Difference of Goodwill Accounting between IFRS and GAAP - Example

Contents Introduction 2 History of Goodwill Accounting 4 Period 1880-1929 5 Period 2 – 1929 -1959 7 Period 3 – 1959 -1973 8 Period 4 – 1973 -200110 A brief introduction to FASB 11 A brief introduction to IFRS 12 Accounting of goodwill under IFRS and GAAP 13 Difference of goodwill accounting between IFRS and GAAP 17 Scenario Analysis 18 Reporting of goodwill under IFRS 18 Reporting of goodwill under GAAP 20 Conclusion 22 References 23 Introduction In the accounting world, the term ‘goodwill’ is defined as the intangible value of an asset owned which has a quantifiable value when that particular asset is utilized in the business. To understand the general concept of goodwill, the following illustration is presented. Company A, an open ended mutual fund, has net assets the book value of which is $10 million Due to global financial turmoil, the company was in difficult financial conditions as it was incurring net loss every year and eroding its equity. Company B, a multinational bank, has floated an offer to acquire 100% share of the company. Company B has decided to assume all the assets and liabilities of Company A, after which the Company A will be merged with Into Company B. After several deliberations, the purchase consideration agreed for the acquisition transaction arrived at $15million. A due diligence was also conducted by company B for assessing the market value of the net assets of the Company A which were assessed at $13 million. The table below show the goodwill recorded by Company B on the business combination Particulars In million $ Purchase Consideration 15 Market value of net assets acquired 13 Goodwill 2 The goodwill of $ 2 million will be recorded in the statement of financial position of Company B under long term non-current assets. Goodwill is an intangible asset, which means that the physical existence of it cannot be verified. However, as per the most accounting conventions and treatments, the goodwill is usually shown separately from intangible assets. Since the very inception of concept of goodwill, it has always remained a debatable topic among financial and corporate sector at large. Several accountants believe that internal generated goodwill should be recognized as it represents intangible benefits brought to the company through expenditure incurred by them. However, recording of internally generated goodwill is not allowed under IFRS accounting conventions. Apart for the initial recognition of goodwill, the subsequent measurement of goodwill has also been debated at large in accounting circles. During the much talked about global financial crisis of 2008-09, a large number of giant multinational corporations faced the situation where they had to record an impairment to the goodwill recorded. At present there are two major accounting bodies who issues accounting standard for companies. These are FASB and IASB. Financial Accounting Standard Board (FASB) is a private sector organization in the United States of America which is responsible for establishing and issuing financial reporting standards. International Financial Reporting Standard (IFRS) is the most commonly used accounting standard in the world which is also responsible issuing such accounting standard and conventions in order to harmonize the financial reporting process. This paper presents a historical background of the accounting treatment of goodwill and how improvement and changes were brought in over the period of time. The paper also presents and discusses the difference in the accounting treatment of goodwill under IFRS and FASB. History of Goodwill Accounting Accounting of goodwill has always remained a very debatable topic among the accounting circles since its very inception. Goodwill arising from the business combinations has remained the particular source of attention for accountants and standard setting organizations all across the globe. Hughes (1972, 1982) investigated significantly regarding this particular accounting issue and was responsible for analyzing the American and British literature available on the topic. It has always remained a general notion that goodwill is a product of business and thus Hughes analyzed the treatment of goodwill within the then prevailing business environment. Another study was made by Bump (1970) in which he analyzed the mergers and acquisitions that took place in the US. In his study he presented that fact institutions and regulators have a key role in setting the standard for the accounting treatment of goodwill in the financial statement of any corporation. Nobes (1992) was able to indentify several stakeholders who play an active part in the standard setting of process of the goodwill accounting treatment in the United Kingdom. He noted that the standard setting of goodwill treatment was rather political where senior policy maker, government authorities in the favor of standard setting, while on the other hand the management of corporations was against it as according to them such standard setting would adversely impact the financial outlook of the company. Ding et al. (2005) was also actively involved in the studying the history of goodwill accounting. He put forward a comparative history of accounting of goodwill in four countries; the US, the UK, Germany and France. He pointed out a very interesting fact that the main influential role played by the social group in the standard setting of the accounting treatment was of investors, managers, creditors and the tax administration. Each of the aforementioned country has their own tax laws and corporate governance structure. This diversity has resulted in a different accounting treatment of goodwill in these particular regions of the globe. If we analyze the historical accounting treatment of goodwill in, we come across two different classifications. The first classification of income is based on the representation of flow of income where as the other classification of income is based on the net worth of the stock. As per the study conducted by Ding et al, 2005 the classification of income as aforementioned, gave rise to four different accounting treatments which are as follows: Alternative 1: Recognition as an asset at cost, and amortization over useful life Alternative 2: No recognition as an asset, or immediate write off against reserves Alternative 3: Recognition as an asset and permanent retention it the balance sheet, possible adjustment of value (usually written down) Alternative 4: Immediate or rapid expensing For the purpose of studying the historical treatment of goodwill, we have divided the history into four eras. The first era span from 1880-1929 where the great depression ends. The second period covers the era of 1929 till 1959, third from 1959-1979 and the last period from 1978-2001. Period 1 – 1880-1929 In this particular era, there was no concrete concept of corporate governance and standard setting, due to which, the accounting practice always remained questionable. It was during this era that the concept of ownership changed from sole proprietorships to corporations. A change was witnessed in the corporate world where the ownership and management of the firm was separated and number of corporations started increasing. As per historians of financial accounting, it is generally accepted that the core concept of goodwill emerged in this era and goodwill was no longer associated with the owner and it was transferable to other entities as well. During this period, a no ‘par stock’ rule was also issue as per which the shares will not be issued to a holder unless they have been fully paid for. In that time, whenever a business combination occurred, the consideration paid was usually less than the price of shares issued at the time of merger. But even at this point of time, the accounting of how to record this difference as goodwill was highly debated. Yang in 1927 presented that in order to record goodwill, the normal earning capacity of all the assets of the companies should be recognized and then subtracted from the total income of the firm at the time of merger or business combination. The difference (i.e. how much the annual income of the acquire company exceeds the normal expected income from assets) over and above was multiplied with a certain percentage in order to account for the margin of error, and the residual figure was recorded as goodwill. It was also observed in this era that the incidence of writing up of goodwill were frequent in this era where the businesses and corporations used to include goodwill in their balance sheet in order to bring the book value of the assets equal to the market value. As a consequence of this particular method, several type of goodwill appeared in the balance sheet of a company such as acquired goodwill, internally generated goodwill (the corporations at that particular era thought that the advertising expenditure incurred by the company creates intangible assets for the company in form of market shares etc.) capitalization of early losses and arbitrary writ-ups in order to bring the market value equal to the book value of the company. It can be concluded that in that particular period, accounting treatment of goodwill were significantly disrupted by the changes in the corporate governance policies and market dynamics. It was claimed by few of the accountants of that era that goodwill is a permanent non-current assets while the others argued that goodwill needs to gradually written down. Period 2 – 1929 -1959 In the 1930, the entire world was in a ramshackle by the great depression. It took a long time for the corporations to revive from such financial slump. Political disorder and social disability was at large in all parts of the globe. In order to restore the investor’s confidence and boost the trading in the financial market, several immediate reforms were taken such as the establishment of Securities and Exchange Commission. In addition, it was also made compulsory for the listed companies to get audited from an auditor on the panel of the Securities and Exchange Commission. The regulators prohibited the practice of writing up of the assets of a company in order to match it with the market value. This step was implemented by the regulators as they had experienced in the past that these practice was abused by a lot of corporations. In addition, the general concept of accounting also shifted from focusing more on calculating the net work of the stock to the measurement of income and earning capacity of a company. It was in this era that the concept of auditing flourished mainly in this era. The auditor was advised from the regulators to change their focus from identifying the fraud in a company, to assessing the true value of the assets as appearing in the balance sheet of a company. Hughes has mentioned in his study that there was no particular relationship between the book value of the assets of a company and its market value. The accounting treatments then shifted from focusing more on the valuation of the stock to managing the allocation of historical cost and income with respect to the current accounting period. As an after effect of the implementation of this accounting treatment, the capitalization of self generated or internally generated goodwill was strictly prohibited in the corporations and the acquired goodwill (resulting in a business combination) was instructed to amortize over a useful life. After the great depression, only acquired goodwill was allowed to be recognized by the accounting bodies and the rest three, as previously mentioned, were discredited. It was assessed in that particular period that the goodwill keeps on fluctuating and it should be recorded at cost in the balance sheet of a company. Another long debate arose considering the useful life of the asset over which it should be amortized. The conservative and prudent minded accountant suggested the view that the goodwill should be amortized over a considerable period of time and should not be in retention in the balance sheet of the company over a longer period. The accountant suggested that the goodwill should be amortized based on a systematic and gradual basis.ARB No. 24 (1994) can be considered as the first official attempt in order to classify the goodwill as an intangible asset in the balance sheet of a company. In this era, after the great depression, the accounting practices were thoroughly scrutinized and evaluated in order to identify what were the mal practices that led to distorted financial outlook of a company. Period 3 – 1959 -1973 In this particular accounting era, the pooling of interest method gained a lot of credibility and attention in the accounting circles. As per the pooling of interest method, in a business combination, neither of the company is considered to be acquire or acquirer. It is considered that now a new entity will replace the previous two entities. The balance sheet of the new entity will carry the assets of the former two entities at book value. According to Wyatt (1963), the pooling of interest method gained a lot of attention as in that particular time SEC required all the corporations who have recorded goodwill, to amortize it through the income statement. Catleet and Olson presented an argument that the goodwill should not be included in the balance sheet of a company as it is merely as estimation and is likely to distort the financial outlook of the company. It was also argued that the amortization of the goodwill should not be made through the income statement as it is against the matching principle. In the income statement only those items should be charged off against which some income is generated, and since the goodwill is not an income generating item, it should not amortized through the income statement. But this argument was debated with the fact that the depreciation on the fixed asset is also routed through the income statement of a company and it does not provide any direct earnings. Despite its acceptability at large, APB later on discouraged the use of pooling of interest method. The APB no. 17 made it mandatory for the accounting of the goodwill to be in line with that of other intangible assets. Since the useful life of goodwill is not determinable, thus the standard made it compulsory to amortize the goodwill over a period of forty years and it will be charged to the statement of income of an entity. Both the permanent write off and retention for an unlimited period of time was eliminated by the board. These particular regulations were also criticized by corporations stating that the amortization of goodwill and charging it to the income statement was a double charge, since the expenditure were also incurred by the company in order to bring this goodwill. In conclusion, in this era the accounting treatment of goodwill focused more on the historical cost approach. Arbitrary recording, writing up and writing down of the goodwill was strongly prohibited by the APB. Amortization of goodwill was appreciated through the income statement approach. Period 4 – 1973 -2001 This era marks the beginning of the end of the Second World War. Despite severe global economic turmoil, America was able to sustain and revive back. This era also saw the internationalization and globalization of the capital markets all across the globe. The domestic accounting standards were questioned and challenged by the international accounting practices. An example of it could be taken from the fact that the British companies were instructed as per their local regulations to write off the goodwill immediately, whereas, as we have already seen in the previous periods, such practice was made forbidden in the American economy. FASB issued a conceptual framework, which can be regarded as the significant milestone in this particular era. As per this conceptual framework, the emphasis was given more on the balance sheet approach rather than representation of income creation. After the conceptual framework was issued, debates arose on the accounting of goodwill over whether the presentation should be historical cost based or based on the fair value. Majority of the accountants and the standard setting organization were of the view that since the goodwill represent the present value of the future superior earnings of the assets of a company, thus it should be carried in the balance sheet of a company at fair value rather than the historical cost. On the other hand, there were other accountants who were of the view that the goodwill should be carried at historical cost basis as the assets generate revenue but at the same time, these assets also incur expenditure. Thus the pro historical cost approach accountant were of the view that recording goodwill at the fair value will be similar to recording revenue against expenses which has not been incurred and thus would be against the matching principle. In this particular era, the permanent retention of goodwill was discouraged and at the same time pooling of interest was also not considered suitable. Some of the corporations were of the view that the amortization of goodwill creates unnecessary burden on the earning potential of a company. A brief introduction to FASB Financial Accounting Standard Board (FASB) is a non-profit organization board which has the prime responsibility of developing generally accepted accounting principles (GAAP) in the united states. In the year 1973 Securities and Exchange Commission designated FASB as the accounting setting organization for the public in the United States. The FASB’s standard is based on the following 11 concepts: Money measurement Entity Going concern Cost Dual aspect Accounting period Conservation Realization Matching Consistency Materiality A brief introduction to IFRS The international financial reporting standard (IFRS) is the global language for financial reporting. The main motive of this organization is to promulgate such accounting standards that the annual reports of all the firms are prepared on a predefined standard and are comparable. This accounting standard board places the interest of the investors on the priority so that they are safeguarded. The IFRS is being followed by a number of countries and it is actively replacing all the domestic accounting standards all across the globe. As per the objective of IFRS, the financial statements should present a true and fair view about the affairs of the company and should be consistent and comparable. One of the main assumptions of IFRS is the going concern which means that the company would be able to discharge its liabilities in the future and will be able to operate at least 12 months from the end of the financial year to which the annual report belongs. Accounting of goodwill under IFRS and GAAP Under IFRS reporting system, goodwill is accounted for under the IFRS 3 “Business Combination”. The IFRS 3 presents the accounting for the goodwill recorded at the time of merger and acquisition. Following is the accounting treatment as presented in IFRS 3. As per the provisions of IFRS 3, the parties first should identify a business combination. In order to do so, the parties engaged in the business combination transaction should evaluate the definition of business combination as per the standard and then assess whether the transaction is actually a business combination or not. IFRS 3 “Business combination” requires that the assets acquired and the liabilities assumed constitute a business in order for the transaction to be a business combination. In case if the acquiring entity assesses that the assets acquired do not constitute a business combination that the transaction will simply be presented as acquisition of asset. The IFRS 3 enumerates that when an acquirer an entity, the entity shall apply the acquisition method. The acquisition method requires that following: (a) The acquirer should be identified (b) The acquisition date is determined (c) The identifiable assets must be acquired and measured. The liabilities assumed must also be identified in addition to any non-controlling interest. (d) Recognizing and measuring goodwill or a gain from a bargain purchase In every business combination, a single company shall be regarded as the acquirer and the other entity shall be regarded as acquire. IFRS 10, consolidated financial statements provides a definition for the acquirer entity. The acquirer entity is defined as the entity as the one which take ownership control of another entity. In addition, the acquirer shall also identify the acquisition date. The acquisition date is regarded as the date on which the acquire entity holds all the assets and liabilities of the other entity. This situation can also be interpreted as that day when the acquire entity acquires all the controlling shares in the acquire entity. In most cases, as observed in the corporate sector, the merger and acquisition transaction usually takes place at the end of the financial year. This is generally done for the sake of simplicity of recording the acquired assets and liabilities in the books of the merged entity. But, the controlling entity can also acquire the assets and assume liabilities on any other date as well. At the date of the acquisition, the controlling entity i.e. the acquirer, shall record the assets and liabilities and any non-controlling interest. The acquirer shall do so in addition to the goodwill being recognized at the time of business combination. International financial reporting framework and financial accounting standard board have both provided the definition of assets and liabilities in their framework. This can be further elaborated through an example. Any cost which the controlling entity expects will result in an outflow in the future does not necessarily represent a liability at the date of acquisition. An example of this would be relocation expense or future restructuring cost. Thus, IFRS 3 prohibits that contingent cost should not be recorded as a liability at the time of business combination. There are separate in the financial statement of the controlling entity which is recorded in the post merged financial statements. On the date of acquisition, the controlling entity shall make sure that the identified assets which are acquired as part of the business combination are classified appropriately so that subsequently in other years accounting years are applied appropriately. The example of these classifications would be between current or non-current assets or whether the assets are tangible or intangible. It is imperative for the controlling entity to consider economic conditions, contractual obligations, operating and accounting policies and other pertinent while make such classifications. One of such assets recognized at the time of classification would be goodwill. The controlling entity will recognize the goodwill at the date of acquisition which would be the excess of (a) over (b) (a) The sum of (1) Consideration transferred which is measured in accordance with IFRS 3. This consideration is usually measured at the fair value on the date of acquisition (2) The amount of any non-controlling interest in the acquire (3) In case the acquisition is piece meal i.e. the business combination takes place in stages, the acquisition-date fair value of the acquirers previously held equity interest in the acquiree. (b) The fair value of net assets acquired in the business combination. (fair value of net assets is the total assets less the total liabilities) The consideration transferred can be of two types. The first type would be in the form of cash and cash equivalent in which the controlling entity transfer cash to the acquiree in return of their net asset. The second type would be in the form of the assets of the acquirer itself. These assets are transferred by the acquirer to the acquiree at their carrying value. In such cases, if there is a difference between the carrying value of these assets and the fair value then the gain and loss shall be recognized in the profit and loss of the acquirer. But this is the case where the assets and liabilities do not remain within the combined entity. In other situations, the assets transferred may remain the same entity and thus the acquirer has control over the entity even after their disposal. In such situation, the acquirer shall measure these assets and liabilities at their carrying value only and would not recognize any gain or loss in the financial statements. There may also be a situation where in a business combination, the acquirer and acquire (or the former owner of the merged entity) exchanges only equity interests. In such situations, for the purpose of measuring the fair value of the consideration, the acquisition date fair value of equity interest of acquiree is a more reliable measure than the same of acquirer. Thus, the goodwill shall be measured using the equity interest of acquire only. There might be a condition in which the amount of goodwill appears to be negative. This is the situation in which the fair value of net assets acquired in the business combination exceeds the fair value of the consideration transferred. Consider the following illustration: Particulars Amount in Million $ Fair value of net assets acquired 500 Fair value of consideration transferred 350 Gain on bargain purchase (150) These are the situations in which the assets of an entity are purchases below their fair value. These transactions usually occur in situations where the acquire entity is not performing well and presents a negative financial outlook. The negative goodwill is termed as gain on bargain purchase. The acquirer shall recognize the gain on bargain purchase in its income statement and shall be attributable to the parent company only. It is imperative for the acquirer that before recognizing the gain on bargain purchase the assets and liabilities correctly identified. Difference of goodwill accounting between IFRS and GAAP The accounting of goodwill between the two methods, i.e. IFRS and GAAP are slightly different from each other. The following table summarizes the difference between the two accounting treatment. Standard IFRS US GAPP Goodwill is measured as In the IFRS system of accounting, the difference between the cost of the acquisition over the acquirers interest in the net fair value of the identifiable asset, liabilities and contingent liabilities the excess of the cost of an acquisition price over the fair value of the acquired net assets Impairment annually or more frequently if circumstances indicate additional impairment annually or more frequently if circumstances indicate additional impairment the method of testing two step process is not in use a two step process Elimination of impairment losses reversals of impairment losses relating goodwill are not permitted (IAS 36 permits reversals of other intangibles) reversals of impairment losses are not permitted in any circumstances Negative losses any discount on acquisition is taken to profit or loss statement any discount on acquisition is taken to the profit and loss statement Scenario Analysis Reporting of goodwill under IFRS Extract from the statement of financial position of XYZ company Figures in thousand $ Year 1 Year 0 Goodwill 1,000 - Notes to the financial statements Note x: Accounting for goodwill and other intangible assets Goodwill The carrying value of goodwill is determined in accordance with IFRS 3 Business Combinations and IAS 36 Impairment of Assets. Goodwill arises on the acquisition of subsidiaries, associates and joint ventures, and represents the excess of the fair value of the purchase consideration over the fair value of the Group’s share of the assets acquired and the liabilities and contingent liabilities assumed on the date of the acquisition. Goodwill is reviewed annually for impairment, or more frequently when there are indications that impairment may have occurred. The test involves comparing the carrying value of goodwill with the present value of the pre-tax cash flows, discounted at a rate of interest that reflects the inherent risks, of the cash generating unit to which the goodwill relates, or the cash generating unit’s fair value if this is higher. Goodwill Brands Customer Licenses and others Total Cost as at the beginning of the year - xxx xxx xxx Additions 1,000 xxx xxx xxx Disposals/amortization - xxx xxx xxx Exchange and other movement - xxx xxx xxx As at the end of the year 1,000 xxx xxx xxx Extract from the statement of financial position of XYZ company Figures in thousand $ Year 2 Year 1 Goodwill 450 1,000 Goodwill Brands Customer Licenses and others Total Cost as at the beginning of the year 1,000 xxx xxx xxx Additions - xxx xxx xxx Disposals/amortization 550 xxx xxx xxx Exchange and other movement - xxx xxx xxx As at the end of the year 450 xxx xxx xxx Reporting of goodwill under GAAP Extract from the Balance Sheet of XYZ company Figures in thousand $ Year 1 Year 0 Goodwill and intangible assets 1,000 - Notes to the financial statements Note x: Accounting for goodwill and other intangible assets The FASB issued ASU 2011-08, which becomes effective for the company on January 1, 2012. The standard simplifies how companies test goodwill for impairment. The company does not anticipate any impact to its results of operations, financial position or liquidity when the guidance becomes effective. Goodwill resulting from a business combination is not subject to amortization. As required by accounting standards for goodwill (ASC 350), the company tests such goodwill at the reporting unit level for impairment on an annual basis and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of the reporting unit below its carrying amount. Goodwill Cost as at the beginning of the year - Additions 1,000 Impairment loss - As at the end of the year 1,000 Extract from the Balance Sheet of XYZ company Figures in thousand $ Year 2 Year 1 Goodwill 450 1,000 Goodwill Cost as at the beginning of the year 1,000 Additions - Impairment loss 550 As at the end of the year 450 Conclusion The above discussion sheds some light on the historical treatment of the goodwill. The concept of goodwill arose during the merger and acquisition transactions when the accountants denote different values to the acquired assets as the book value and the market value of the entities. Initially it was observed that the writing up and writing down of goodwill was arbitrary and there was no consistent practice whether to route the amortization through statement of income or through statement of changes in equity. Later on, accounting standards were established in order to facilitate the proper accounting treatment of the goodwill in the books and accounts of multinational corporations. Majority of the accountants and the standard setting organization were of the view that since the goodwill represent the present value of the future superior earnings of the assets of a company, thus it should be carried in the balance sheet of a7 company at fair value rather than the historical cost. On the other hand, there were other accountants who were of the view that the goodwill should be carried at historical cost basis as the assets generate revenue but at the same time, these assets also incur expenditure. Thus the pro historical cost approach accountant were of the view that recording goodwill at the fair value will be similar to recording revenue against expenses which has not been incurred and thus would be against the matching principle. In the modern times, the accounting of goodwill is regulated through IFRS and American GAAP. Although, the conceptual framework is the same in the both of these accounting standards, there are a few differences in the presentation and valuation of goodwill. But both of these accounting standards ensure that financial statements of corporations are presented fairly and give a true and fair view of the goodwill accounted for. References Hughes, H.P. (1972), A history of the issues and problem surrounding goodwill in accounting, Doctors’ dissertation, the university of Alabama Hughes (1982). Goodwill in Accounting: A history of the issues and Problems, Business publishing division, college of business administration, Georgia State University Bump, E.A. (1970), An empirical Evaluation of the Nature and Structure and Problems in Accounting for Business Combinations, Doctor’s dissertation, the University of Missouri Nobes, C. (1992) “A political history of Goodwill in the UK.: An illustration of cyclical standard setting”, ABACUS, vol. 28(2), pp 142-167 Yang, J.M (1927), Goodwill and other intangibles: their Significance and their treatment in Accounts. New York: Ronald Press Company. Catlett, G.R. and N.O. Olson (1968), “Accounting for Goodwill”, Accounting Research Study No. 10, New York: American Institute of Certified Public Accountants. Deloitte.com (2013). Deloitte | Audit, Consulting, Financial Advisory, Risk Management & Tax Services | Global |. [online] Retrieved from: http://www.deloitte.com/assets/Dcom-UnitedStates/Local%20Assets/Documents [Accessed: 30 Mar 2013]. Iasplus.com (2004). IAS Plus newsletter — Summary of Key Differences Between IFRSs and US GAAP — IAS Plus. [online] Retrieved from: http://www.iasplus.com/en/publications/global/ifrs-in-focus/2004/ias-plus-newsletter-2014-summary-of-key-differences-between-ifrss-and-us-gaap [Accessed: 30 Mar 2013]. Kpmg.com (2009). 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