Effects of Changes in Goodwill Treatment - Term Paper Example

 Effects of Changes in Goodwill Treatment Introduction Business combinations are source of acquired goodwill as internally generated goodwill is not treated as an asset. The changes by IFRS 3 on taking over from IAS 22 over the issues of accounting and reporting of acquired goodwill on combinations, has brought in many issues that have impacted the financial statements of the acquirers. Some of the issues like adoption of only ‘purchase method’ of accounting for combinations, non- amortization of goodwill and other intangible, recognition of intangibles in larger way, fair valuations of contingent liabilities, and others have increased the vulnerability of financial statements. IFRS 3 was introduced in 2004 and revised in January 2008. In this essay an evaluation has been made on the effects of changes that have taken place from shifting the regulations relating to acquired goodwill from IAS 22 to IFRS 3. Contents Introduction Contents Goodwill as was regulated under IAS 22 Effects of regulations under IFRS 3 Conclusion References Goodwill as was regulated under IAS 22 There are two methods for accounting the acquired goodwill under business combinations, namely, ‘pooling of interest’ and ‘purchase’ (or ‘acquisition’) method. IAS 22 permitted goodwill accounting under both methods. Pooling of interest method is an application of the going concern concept and that all combining entities remain in existence. Accordingly only the assets and liabilities of merging entities are combined at their values, and thus there results no goodwill. Even when books and records are not combined, the parent will record an investment in subsidiary. The amount will be equal to the net amount of the book values of the assets and liabilities. This will be equal to the stockholders’ equity of the subsidiary as of the date of the combination. Thus no goodwill results under both alternative accounting under pooling of interest method. Under purchase method of accounting as was applicable under IAS 22 assets and liabilities are acquired as per their fair values and these acquired net assets when compared with purchase consideration results into goodwill or negative goodwill, as the case may be. IAS 22 also allowed amortization of acquired goodwill under business combinations over the estimated useful life of goodwill, but not exceeding 20 years. However in rare case the amortization of goodwill could go beyond 20 years when the management was of the opinion that economic benefits to the entity from acquired goodwill would go beyond that period. The basic weakness of the IAS 22 was misuse of pooling of interest method, as using merger accounting many combinations avoided the reporting of goodwill for certain vested interests. Secondly during the period of fair value applications, amortization of intangibles like goodwill seems out of date. In fact Peter William, (22 Feb 2007)1 has rightly argued that with elimination of merger accounting inter- comparability of companies will be enhanced Effects on financial statements Pooling of interest method does not comply with the requirements of conceptual framework envisaged by IASB as under no circumstances there would be fair representation of acquisition transaction. First of all it is not necessary that entities unite under acquisition as mostly acquired entity does not remain in existence. Secondly as cost of acquisition rarely matches with book value of net assets acquired, and the only treatment of difference in cost of acquisition and book value of net assets would be to reduce the balance of additional paid in capital if consideration is discharged through issuance of equities or to charge the difference to ‘retained earnings’ when equities are not issued. Under both ways there would be non compliance of IFRSs. Total assets as well as equities will be understated resulting into higher ROA, ROE, and ROCE. Income statement will show increased operational income in absence impairment loss or amortization effect of unrecognized goodwill. Depreciation charged on book value of acquired assets would not be fair treatment as historical costs instead of fair values of assets would be used to compute deprecation. Effects of regulations under IFRS 3 One of the main features of IFRS 3 is that only purchase method of accounting will be used for business combination, and this will enhance the comparability value acquisition reporting. Next most important change is that Goodwill shall not be amortized over its useful life, but it will be tested for impairment at every reporting date or earlier as per requirements. In effect “Goodwill will have to be treated as a permanent asset with no amortization but with a requirement for an annual impairment review of the goodwill.”(Robert Kirk, page 5)2 Goodwill is an asset as it represents probable future benefits acquired by the entity because of the result of past transactions. The basic reason for testing goodwill for impairment is that IFRS 3 treats that goodwill has an indefinite life. The method of computation of goodwill is the same as the residual between cost of acquisition and fair value of net assets. Fair values of all identified assets including intangibles (other than goodwill) are computed and there from the fair values of identified liabilities including contingent liabilities are deducted in order to compute fair value of net assets. IFRS 3 describes the fair value of an asset or a liability as the amount that is exchangeable at arm’s length transaction between parties having complete knowledge of that asset or liability. The important thing to note is that cost of acquisition or purchase consideration includes all interest of the acquirer into the acquired business. “If the interest in target were not held at fair value, the interest is re measured at fair value with change recognized in income statement.”(IFRS News, page1-2)3 Transaction costs are now not the part of cost of acquisition. Also only those contingent liabilities are considered for calculating net assets that have a measurable fair vale at acquisition date. Acquired goodwill computed as per above rules will impact financial statements in a number of ways. First the acquired goodwill mark up the capital base of the acquirer and this will dilute ROE (return on equity), ROA (return on assets), and ROCE (return on capital employed). Capital base will be enhanced because of recognition of acquired goodwill as an asset as result of difference between purchase consideration and fair value of net assets acquired. Secondly IFRS 3 (2008) paragraph 42 seeks re- measurement of previously held equity. At acquisition date goodwill on balance sheet of acquirer will consist of acquired goodwill at fair value and existing goodwill at historical value. The requirements of IFRS 3 make it compulsory to re- evaluate existing goodwill also at fair value. This will further enhance the total value of assets held by acquirer and its capital base. The acquired and existing goodwill will raise the capital base and thereby the net worth of company will also increase. Under purchase method it is good to make over payments as this enhances the net worth of the acquirer. Increase in net worth of the company will enhance the company’s bargaining power when negotiating for fresh loans. It will also help in raising fresh capital from fresh issues. Under inflationary conditions the fair values used will enhance acquired assets value, and thereby increased depreciation will reduce income attributable to equity holders. That means EPS (earning per share) will decline. The reverse is true if the acquisition takes place under deflationary conditions. However, non amortization of goodwill will check the fluctuations in earning ratios to some extent. The issue whether regulations of IFRS 3 contribute to creative accounting is highly debatable. In terms of Zacher and Betriebswirt (2008,page 34)4 ‘when accounting rules are inadequate and give rise to window dressing and creative accounting, regulations may turn out to be meaning less’. That is to say creative accounting occurs in absence of laid down principles. Is IFRS 3 insufficient to regulate acquisition accounting? There exists difference of opinion in this regard. Peter Krijgsman (March 2007)5, insists that even after introduction of IFRS 3 most of acquisitions among FTSE 100 companies during 2006 remained unaccounted for. This suggests that IFRS 3 lacks the drive to promote transparency in acquisition transactions. Simultaneously it is being believed that IFRS 3 has opened the gates for creative accounting because of intangibles valuation which corporations used to avoid because of amortization effects on income; and also full goodwill calculations while considering minority interests. The problem of internally generated goodwill has not been addressed even by IFRS 3. At least some methodology was there as when to expense acquired goodwill by amortizing it over useful life under IAS 22. Further, testing for impairment can be manipulative as there may not be ready markets to disclose fair value of intangibles like goodwill. That means impairment effect is a manipulative tool that give rise to creative accounting. So there are lots of lacunas in IFRS 3 that may promote creative accounting. The only saving grace is application of purchase method for all acquisition adding the attribute of comparability. Conclusion IFRS 3 has changed the scenario of acquisition accounting basically because of omission of amortization of acquired goodwill and other intangibles. Effects of changes of bringing more intangibles and contingent liability into goodwill calculations on financial statements are imperative from the investors’ point of view as these changes bring fluctuations in assets based and equity based ratios, particularly the EPS. Negative goodwill accounting is an addition to fair presentation attributes of financial statements. But IFRS 3 has also given rise to creative accounting because of testing all intangibles for impairments, elimination of amortization, and again not considering any solution to internally generated goodwill. Overall, goodwill treatment by IFRS 3 has revolutionized its accounting and reporting in an effective way. References Read More