Failed acquisitions do not always result in goodwill impairments. Management optimism is part of the problem, but so is application of the impairment test in a way that maximises the shielding effect of other assets. This reduces the value of goodwill impairments for investors.
Analysing the success or failure of M&A is important to assess management stewardship. We applaud the IASB’s proposal for more disclosure, but also believe the goodwill impairment test needs a critical review. Some use the ‘too little, too late’ character of impairment to advocate re-introducing goodwill amortisation. We do not agree.
Goodwill impairments should help you assess whether a business acquisition has been successful and to hold management to account for acquisition decisions. However, value can be destroyed with no impairment being recognised.
Management are often reluctant to admit to poor acquisitions and use the subjectivity of business valuation to obfuscate and resist booking impairments. But, we also think that the effectiveness of the impairment test is diluted by management applying it at a high level of aggregation. Better enforcement of the current rules would help. However, we also think that part of the solution could be reform of the impairment test itself, both remove the incentive to aggregate before testing and to improve its effectiveness. The impairment process should provide valuable insights for investors; the impairment methodology and its application in practice does not always achieve this.
Contrary to common perception, the goodwill impairment test is not actually a test of goodwill specifically, but rather a test of whether the aggregate carrying value of the assets of a business unit (cash generating unit or CGU in IFRS terminology), that includes the goodwill, is recoverable. If the recoverable value of a CGU is less than the balance sheet carrying amount of the assets of that CGU, then the company recognises an impairment that involves writing down the goodwill. The reason goodwill cannot be tested directly is simply that goodwill does not generate cash flows in isolation. It is not possible to measure the value of goodwill directly, but only as a residual.
As a result, the size of any goodwill impairment depends on the recognition and measurement of the other assets in a CGU. Accounting is naturally conservative, with internally generated goodwill and many intangible assets not recognised at all and others measured at less than their economic value. This provides a buffer (referred to as headroom or shielding) for the acquired goodwill. A goodwill impairment is triggered only if the value of the CGU has fallen by more than other assets are understated. In effect, goodwill is allowed to be overstated as long as other assets are understated by at least as much. This is why an acquisition can fail (for example, hoped for synergies fail to materialise) and goodwill is lost, but no actual goodwill impairment is recognised.
Does it matter? Maybe not. If the objective of the impairment test is simply to ensure that the carrying value of CGU assets does not exceed the value of that business, then the test works fine. But if you are using goodwill impairments to help determine whether an acquisition has destroyed value, or to assess management stewardship, then impairment testing is deficient.
Is there a solution? Maybe. The effectiveness of the existing test would be improved if it were applied at a more granular level, but it could also be modified to remove or reduce the shielding effect. There are various ways to do this; we illustrate one approach below. This was previously applied in the UK where, before the adoption of IFRS in 2005, UK companies had to comply with UK GAAP FRS 11 (see paragraph 50).
The goodwill impairment test
Goodwill is the difference between the purchase price of a business and the sum of the fair values of the individual assets and liabilities acquired. Like other assets measured at historical cost in financial statements, goodwill is subject to impairment if the carrying value is not recoverable.
The test involves comparing the value (recoverable amount) of the cash generating unit, to which the goodwill has been allocated, with the carrying value of the assets of that CGU or sometimes a group of CGUs. Any excess of carrying value over recoverable amount is initially applied in order to write-down goodwill and then to write down the other intangible and tangible assets of the CGU.
A CGU is defined as the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets. The recoverable amount of the business is the highest of its fair value less cost of sale and ‘value in use’ (the value of the cash flows the business is expected to generate).
Of course, this is a very simplified explanation – the full detail can be found in IAS 36.
Why is headroom a problem?
If an acquired business is kept as a separate business unit within the acquiring group structure, such that it generates identifiable and largely independent cash inflows, then the goodwill impairment test can be applied directly to this acquired business. In these cases, the impairment correctly targets the goodwill itself.
Assume a business is acquired for 1,000 when its identifiable net assets, including any acquired intangibles, are valued at 600. Goodwill is therefore 400. One year later the business has not performed as expected and management estimates it is now worth 800. In spite of the fall in value, the business has been profitable and, as a result, net assets have increased to 650. Recoverable goodwill is now only 150 (800 – 650) and an impairment loss of 250 (400 – 150) would be reported.
Unfortunately, impairment testing is generally not that simple. Most acquired businesses are not kept as stand-alone business units but are instead integrated into existing activities. Goodwill is then allocated to the cash generating units into which the acquisition is integrated, with the impairment test done at this higher level. It is this integration into larger CGUs that provides an impairment shield or headroom.
Let’s continue with the above example (all figures are summarised in a table below). Assume that the new subsidiary is integrated with an existing business with the combined operation being a single cash generating unit. The existing business has a value of 2,000 and balance sheet net assets of 1,100. At the time of the acquisition the value of the enlarged CGU is 3,000 and the combined net assets excluding goodwill are 1,700 with acquisition goodwill of 400.
The existing business had inherent goodwill of 900 at the time of the acquisition, but this is not recognised in financial statements. It is this unrecognised goodwill that provides headroom or a shield for the purchased goodwill. The value of this cash generating unit would need to fall by more than 900 before the purchased goodwill needs to be impaired.
A significant reduction in recoverable amount (we assume from 3,000 to 2,400 in the table below) produces no impairment. This shielding effect results in fewer impairments than investors might reasonably expect and limits their usefulness as a signal of value being lost through M&A.
Goodwill impairment without a ‘headroom’ adjustment
Not only does unrecognised inherent goodwill provide a shield, but so too would other unrecognised assets, such as intangibles, or indeed recognised assets that have a balance sheet value below their economic value, such as property or investments measured at historical cost.
Goodwill impairment after adjusting for headroom
While internally generated goodwill is not recognised in the balance sheet, it could still potentially be incorporated into the impairment test. For example, the internally generated goodwill of the existing business above could be included in the CGU assets for the test and ‘impaired’ along with the purchased goodwill, Only the impairment of the purchased goodwill would actually appear in the financial statements. The effect of this would be to overcome the shielding effect and recognise impairments of purchased goodwill on a timelier basis.
Using our example, if the inherent goodwill present in the cash generating unit at the time of the acquisition is included in the calculation, then the value of the cash generating unit is less than the recognised assets plus this headroom adjustment, producing a notional impairment of 700 (3,100 – 2,400). This amount relates to both the recognised purchased goodwill and the unrecognised inherent goodwill. The impairment of the purchased goodwill, based on a simple allocation, is 215 or 700 * 400 / (400 + 900).
Goodwill impairment with and without a ‘headroom’ adjustment
Although this revised test relies on a simplistic allocation, we believe it better focuses on the goodwill itself and produces the correct signal for investors that some of the cash spent on the acquisition has been lost.
Adjusting for headroom is not without its challenges. For example, should the headroom be updated each period? What happens to the headroom adjustment when a business is reorganised? Does the simple allocation we have done above faithfully target the acquired goodwill? Implementing such an approach may also increase the cost for companies.
It is all about the level of aggregation
The effectiveness of the existing indirect CGU-based impairment test on targeting acquired goodwill critically depends on the level of aggregation. As we demonstrate above, where an acquired business is a separate CGU there is no headroom, at least initially. However, the effectiveness of the test and the likelihood of impairments critically depends on companies define CGUs in practice and whether CGUs are combined for the purpose the test.
Youwould expect most companies to have a relatively large number of CGUs, as the business unit essentially just has to have a largely independent revenue stream. Even if acquired goodwill is associated with more than one CGU, the test must be done at the CGU level after allocating the goodwill to the CGUs expected to benefit from the synergies the goodwill represents.
However, in practice, it is more common to see a relatively small number of CGUs. The main cause of this seems to be that CGUs are aggregated before goodwill is tested. IAS 36 anticipates the need to aggregate if goodwill cannot be allocated to CGUs on a “non-arbitrary basis”. The standard also links this grouping to how management monitors goodwill. Paragraph 80 of IAS 36 says …
Each unit or group of units to which the goodwill is so allocated shall:
(a) represent the lowest level within the entity at which the goodwill is monitored for internal management purposes; and
(b) not be larger than an operating segment as defined by paragraph 5 of IFRS 8 Operating Segments before aggregation.
The effect of this is to provide companies with some flexibility regarding the level of aggregation applied in the impairment test. Here are two examples:
GlaxoSmithKline’s CGUs correspond to its three business segments
GSK provide extensive disclosures about how they test goodwill for impairment. However, it appears that these tests are done at the segment level which means a total of three tests for the whole group.
GSK uses fair value less costs to sell rather than the value in use methodology to determine the recoverable amount of their CGUs. IAS 36 defines recoverable amount as the higher of the two measures but if one, such as the fair value approach, produces no impairment then there is no requirement to calculate both.
Fair value less costs to sell often works out to be higher than value in use because the latter is restricted by not being able to take into account the value of future investment.
GSK aggregates individual cash generating units to produce the 3 combined CGUs that are tested. We assume this is because goodwill cannot be allocated to the individual CGUs in a non-arbitrary manner.
Source: GSK 2018 financial statements. Click highlighted areas for more information.
AB InBev uses a more granular geographical split
AB InBev uses a more granular geographical basis rather than business segments for its CGUs. However, it is difficult to identify the extent of any shielding as it is not clear whether the acquired businesses that resulted in recognition of acquired goodwill were combined with existing activities for which there is unrecognised goodwill.
Source: Ab InBev 2018 financial statements. Click highlighted areas for more information.
Testing at a higher, more aggregated, level reduces the likelihood of impairment being recognised due to the larger shielding effect. We have the impression that many companies default to the segment level when testing goodwill for impairment.
We appreciate that goodwill impairments are perhaps not the best way to evaluate management stewardship regarding acquisitions. However, we believe that they should at least be meaningful and contribute to that analysis. The problem with the existing test, and its application in practice, is that goodwill impairments contribute very little. It is understandable that most investors ignore goodwill impairments.
Is the IASB doing anything?
The IASB has long acknowledged the issue of headroom and the wider problem of goodwill impairments being ‘too little too late’. However, they have concluded that any approach to deal with headroom by modifying the impairment test itself would be too challenging to implement and that any benefit for investors would not outweigh the added cost and complexity for preparers. We do not think reform of goodwill impairment should be dismissed so readily.
The effectiveness of the existing test depends on the level at which it is applied, and particularly the extent to which CGUs are aggregated. Enforcement may be the main issue here, but we also think that it would help if the rules related to CGU determination and aggregation were clarified and/or modified to force the test to be applied at a more granular level.
The only changes to goodwill impairments currently being considered by the IASB is to make the existing test simpler and less costly for companies by modifying the value-in-use methodology and removing the requirement for annual quantitative testing. However, the IASB aims to improve the information that investors receive about the success or otherwise of acquisitions, through disclosures about the post-acquisition performance of the acquired businesses. We welcome these proposals, particularly that they should help in assessing company statements about synergy benefits. You can find out more in this article.
But aren’t impairments useless anyway?
You may be wondering why we are so concerned about the effectiveness of the goodwill impairment test, considering that most investors seem to ignore fixed asset impairment expenses when assessing performance. Ignoring goodwill impairments may seem sensible considering:
- Impairments are only ever reported some time after the event and generally do not inform investors beyond what they already know and have already incorporated into forecasts.
- The amount paid for an acquisition is a sunk cost and whether or not goodwill is impaired does not change future cash flows. The impairment itself is also a non-cash item.
- Impairment expenses are usually regarded as non-recurring with little predictive value.
- Impairment charges are invariably excluded from alternative performance measures on the grounds that they are ‘non-core’ or not part of ‘underlying’ performance.
We agree that goodwill impairments relate to a sunk cost and have limited predictive value regarding future cash flows. In forecasting profit, it is generally perfectly reasonable to assume zero for future impairments. We also agree that, at best, impairments, only provide incremental information because capital markets are generally able to incorporate expected changes in earnings and cash flows in stock prices timelier than company management can in the impairment test.
However, we still think impairments are important, even though they should be analysed separately from other more persistent components of performance. Impairments are relevant for both assessing stewardship and for equity valuation.
- Stewardship: Holding management to account for the results of their decision making is one of the key objectives of financial reporting and of vital interest to investors and to capital markets. Although one could argue that accountability for acquisitions comes in the form of the overall performance of the business, this does not specifically target the acquisition decision.
- Equity valuation: A record of past goodwill impairments may help to assess investment risks and whether a company is a habitual value destroyer regarding its acquisition programme (which academic literature would indicate is often the case).
Would a return to amortising goodwill solve the headroom problem?
Some argue that returning to an amortisation approach would take pressure off the impairment test and, at least in part, resolve the impairment headroom problem.
Amortisation, particularly if a short maximum period is specified, would certainly reduce the carrying value of goodwill and make impairment less likely. But amortisation is not a substitute for the information that should be provided by impairment losses. Our experience from times when goodwill amortisation was required is that the amortisation charge has little information value and was also routinely ignored by investors.
Even if goodwill amortisation were to be reintroduced (there are other reasons why some support this) we think the impairment process is still needed and, without allowing for the headroom issue, would still be deficient.
While we would like to see application of the impairment test strengthened, we think, the existing impairment-only approach is preferable to goodwill amortisation. Imperfect impairments are better than unhelpful amortisation with even fewer imperfect impairments.
Insights for investors
- Don’t rely on reported impairment charges to assess the success or otherwise of acquisitions. A reported impairment is likely to mean value has been lost, but a lack of impairment can be a false positive.
- Consider the level at which impairment tests are conducted. Large CGUs and more aggregation of CGUs will reduce the likelihood that failed acquisitions will result in impairments.
- Be aware that a CGU approach may be applied to other assets, particularly intangibles.
- Consider a company’s track record regarding acquisitions and fixed asset impairments and do not automatically include zero for future impairments in your profit forecasts and related valuation metrics.
- Remember that the goodwill impairment test is a test of the carrying value of a CGU and not specifically of the acquired goodwill.