Goodwill under Business Acquisitions - Term Paper Example

 Implications of financial reporting of Goodwill Introduction From accounting point of view goodwill occur during business combinations, as internally grown goodwill is not treated as asset. Since April 2004 IFRS 3 has taken over the matters of accounting and reporting of acquired goodwill under business acquisitions. With the effect a number of factors have emerged that play a role in computing goodwill like selection of purchase method, identifications of intangibles and contingent liabilities, recognition of non- controlling interests in different way, writing back negative goodwill and writing off of cost of structuring acquisition to profit and loss. This has impacted the financial statements of entities. In this essay the implications of these changes of financial accounting and reporting of goodwill are evaluated and discussed in detail. Contents Introduction Contents Changes in IFRS 3 affecting goodwill computations Implications of treatment of goodwill under IFRS 3 Effects on Financial Statements Conclusion References Changes in IFRS 3 affecting goodwill computations Goodwill computations will be highly affected with effective changes brought in by IFRS 3. Business combinations will now be accounted for only under purchase method, and merger accounting is banned. Intangible assets will be identified in larger way impacting goodwill as the IFRS 3 contains a list of suggestive intangibles. Contingent liabilities will play effective role in goodwill valuation as they will be recognized at fair value. Henceforth goodwill will not be amortized but will face impairment test will all other intangibles. Non- controlling interests will play effective role in determining cost of acquisition and thus in goodwill valuation for acquirer. Cost of restructuring the acquisition will be written off to profit and loss. This will play a part in enhancing goodwill valuation under purchase method. Excess of cost of acquisition over fair value of net assets acquired shall be treated as gain or negative goodwill and will be credited to profit and loss. Implications of treatment of Goodwill under IFRS 3 The major impact is that Goodwill now be considered a permanent asset. IFRS 3 has restricted business combination accounting only under ‘purchase’ method where “the acquiring company records net assets received at fair value at the date of combination. Any excess of cost over the fair value of net assets is allocated to goodwill.” (Venkatesan Sundarrajan, 1995)1. Fair value of net assets is calculated by deducting the fair market value of liabilities (including contingent liabilities) undertaken from the fair value of identified tangible and intangible assets acquired, and goodwill is the difference between cost of acquisition and the fair value of net assets acquired on acquisition date. Though goodwill was also earlier being recorded as residual value under business combinations, but IAS 22 in addition thereto permitted amortization of goodwill over useful life, which was considered as 20 years. Now amortization of goodwill is not permitted and will face the tests of impairments. Though “amortization of purchased goodwill is in line with the matching concept of accounting, in that the cost of purchasing the synergistic benefits attributable to purchased goodwill must be charged to earnings over the period of the consumption of such benefits.” (Sacho, Zwi Y, February 2005)2, but logically amortization of goodwill is not acceptable in view of fair valuation of identifies assets and liabilities. Again it is not possible to accurately estimate the useful life of the purchased goodwill. Sacho states in his article that “because the useful life of goodwill and pattern of its consumption are not possible to predict with sufficient accuracy, the amortization charge to earnings was an arbitrary estimate of the consumption of economic benefits embodied in goodwill.” (Sacho, Zwi Y, February 2005)3 Those who favor amortization argue that acquired goodwill plays a role in developing internal goodwill. Robert N. Waxman (2001)4 is of the opinion that “potential for economic benefits that was purchased initially is being progressively replaced by the potential for economic benefits resulting from subsequent enhancements of goodwill. In other words, the goodwill that was purchased is being replaced by internally generated goodwill. IAS 38, ‘Intangible assets’ prohibits the recognition of internally generated goodwill as an asset. Therefore, it is appropriate that goodwill is amortized on a systematic basis over the best estimate of its useful life.” Accordingly there are opinions in favor as well as against the amortization of purchased goodwill. But the stance of amortization of purchased goodwill adopted by IAS 22 could not hold itself due to unscientific and arbitrary method of calculating each year’s amortization amount. That is why IFRS 3 was introduced in 2004 and it completely washed out amortization process of purchased goodwill. The stance of IFRS 3 is that “the amortization of goodwill acquired in a business combination is now prohibited and instead it requires the goodwill to be tested annually for impairment, or more frequently if events or changes in circumstances indicate that asset might be impaired, in accordance IAS 36 Impairment of Assets. Previously recognized goodwill should discontinue to be amortized.” (Anders and Tommy, page 17)5 IFRS 3 seeks goodwill to be tested for impairment on annual basis or even more frequently if the situation so warrants. It also suggests that goodwill impairment will not be reversed. This fair value process of judging goodwill from the angle of impairment is controversial because of two reasons: firstly, the process of impairment test is very complicated particularly for intangibles; and secondly internal goodwill generated over a period of time by the use of acquired goodwill is not recognized under standards. Some argue that under these circumstances the non- amortization of goodwill is not fair. There is also a feeling that introduction of testing goodwill for impairment was just a move to bring convergence of IFRSs with SAFSs of US. Interpreting this situation of non- amortization of goodwill in respect of technological companies, Roy E Johnson (2001,page 80)6states that “unless there is no goodwill or intangibles, uncommon for most technological companies and those firms growing through acquisition, I believe we should add back the amortization and calculate operating income on more of a cash flow basis. This treats the goodwill (or any other intangible) as a sunk cost, which is what it is.” Should this hike in EPS be treated a real one or artificial can be any body’s guess. This certainly is an artificial creation after goodwill becoming the sunk cost, as explained above. Considering such an impact of debarring amortization, the ISAB should once again consider the provisions IFRS 3, and bring back amortization in a refined form. Effects on financial statements On application of IFRS 3 the companies are feeling the impact of non- amortization on their financial statements. Income for shareholders was increasing because of fewer expenses charged to revenue. Certain companies even started reclassifying existing goodwill like intangibles as goodwill in order to take benefit of impairment process. Like UBS in its magazine ‘Quarterly Themes’ (Feb. 8, 2005)7 has stated that “Following the new standard, we have also reclassified the net book value of former PaineWebber trained workforce intangible assets to goodwill” With abolishment of amortization of goodwill, the cost of goodwill purchased becomes a sunk cost and non- amortization will hike the shareholders’ value through inflated income, as impairment losses on goodwill do not occur in successful ventures. Eventually there will be artificially inflated EPS creating positive but unreal impact on market value of shares. The recognition of contingent liabilities will enhance the value of goodwill, and same role will be played by intangibles. The standard provides a list of intangibles some of those earlier were never identified in acquisition transactions. The immediate impact of such a treatment would be enhancement of value of total assets of the acquirer as now contingent liabilities and intangibles which were not earlier used to be identified would play a role in goodwill calculations. Increased value of total assets would bring down ROA (return on assets) ratio as non amortization effect on profitability may be neutralized by the impairment effects on profit and loss. Financial statements will now be constituted in different manners. Assets appearing at fair value and visibility of intangibles are likely to show more volatility in earnings of the acquirer. Goodwill will be treated as an asset, and rightly so as it has all the capabilities of bringing future economic benefits to the entity. Goodwill that has been acquired will raise both the capital base and asset base of the acquirer’s financial statement. With the result ratios like ROA, ROE, and ROCE will go down. During the initial periods of acquisition there will be few impairment losses as fair market value of intangibles will approximate book value. With amortization out of reckoning and fewer impairment losses, the increase in profits for shareholders will provide a hike in earning per share (EPS) and may affect the market value of shares accordingly. Conclusion The non- amortization of goodwill, identifications of intangibles in big way, fair, valuations of contingent liabilities, treating negative goodwill as profits, and other factors brought in by IFRS 3 have greatly impacted the valuation of acquired goodwill. With the result financial statements have become more volatile in determining the financial results and financial position. It is likely that financial results computed by operations of the entity may get changed by these effects on acquired goodwill under business combinations. Word Count: 1542 References Read More