Accounting for Goodwill - Essay Example

A Transition from IAS22 to IFRS3: Treatment of Goodwill Introduction This report is a blue print of the change in treatment which has been brought by the replacement of IAS22 to IFRS3. The report will analyse the impact on the treatment of goodwill and its impact on the companies. The report will analyse the accounting strategies which different companies are adopting in response this change. Discussion: With the changing environment of business all over the world the need for the companies to audit and update their strategies has also increased. Merger is an important strategy, which is being adopted by most of the companies in order to increase their market share and acquiring other motives. “Usually mergers occur in a consensual setting where executives from the target Company help those from the purchaser in a due diligence process to ensure that the deal is beneficial to both parties.” (Wikipedia) Goodwill is defined as the present value of future earnings in excess of the normal return on net identifiable assets. According to the acquisition events it's defined as the excess of the cost of acquisition over a group's interest in the fair value of the identifiable assets and liabilities of a subsidiary, associate or jointly controlled entity at the date of acquisition. Goodwill is treated as an asset in the balance sheet of a company. The reduction in the goodwill needs to be calculated at annual basis and the decrease should be written off in the profit and loss account. Due to the replacement of IAS22 by the IFRS3 the treatment of goodwill changed to the defacement-only practice in January 2005. The US GAAP has the same treatment of Goodwill and defines it as the surplus acquisition price paid in addition to the fair value of the net identifiable assets. The change in treatment was first undertaken after the imposition of the SFAS142 which transformed the goodwill accounting from changed accounting for goodwill from a paying-off method to defacement-only method in July 1, 2001. As the standard was affecting international groups many of them preferred using US GAAP standards which could minimize the adverse effects of goodwill amortization and was beneficial for the groups The acquiring company should make sure that the value in excess to the fair value of the net assets should not be reduced and hence this difference should be treated as an asset that's not really identifiable. The standard addresses all the issues regarding the disclosure of the information regarding the acquisition and the management can play an important role in making the most of this information. It suggests that an effective business report must have More forward looking information Have more coverage of non-financial value creating information. Should align internal and external information. The model includes different components of business reporting, which are: 1) financial and non financial data regarding the acquisition 2) Management’s analysis of financial and non-financial data. 3) Future forecasting information regarding the goodwill. 4) Shareholders and management related information. 5) Background information. 6) Proper disclosure of information 7) Proper information regarding each business segment. The model provides the shareholders and investors with the case of proper information regarding the securities in order to save them from being misallocated. IFRS3 puts more emphasis on stakeholders’ relationship rather than on financial measures. Heavy reliance on financial measures has damaged most of the company’s reputation. The financial performance does not represent the overall performance of the business. The position of the company in the market and the performance cannot be judge by only addressing the financial measures. The standard recommends that the role of the intangible assets is growing in determining the future performance of a company. The standard provides the solution in shape of focusing more on qualitative measures rather than quantitative measures. According to IFRS5 a company needed to be successful it must reveal the information about its stakeholders and the way these stakeholders are being dealt which are for more different from the traditional accounting. The model emphasises the needs that the company should clearly state the information about its purpose, mission, goals and strategy. It states that the financial reporting should go beyond only disclosing the financial information. In short the model recommends an extension of financial reporting rather than transformation. The standard supports inclusive manner which will require the companies comparatively betters from its competitors. This will generate value for all stakeholders including shareholders. The change in the treatment of Goodwill also effected the per share earnings. The companies report the operating profit before goodwill amortisation and impairment. Cash flow evaluation is a beneficial strategy for both the investors and analysts, where there is no goodwill amortisation effect. One of the main purposes of annual reports is to provide information that is useful to their users (Day, 1986). Many authors have dealt with the issue of clarity and understand ability of the annual reports (Lee and Tweedie, 1975; Smith, 1992; Keane, 1977). In fact many authors emphasised the fact that shareholders tend to read the narrative part of the annual report which normally includes good news, rather than reading statutory part and usually investors make their investment decisions depending on those good news (Tauringana and Chong, 2004; Smith and Taffler, 1992). However In order to make an informed investment decision, an investor who is contemplating investment needs to understand both the potential rewards and the associated risks (IOSCO, 1995).But there is still a strain on the financial resources of a group where debt has to be repaid if it borrowed for acquisitions and increased interest expense, irrespective of the accounting engineering it has introduced. The goodwill factor consists of the following characteristics: * An unidentifiable asset on the balance sheet which has material value. * The costs of transactions are also included with it. * Amortisation and impairment charges to the profit and loss account. * In a liquidation: no value. Goodwill at the date of the change in the accounting treatment for acquisitions could be written off to reserves. Similarly, the surplus against net assets on a flotation could be netted off against the share premium generated and not left on the balance sheet as goodwill. With the changing business methods and environment the values playing important part in business has also changed. The label of assets has transformed from tangible to intangible assets. In this scenario it is become difficult for the users to analyse the future performance of the company. The companies mostly practise the old traditional accounting techniques according to which intangible assets such as knowledge brand etc are not included in the financial statements as assets. Although in today’s business scenario it is important for the users to have complete knowledge of these intangible assets in order to undertake their decisions accordingly. The IFRS3 proposed that in order to help the investors and users to evaluate the value of the company the information provided needs to be more transparent regarding the intangible assets as compare to the past. IFRS3 suggests that all the tangible and intangible assets need to be calculated at their fair values and should be reported in order to provide the clear and transparent information. The standard gives two dimensions to the information 1) Goodwill and its configuration represented by company. 2) Information on non-tangible assets. The standard suggests the businesses to reveal information about their mission, strategy, and business process and risk management. The IFRS3 gives importance to the value chain of intangibles, and suggests that the assets should be disclosed to a certain level. The Companies should keep on discovering, developing and commercialising the stages of the value chain for intangibles. It is also suggested that the reporting of the intangibles should be done with great care since poor reporting of intangibles leads to under valuation of and increased cost of capital for knowledge intense companies. References Dogra, K., (2005). Accounting for goodwill, Financial Management, Sunday, May 1 2005, available at http://www.allbusiness.com/accounting-reporting/reports-statements-cash/993311-1.html Day, J. 1986. The use of annual reports by UK Investment Analysts. Accounting and Business Research, 16(64): 295-307. International Organisation of Securities Commissions, (1995). Disclosure of risks a discussion paper. Available from: http://riskinstitute.ch/135610.htm Keane, S. 1977. Examining the Problems of Understandability. Accountancy, June, 88 (1006): 82-84 Lee, T.A. and Tweedie, D.P. 1975. Accounting Information: An Investigation of Private Shareholder Usage. Accounting and Business Research, 5(20): 280-291. ICAEW, 2003. New Reporting Models for Business, available from:http://www.icaew.co.uk/viewer/index.cfm?AUB=TB2I_59349&tb5=1&CFID=4671330&CFTOKEN=87121964 Smith, M. and Taffler, J. 1995. The Incremental Effect of Narrative Accounting Information in Corporate Annual Reports. Journal of Business Finance & Accounting 22 (8): 1195-1210 Tauringana, V and Chong, G. 2004. Neutrality of narrative discussion in annual reports of UK listed companies. Journal of Applied Accounting Research 7(1): 74-107. Wikipedia, (2006). Mergers and acquisitions, available from http://en.wikipedia.org/wiki/Mergers_and_acquisitions Read More