Double Accounting for Goodwill - Coursework Example

Goodwill Goodwill arises as a result of the acquisition of a company by another by paying more than the net asset value of the company. It is an intangible asset and sometimes it has even higher value than tangible assets. In short it is the value paid by the purchases in recognition of the value of brand or reputation of the company’s name (Bloom.Martin). According to the financial reporting standards amortization of goodwill was suspended, and management is required to make estimates regarding the value of the goodwill and if there is any there is any sign of devaluation, it is impaired as per the guidelines of the accounting standards. Current treatment of goodwill In 2004, International Accounting Standard Board issued revised international accounting standards. Changes were made in the International accounting standards (IAS) 36-Impairment and IAS 38-Intangible assets. These revised standards suggested significant changes in the accounting treatment of the intangible assets including goodwill. New standards demand that the goodwill is no longer amortized, but the management is responsible for testing it for impairment each year. Similar treatment US GAAP suggested few years earlier than IASB. The reason for the revision of the International Accounting standards is to bring the differences closer with the US GAAP. However, there are still few differences in treatment of goodwill suggested by both these bodies. Some of them are highlighted below, Standard IFRS GAAP Goodwill is estimated as The difference between amount paid for the acquisition and the seller’s interest in the net assets Amount paid in excess of the fair value of the required net assets Impairment IFRS require impairment to be tested once a year or even earlier if there is any indication Same as IFRS Method of testing It does not use two step process Uses two step process Removal of impairment losses Reversal of the impairment losses relating to the goodwill is not permitted, however; allow reversal on other intangible assets It does not permit any reversal in any circumstances Negative goodwill Any discount arising on the acquisition is included in the profit and loss statement US GAAP suggests similar treatment. As mentioned above externally generated good arise on acquisition of the new entity and it is recognized fully according to the treatment suggested by the relevant board. Australian Accounting Standard Board also suggests the same treatment of the recognition of goodwill as suggested by IFRS after the adoption of IAS 38. On the other hand, GAAP suggests a little different way of the recognition of externally generated goodwill. In order to be recognized as intangible assets it must meet the criteria of recognition such as future economic benefit would flow to the entity and the cost of assets can be measuredW reliably as given in IAS-38. As far as the internally generated goodwill is concerned IAS is very clear that it should not be recognized as an asset, but it should be expensed out in accordance with the guidelines of the IAS 38 (Para 48) (Deloitte). There is a little inconsistency regarding the recognition criteria. Internally generated goodwill may also fulfill both the conditions that is it may result in future benefits and its cost may also be identifiable, but it is not recognized. This inconsistency may exist due to the reason that, if the companies are allowed recognizes internally generated goodwill they will window dress their financial statement and the true financial position may not be revealed. History of Goodwill accounting Since many years area of the goodwill accounting has been under the debate. During 1960’s and 70’s some of the researchers ever argued that valuation of the goodwill based on share price is just a speculation about the future earnings of the company and nothing else. Some other experts conducted their research and reached to occlusion that goodwill cannot be recognized as an asset, since it does not eat the definition of the intangible assets, given by 1AS-38. For example, it cannot be sold separately to other assets. In November 1983, IAS-22 “Account for Business Combinations” was issued. This standard recognized goodwill as an asset and suggested that it must be amortized for its useful life. Normally amortization period was of five years, but it could extend to maximum 20 years if the useful life of the assets exceeds five years. In addition to this IAS-22 suggested that the remaining value of the goodwill should be reviewed annual and if it exceeds the future value of economic benefit, the excess part should be charged as an expense. In July 1998, some of the paragraphs of IAS 22 were revised in order to bring the consistency between IAS-22 and other standards including IAS-36, IAS-37, and IAS-38. In addition to this, it was decided that the goodwill can be amortized for more than 20 years, but the management need to make a note in the financial statement discussing the assumptions ado in the computation of useful life. In January 2005, IAS-22 was repealed by IFRS-3 effective from the same date. Provision of IFRS-3 requires goodwill to be recognized at cost. After the initial recognition, it must be tested for the annual impairment. Further, it stated that each cash-generating unit should be tested for impairment separately. In addition to this standard prohibited the reversal of the impairment loss already charged to goodwill. On 10 July 2009, a revised version of the IFRS-3 was issued by International Accounting Standard Board, which suggested that the goodwill should be recognized at the one the entity obtains controls. This treatment suggested an improvement as compared to last standard, which requires goodwill to be recognized for each separate acquisition of the shares (Feleaga.Liliana and Feleaga.Nicula). The Anglo-American accounting systems are based on the system of accounting that is heavily influenced by the professional bodies such as IASB, AASB, etc. rather than government department. This model supports the clear terms such as true and fair and it takes into account the concept of substance over form. Both of these methods had differences of treatment for the different areas of accounting including goodwill. In the modern times all the professional bodies around the globe are continuously trying to minimize the differences between the applicable standards. As a result of these efforts there is similar treatment of goodwill offered by these two accounting systems. The Anglo Amercian Accounting Bodies have introduced a new accounting standard for the fair value measurement. This standard known as AASB 13 has eradicated many of the contradictions that were existent in previous Anglo American Accounting standard and other International Accounting Standards. Fair Value: Now the standard provides a standard definition of fair value which is consistent with the definitions provided by other Accounting standards. The standard has now introduced the concepts of highest value and the best values possible, valuation premise and the principal market. The standard now provides more clarification with respect to the value to be taken. Now, the exit entry has o be taken rather than the entry value. The standard now provides the hierarchy of the inputs that is available for the fair value measurement. It is now suggested that firstly, the observable inputs will be taken and then the unobservable input will be taken that is unavailable in the market. The Standard provides more refinement to the value assigned to the liability. Previously, the value that was used to settle the liability was assumed as the fair value, but now the value taken to transfer the liability to a third party in the market is taken as the fair value of the liability. The standard has attempted to reduce the intervention and judgment of the management. The definition of the fair value applies to all the entity irrespective of the fact that the company intent to sell the product or not. Similarly, the value taken is market based rather than entity-specific value. This also reduces the chances of manipulation by the management’s intention. The value taken is independent of the activity and volume of the product or good in the market. Measurement: AASB 13 has also provided the financial framework for the measurement of the fair value. This framework provides additional clarification and guidance for application. Moreover, new disclosures have also been provided with regard to the measurement of the fair value. Recognition: AASB 13 specifically excludes goodwill and internally generated brands. The conditions for recognition have also been stated with more clarity in the new standard. Amortization: For amortization, the Anglo American Accounting standards now provide more clarity. The amortization has to be made on the finite useful life of the asset. The cost of the asset will be amortized. If the value of the asset changes as a result of the impairment testing, then the revised value of the asset will be amortized over the useful life of the asset. The above changes and revisions have been made in the accounting standards to bring them in line with the international accounting standards. Principles of Valuation and Impairment of Assets by IASB for Intangible Assets Lacking Established Market Values For intangible assets that do not have the established market value, IAS 36 allows the usage of value in use for the purpose of initial recognition. Value in use is the present value of the sum of the cash flows that are projected to be generated in future by the asset (Abbas, Graham, & Liesel, 2011). Such cash flows should be computed by taking into consideration all the factors like time value of the money, liquidity conditions of the market etc. The assumptions taken for the computation of the cash flow should be reasonable and realistic. For instance, if internal budgets and forecasts are used then they should be used of the most current period available. Thorough comparative analysis should be made between the previous cash flows and projected cash flows. The cash flows that are projected should be extrapolated on the basis of the current situation of the asset. It means that any capital expenditures that are not yet incurred should not be considered as having been capitalized. Moreover, the cash flows that are projected should be based on the core operations of the asset. Debts, tax receipts and other finance inflows should not be included in that assets value. IAS 36 states that the discount rate that is used should be pre-tax rate that has incorporated the effects of time value of money of time value of money. Other risks such as the economics conditions of the country should also be taken in to consideration at the time of selection of the discount rate. In the absence of such rate, IAS 36 allows the usage of company’s internal discount rates such as the weighted average cost of capital, entity’s incremental borrowing rate and other market borrowing rates (Ernst and Young, 2012). For impairment of the asset, as the fair value is not available, again the value in use will be computed at the time of impairment testing so that the cost of the asset is compared with it. Discounted Cash Flow techniques Discounted Cash Flow technique refers to the technique which is based on the future estimated cash flows. The future cash flows are then discounted by using a suitable discount rate at the present date. The sum of the discounted cash flows is then taken as the Present Value of the assets. The demerits attached with this technique are discussed as follow: Estimation of the Cash Flows: The technique is based on the cash flow projections. The projection of cash flow may be made incorrectly as it is itself subject to many assumptions related to corporate governance structure of the company, economic situation of the country, market stability, current and future performance of the company etc. All these assumptions are by themselves subject to volatility. Moreover, the impact of the changes in assumptions will change the future pattern of the cash flows. Such cash flows will change the present value of the asset as well. This is one of the primary limitations in the Discounted Cash Flow technique (Pascal, Le, Antonio, & Maurizio, 2011). Moreover, it is also a debatable topic as if all of the cash flow projected is pertaining completely to the asset under construction or do they relate to other assets also. It is a matter of subjective judgment to partition the cash flows into assets who are responsible for generating the future cash flows. Discounting rate used: Discounting rate used is representative of the market situations. Such market conditions include the monetary policies and their impacts on the economy, the future planned fiscal policies and their relationship with the economic situation, the inflation rate that will persist in the economy etc. All these factors are highly vulnerable to each other. A change in one variable can change the position of the other. This will bring much more changes in the discounted cash flow value of the present under consideration. Apart from this, the selection of the discount rate is a subjective matter. However objectivity may be incorporate by taking due consideration for the factors that are discussed above but the management is in the unique position to manipulate the figures. A slightly high rate in the discounting will reduce the value of the asset which will ultimately increase the expenses of the company. Such high rate will be used when the company is interested in evading taxes. Contrary to this, a slight lower rate will increase the value of the asset. This increase in asset will improve the balance sheet position. Such manipulation may be used by management to attract the investors. Opinion about Discounted Cash Flow Technique Recognition of goodwill has always been in heated debates. There are assenting and dissenting opinions about the recognition of the goodwill. Those who disregard the recognition of goodwill of such view because of the subjectivity involved in its measurement. It is difficult to measure the aspects of the business like customer satisfaction, customer loyalty, ownership of the employees, retention of the employees etc. Discounted Cash flow technique does not provide a solution to these reservations. In getting an in depth analysis of the goodwill recognition and its measurement, it comes to front that the controversy is far more deep rooted that can not be resolved by just using the Discounted Cash flow technique. The opponents of goodwill challenge it to be recognized as an asset; measurement by using DCF method is a secondary issue. In addition to the measurement of goodwill there are disputes which relate to the impairment of the goodwill. The impairment of the goodwill is also a matter of judgment. Impairment exists when the recoverable value of the asset is below the fair market value. The fair value of the goodwill is difficult to be ascertained due to numerous factors. The cash flow is normally representative of the company performance in the given market conditions, whereas fair value is representative of not just the company performance but is also incorporates artificial market forces like unnecessary capital injected into the market. In addition to this, there are lesser reliable sources available for ascertaining the value of the goodwill as compared to other assets. All these factors prove that Discounting Cash Flow technique is not the ideal technique to measure and impair goodwill. References Abbas, M., Graham, H., & Liesel, K. (2011). Wiley IFRS: Practical Implementation Guide and Workbook. New Jersey: John Wiley and Sons. Bloom.Martin. (2009). Double Accounting for Goodwill: A Problem Redefined. New York: Routledge. Deloitte. (2014). Standards. Retrieved from http://iasplus.com/en/standards/ias/ias38 Ernst and Young. (2012). International GAAP . New Jersey: John Wiley and Sons. Feleaga.Liliana, & Feleaga.Nicula. (2011, March 22). Accounting for goodwill: a historical review. Retrieved from http://www.freepatentsonline.com/article/European-Journal-Management/260791874.html Pascal, Q., Le, F. Y., Antonio, S., & Maurizio, D. (2011). Corporate Finance: Theory and Practise. New Jersey: John Wiley and Sons. Read More