Remember that the cost of businesses, even if not reflected in recognised assets and liabilities, affects equity dilution and/or leverage. The financial effect of the price paid is not lost from financial statements if goodwill is eliminated on acquisition.
- Management must be held accountable for the full acquisition purchase price. Including goodwill in capital employed may well help, but it is not sufficient. Focus more on the value effects of business combinations and whether promised benefits have materialised.
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