Accounting for Goodwill and Intangibles : Impact of convergence from US GAAP to IFRS - Research Paper Example

?Cover Page This study aims at scrutinizing the impact of the anticipated convergence of the US GAAP to the International Financial Reporting Standards (IFRS). The study mainly focuses on accounting for goodwill and intangibles as espoused in the new rules propagated by the IASB/IFRS whereby goodwill gained from busi­ness combi­nations ceases to be amortized but is rather tested for impair­ment costs annually. Secondly the study seeks to discern the veracity of embracing these internationally accepted standards as opposed to retaining the US GAAP. Although the significance of goodwill in contemporary organizations has been evidently enhanced; still this study found that the method of evaluating the impairment costs by the managers in a firm is too subjective hence entails self-interest. Likewise though there is a need to adopt the international standards nevertheless there are still several areas of divergence between the US GAAP and IFRS standards prior to effective harmonization. Table of Contents Introduction 3 Purpose of the Study 4 Rationale of the Study 4 Research questions 4 Significance of the Study 5 Literature Review 6 Indicators of impairment 12 Analysis of Findings 16 Conclusion and Recommendations 18 Implications for Future Research 19 References 20 Introduction The current global recession originating from the US and stretching to nearly all corners of the world has exposed the interlocking links within international financial and economic segments worldwide. Consequently, the errant acts of financial executives as evidenced in the Enron and WorldCom scandals in 2001 and the subprime mortgage crisis from 2008 confirmed that financial accounting exercise must be strongly scrutinized globally to steer clear of any such recurrence. Subsequently numerous national accounting entities in collaboration with the International Accounting Standards Board (IASB) led by the EU established the International Financial Reporting Standards (IFRS). These novel guidelines were designed to initiate harmonized indistinguishable rules to steer accountants and organizations in all nations globally. Statement of the Problem However, though over 100 countries have formerly embraced the standards, The United States continues to procrastinate over its launch by the SEC though all indications point to the palpable unavoidable launch date. Consequently the IASB has been working closely with the FASB to accelerate the launch date SEC. (2010); (IASB, 2008). Nevertheless, various scholars have pointed out on some areas of divergence in the two standards including the twin issues of accounting for goodwill and intangibles plus the impact of conversion from US GAAP to IFRS amongst US corporations and economy (Lev, 2001); (Li, 2010); ( Jerman and Manzin, 2008); (White IV, 2010). Purpose of the Study This research paper therefore seeks to explore the areas of convergence and divergence between the US GAAP and the IFRS standards in regards to accounting for goodwill and intangibles as well as examining the effect of the conversion from the national GAAP to the internationally recognized IFRS amongst US firms. Rationale of the Study This study will aim at examining the diverse literature on the topic of discussion in efforts to discern the impact of IFRS amongst organizations and jurisdictions that have adopted the standards. The emphasis will be to critically detect the suitability or disadvantage inherent in the system particularly in regards to accounting for goodwill and intangibles. The second aim id to discern the impact of the adoption amongst firms that have already implemented the system and probable positive or negative effect for firms within the US after using the IFRS from the US GAAP. Research questions Does IFRS offer better financial reporting and financial statement information than U.S. GAAP? Does the new IFRS ac­counting handling offer a superior data content of impair­ment costs or it is an oppor­tunity for crea­ti­ve ac­counting? What are the conse­quences of the implementation of the new ac­counting system of goodwill? What are the likely prospective developments of ac­counting for goodwill and intangibles? Significance of the Study Although numerous studies have focused on the latter aspect including the expected changes in reporting by issuers, few studies have explored the impact of IAS 36 in regards to the reversals of impairment losses and issue of amortisation involving the goodwill. Consequently this study will attempt to breach the gap by examining the switch from the US GAAP to the IFRS hence contribute significantly in understanding the rationale of annual testing for impairment for goodwill acquired through business combination. Literature Review The principal rationale of financial statements is to convey the exact and reasonable state of affairs of the financial situation, performance and adjustment in an institution (Deloitte Touche, 2010). The financial statement is normally sufficient if the reporting organization obey the rules to the commonly established accounting principles (Li, 2010). Nevertheless, corporations have been notorious for manipulation of the figures to offer a more positive image than that existing situation in the firm by using creative accounting practices choreographed to suit their use (PWC, 2009). In this regard the IASB (2008), the architect of IFRS has stated that its core mission is: ..Single set of high quality, understandable and enforceable global accounting standards that require transparent and comparable information in general purpose financial statements….co-operate with national standard setters to achieve convergence in accounting standards around the world. The need for globally acceptable standard was initially borne of the fact that international firms were requiring filing diverse financial returns for each country they operated in hence generating many divergent reports due to the many separate rules practiced in the diverse jurisdictions (Yoon, 2009). Nonetheless though the convergence of the accounting standards under the umbrella of the IASB has somewhat breached the gap, there still exists differences between the IFRS statutes and the national GAAP’s (PWC, 2009). The fact that the US has the most significant number of large international corporations worldwide including 40 percent of the Global Fortune 500 indicates that it is prudent to adopt the IFRS. This due to it being vital for diverse US interests and since it has more to gain in adopting the standards to cater amongst its foreign legion of conglomerates (SEC, 2010). The IFRS reminiscent of the nationwide GAAPs compel public corporations to regularly issue financial statements as well as the profit and loss account, income statement, statement of all monetary transactions involving the directors, and a cash flow statement (PWC, 2009). Consequently the latest IFRS standards have currently been embraced by over 100 countries and over 12,000 organizations globally [Figure 1]. However, the IFRS regulations are mired by the lack of enforcement even as diverse nations and states have made some exemptions to the edicts. In the US, there have also been unease on the overheads repercussions in the process of conversion to the arrangement particularly amongst the SMEs; nonetheless, the IASB has started a customized IFRS for SMEs. In the US, there is also reluctance to leave the valued US-GAAP standards (Deloitte Touche, 2010), (Armstrong et al., 2008). Figure 1 Source: Swenson Advisors, LLP (pg.24) The IFRS has been extensively received worldwide including Europe, Australia, Asia, Africa, South America, Africa and Canada. The solitary exceptional key international nation indisposed to completely espouse the structure is the United States, though even there a good number institutions and authorities see transformation or transition to IFRS as unavoidable owing to the nature of globalization and current recession demanding worldwide standardized accounting system (Gerth and Harlow, 2008). The globalization of trade has dictated the adherence to a standardized financial reporting scheme as local businesses intent on expansion in other regions or in trying to acquire global financing have to observe the globally recognized accounting standards as the countrywide system are normally viewed with unease. According to the Accounting Standards Board of Japan (ASBJ), the union of national GAAP to the IFRS will significantly augment investor confidence, as local financiers will be capable of making a proportional global venture choice by analyzing assorted business statements from other nations in a standardized way (Armstrong et al. 2008). Furthermore, companies working worldwide will have the extra benefit of merging their accounts further effortlessly as contrasted to the earlier dissimilar structure that have a tendency to create compound non-conforming reports (IASB, 2008). Contemporary business transactions have now recognized the importance of intangible assets which is invariably referred to as goodwill. Amongst the hi-tech companies, this forms a substantial component of the firm’s valuation hence leading to a significant change in accounting reporting techniques to incorporate the intangible assets (KPMG International, 2010). The International Accounting Standard Board (IASB) issued International Financial Reporting Standard (IFRS) thus issued the 3-Business Combinations and revised International Accounting Standard (IAS) 36-Impairment of Assets and IAS 38-Intangible Assets in 2004 to deal with the diverse reporting standards prevalent amongst several jurisdictions (IFRS, 2007), (IASB, 2008). In view of the efforts of the FASB and IASB, good­will gained by means of a busi­ness combi­nation ceased to be amor­ti­zed and is now duly tested for impair­ment annually. Although the IASB has been at the forefront in propagating for a convergence of a singular accounting standard, the United States Generally Accepted Accounting Principles (US GAAP) through the Financial Accounting Standard Board (FASB) were the precursor in recognising the significance or value of separating the intangible and tangible assets. Through the FASB’s Statement of Financial Accounting Standards (SFAS) 141-Business combinations and 142-Goodwill and Other Intangible Assets issued in July 2001, auditing firms were requested to make provisions for goodwill in the reports (KPMG International, 2010), (Li, 2010). Despite the efforts of the IASB and FASB there still exists some significant differences in the two standards though they have been continuously revising the statues to reduce the disparities before the tentative US launch date of 2011. Thus the fresh IFRS 3 was aimed at worldwide union, mainly with US GAAP. Consequently of the fresh standard IFRS 3, the amended IAS 36 and IAS 38 reduced numerous gaps that had persisted between IFRS and US GAAP (Mateja and Massimo, 2008). Prior to the issuances of the new accounting rules, corporations reported their returns through either the pooling of interests technique or the purchase process hence generating diverse reports even for similar business due to the lack of a standardised method. The purchase method identifies all intangible assets attained in a business combination, while the pooling method identifies just the intangible assets that were prior reported by the purchased body. Accordingly the stakeholders for the financial reports had problems in distinguishing the economic reports of entities because diverse techniques were utilised. Consequently the executives become aware of the disparities involving the techniques impacted on the rivalry of the firm’s in deals for mergers and acquisitions (Mateja and Massimo, 2008). According to Deloitte Touche (2010), ‘a business combination is a transaction or event in which an acquirer obtains control of one or more businesses’. Nevertheless Miller (2009) argues that the generalization of accounts and reporting by IFRS is imprudent bearing in mind the recent financial outrage and collapse of the worldwide financial structures. The author therefore argues that the extra meticulous US GAAP ought to be made even tougher rather than implementing the ‘weak’ intercontinental standards system that is prone to abuse. Due to the lack of IASB enforcement regime, national GAAP or modified/localized version of the IFRS are utilized since the IASB relies on the local authorities to impose the standards. However in support of the convergence and adoption, Sevin et al. (2007: 676) asserts that the fresh harmonised accounting standards as propagated by the IAS and FASB will greatly enhance ‘financial reporting transparency’ by illustrating accounting for goodwill more plainly, which ought direct to improved insights of the financial statement by stakeholders in regards to the prospects pertaining to the property. However Schultze (2005: 279) dismissive of the efficacy of exercise of annual valuation questions the criteria and objectivity of the process arguing it is still subject to abuse. The lack of readily available fair values as maybe reflected in the market price and the widespread discretion allowed to the sectional heads renders the process suspect (Bens, 2006).. Likewise, Mateja and Massimo (2008: 223) argue that the complexity of undertaking due valuation including getting the “present value, option-pricing models, matrix pricing, option adjusted spread model and fundamental analysis” negates against the idea. The Financial Accounting Standards Board (FASB) has therefore being striving at gaining convergence with the internationally acclaimed IFRS standards in conjunction with the IASB. After years of debate the decision to formerly embrace the IFRS was reached in 2007 by the U.S. Securities and Exchange Commission (SEC) to allow IFRS financial reports for foreign firms (devoid of entailing resolution to U.S. GAAP). Subsequently the full adoption of the standards was put on the fast track. The need for globally acceptable standard was initially borne of the fact that international firms were requiring filing diverse financial returns for each country they operated in hence generating many divergent reports due to the many separate rules practiced in the diverse jurisdictions. Nonetheless though the convergence of the accounting standards under the umbrella of the IASB has somewhat breached the gap, there still exists differences between the IFRS statutes and the national GAAP’s. The fact that the US has the highest number of large international corporations worldwide which includes over 40 percent of the Global Fortune 500 mean that the need to adopt the IFRS is vital for US interests since it has more to gain in adopting the standards to cater for its foreign legion of conglomerates. According to Gerth and Harlow (2008), some of the obvious discrepancies between the US GAAP and the IASB/IFRS standards include the following: IFRS is used a as local standards but with attachment information to ease application. IFRS applied as local standards, plus US GAAP standards to incorporate those issues not included in by the IFRS IFRS changed to suit the local conditions US GAAP standards applied instead of IFRS because they resemble or are similar to the latter. For both U.S. GAAP and IFRS, intangible assets in accordance with new standards have got to be tested for impairment every time modifications in proceedings or conditions signify an asset’s carrying amount might fail to be recovered. Consequently, goodwill and alongside other assets that have an indefinite existence have to be appraised yearly. However, the reversal of impairment losses is a segment of noteworthy disparity between the two techniques of accounting (Li, 2010). U.S. GAAP proscribes any reversal of impairment losses, while the IAS 36 Impairment of Assets permits reversals of impairment losses under special circumstances, apart from in the issue of goodwill (White IV, 2010). In accordance with the new IFRS rules, “impairment losses related to goodwill cannot be reversed” (KPMG International, 2010: 9). Indicators of impairment The market value of the product has shrunk appreciably or the unit has functional or cash losses The operational equipment become outdated Extreme competition leading to the saturation of the market The carrying amount of the firm’s net chattels surpasses its market capitalisation. Enhanced considerable regulatory modifications that negatively affect the firm’s products Physical dent to the treasured property Considerable undesirable outcome on the unit that will transform the mode the chattels is operated or supposed to be applied (Gerth and Harlow, 2008). The revenue classification requirements within the IFRS are principle-based rather than sector-specific thus leading to some levels of irregularities in the detection of incomes by telecom firms (Gerth and Harlow, 2008). However, studies from other regions that have already implemented the IFRS indicate lack of any significant changes in earnings after the adoption of the new rules hence indicating significant advantage for espousing the global accepted standards other than uniformity (Poel et al. 2009), (Armstrong et al. 2008), (Deloitte Touche, 2010), (Swenson Advisors, 2009). Other areas of divergence are evident in the impairment computation, which is undertaken at the Cash-Generating Unit (CGU) level for IFRS and the Reporting Unit level for GAAP (KPMG International, 2010). The CGU is the “minimum identifiable cluster of assets that produce capital inflows that are mostly autonomous of the cash inflows from other chattels or grouping of assets”. The reporting unit is a working section, or one-step beneath a functioning sector, for which executive frequently appraises financial data. In various firms, this may consequently in a diverse stage of examination (the exposure can be at a further cumulative echelon), and thus diverse outcome, for the two techniques (Deloitte Touche, 2010). IFRS also utilizes a one-step procedure, instead of the two-step recoverability test/impairment measurement requisite by US GAAP. In this one-step process, an impairment loss is acknowledged if the asset’s (or CGU’s) carrying amount is larger than equally its (cut-rate) fair value less outlay to vend and its (inexpensive) value in use. Finally, impairment losses are allocated to assets differently under the two methods. For IFRS, an impairment loss identified at the CGU level is first applied against goodwill. Once goodwill has been eliminated, any remaining impairment is allocated to the other assets of the CGU on a prorated basis based on their carrying amounts. For US GAAP, the fair value of goodwill is indicated by recognizing the fair value of the total statement unit and the fair value of every other asset and liabilities of the account unit. Impairment loss is then computed independently for every asset by contrasting its fair value to its carrying amount (Mateja and Massimo, 2008). However the US GAAP (SFAS 141.43, 2007) advocates for goodwill to be reported as the surplus of the expenditure of a purchase fee above the fair value of attained net assets. It is recorded just if the underlying amount of goodwill surpasses its implicit fair value. To test goodwill for impairment, firms have to initially allocate procured goodwill to reporting units. Prior to the fresh accounting management, firms usually reported goodwill in entirety and did not allot it to specific reporting units. A reporting unit in accordance with US GAAP is described as a functioning section or one level under a functional sector (its constituent) (Mateja and Massimo, 2008). According to Li (2010: 29) firms that utilise the IFRS standards across diverse industries tend to report higher returns as opposed to those that use the US GAAP standards. In addition to more complex than the IFRS, the US GAAP is more taxing for firms using it due to the copious documentation necessitated by the standards. Analysis of Findings From the above scrutiny of available writings on the topic and our research questions, a number of significant issues emerge. i) The IFRS has some significant advantage in regards to enhanced earnings due to the reporting structure but also offers levels of volatility due to the annual valuation in impairment costs for goodwill. ii) Due to its simplicity, the IFRS can still be subjected to ‘creative accounting’ by unscrupulous executives and accountants due to the discretion offered in valuation of impairment costs. iii) For IFRS, impairment is recognized in the present year and is accounted on the identical column of the income statement as the amortization cost for the assets or, if it is substantive, in a different column. The impairment loss is reported alongside the reassessment excess equity account to the point that it invalidates an earlier re-evaluation for that chattel. iv) Intangible assets are an affirmation to probable paybacks that lack any material or monetary personification that engender expenditure cutbacks. Goodwill can be acknowledged as an intangible asset simply if it is gained in a business combination. Internally produced goodwill is not to be capitalized in the financial statement since it is not identifiable, it has an undetermined practical existence and it is not distinguishable from other chattels. Intangibles are identifiable after they produce from agreements or legal privileges or are detachable. Hence intangibles which are not identifiable are documented as component of goodwill (Lev, 2001). v) Intangibles have ceased being accredited to goodwill, but the attained intangible property that is specific and ought unlimited existence to be acknowledged in the financial statement and be amortized above their approximate practical existence. Accrued identifiable properties in a business combination are prized at their fair values. The residual value after the classification of all tangible and intangible property is than allotted to goodwill. vi) Goodwill amortization in the previous accounting standard was an unvarying and moderately diminutive cost over an extensive period (over its practical existence phase). The fresh accounting procedure is founded on the basis that very hardly ever goodwill reduces in worth on the straight-line basis. However unlike goodwill amortization, goodwill impairment loss can be comparatively huge (Duangploy et al., 2005: 23). This means that there will be more instability in the markets as the irregular reports on the erstwhile goodwill recording become unstable. vii) The process of amortisation for an intangible asset with a fixed functional survival ought to reproduce the plan of utilization of the financial reimbursement. This must be dependable with executive’s postulation in their financial plan, with amortisation starting at the most basic point at that financial profit are inward bound from the intangible asset. Under IFRS, complications in formative functional existence do not entail that an intangible asset has an indefinite functional survival. This might cause problem for instance, with gamut licences in which it is possible that equipment will in due course cause a licence outdated. Some telecoms, frequently in the US, pursue an approach dubbed the “Mass Asset” accounting strategy in which assets of a comparable disposition, frequently called “equal life groups”, are classified jointly and devalued over the standard practical existence within the cluster (KPMG International, 2010). Good­will handling as regards IFRS and US GAAP Standard IFRS US GAAP Goodwill is measured as The divergence involving the cost of the purchase above the purchase’s premium in the net fair value of the specific property, liabilities and contingent charges. The surplus of the outlay of an purchase cost above the fair value of acquired net chattels Impairment Yearly or further regularly if conditions signify further impairment Yearly or further regularly if conditions signify extra impairment the method of testing Two-step method is not in utilized A two-step procedure Elimination of impairment losses Reversals of impairment losses involving the goodwill are not endorsed (IAS 36 allow reversals of other intangibles) Reversals of impairment losses are allowed in any conditions Negative goodwill Every discount on purchase is engaged to the profit and loss statement Any reduction on purchase is allotted to the profit and loss statement Source: Adapted from Mateja and Massimo (2008: 220). Conclusion and Recommendations Although the standardisation of financial statement reporting is vital for a unified global standard, the lack of enforcement mechanism that allows diverse national jurisdictions to implement a localised version of the standards negates against the very principle of having a singular standard. Its therefore imperative for the IASB to come up with a methodology that will ensure is really unified structure that is not subject to manipulation. Although the US GAAP can be termed vastly superior to the IFRS standards in terms of having better regulatory measures, its convoluted and complex nature makes it cumbersome for foreign firms not conversant with its working and incomparable to other international reports. The SEC and FASB therefore have an obligation of enjoining the US economy and firms to the almost universal IFRS accepted structure to avoid duplicity. The issue of measuring goodwill among the intangibles is still a grey area that has not been clearly elucidated by the existing research however its relevance is not in question particularly among emergent hi-tech firms and other innovative based industries. Nevertheless the discretion offered to line managers in evaluating the impairment costs is too subjective while they lack the requisite skills hence offering limited insight to investors browsing through the financial statement/reports. There is therefore a need to evolve a more effective measurement method that can be verified by experts. Implications for Future Research Further comprehensive research is needed to explore other areas that have been affected by the intended convergence to the IFRS including real estate, banking, insurance etc. In terms of goodwill and intangibles, future research should be directed at the need to have a standardised way of measuring the impairment costs which is clearly untenable in the present format that is too subjective hence offering minimal input in discerning a company’s real worth even if done annually. The future study should therefore attempt at discerning the real meaning of goodwill as opposed to intangibles due to its emerging significance in modern business practice. References Audit Integrity. (2009). US GAAP vs IFRS: An Objective Look at International Financial Reporting Standards (IFRS). Audit Integrity Inc. Austin, Stephen G. and Swenson Advisors, (2009). IFRS – Meets the World of SME’s. Swenson Advisors, LLP. Bens, D. A. (2006). 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