Since the International Accounting Standards Board (IASB) published its conclusions from the post-implementation review (PIR) of IFRS 3 Business Combinations in 2015, it has undertaken a project to look at four of the more significant areas of concern identified, namely:
- the effectiveness and complexity of testing goodwill for impairment;
- accounting for goodwill subsequent to initial recognition ie, whether to just impair, or amortise and impair;
- the identification and fair value measurement of intangible assets; and
- information about the subsequent performance of the acquiree.
The IASB is now ready to publish its preliminary conclusions and proposals, and a Discussion Paper (DP) is expected in February 2020. As a financial reporting expert working in business, I have been following the IASB’s project in this area with interest. This article looks at the changes to financial reporting for goodwill and the impairment of non-financial assets that will (and won’t) be proposed – probably!
As this article is being written prior to the DP’s publication, the areas covered below are drawn from publically available IASB meeting papers, newsletters and other publications. The final DP may differ in some respects from the matters discussed in this article, although these differences are expected to be minor.
What is (probably) changing?
Better disclosures
The most significant proposals relate to the disclosures that an entity makes about its business combination. Commentators have long argued that the economics of business combinations are not disclosed until it becomes necessary to impair the related goodwill. The IASB is now proposing to require management to:
- describe what they expected to achieve by acquiring the business; and
- report on the extent to which they have achieved those objectives. In other words, to report on how successful the acquisition has been.
With respect to what management expects the acquisition to achieve, the disclosures could include:
- a description of the expected synergies and their expected timing
- the amount, or range of amounts, of expected synergies;
- the expected costs, or range of costs, to achieve those synergies; and
- the measures, whether operational or financial, that management expects to use to assess the extent to which the acquisition has achieved management’s objectives.
Some stakeholders have already raised concerns that these expectations would be ‘forward-looking information’. The IASB plans to seek views on these concerns given the range of different regulatory frameworks around the world.
In terms of communicating how successful the acquisition has been, the IASB proposes a new requirement for management to report on the extent it has achieved its objectives by using the identified measures referred to above. The aim is that this will help users hold management to account for their promises as well as being helpful to users for valuation purposes. The IASB does not intend to specify what measures should be used, preferring instead that management disclose what it finds useful for monitoring post-acquisition performance. The IASB expects management to make these disclosures in the year of acquisition and at least the two subsequent years – possibly longer if management continues to monitor those measures.
The current IFRS 3 requires an entity to disclose information about the results of the combined entities as if the acquisition had occurred at the start of the financial year. The IASB considered removing this requirement because of concerns over the lack of guidance, and by implication a lack of consistency, on how entities prepare this information. Users say, however, that this information is crucial for their analysis, so the IASB plans to consult on how the information should be prepared.
Improvements to the impairment test
The main complaints from preparers about impairment tests for goodwill and other non-financial assets relate to complexity and cost. Consequently, they may welcome proposals to improve the requirements for the value in use (VIU) test. Specifically, the IASB proposes two changes to the current methodology of IAS 36 Impairment of Assets:
- Post-tax VIU: Currently, an entity must use pre-tax cash flows and a pre-tax discount rate to calculate VIU, even though a pre-tax discount rate is not market-observable. The IASB proposes to allow the use of post-tax cash flows with a post-tax discount rate to calculate VIU. This could simplify things.
- Permitting the inclusion of future expenditures in VIU: IAS 36 requires management to test the cash generating unit (CGU) for impairment in its current condition, not as it might be after future restructuring or enhancement. Consequently, management must strip out cash outflows relating to future restructuring or enhancement together with the additional cash inflows that may be generated as a result. On the surface this is logical – it is the asset as it exists today that is being tested – but arguably this does not reflect future reality. Expected restructuring and enhancements are included in management’s budgeting and forecasting of future operations, so why shouldn’t the VIU calculation reflect this?
The IASB proposes to allow the inclusion of future restructuring and enhancement expenditures, but it also intends to emphasise the need for good governance to avoid unreasonably optimistic forecasts.
What’s (probably) not changing?
The IASB is not proposing any change for three topics discussed in response to the PIR feedback. These are:
Effectiveness of impairment test
During the project, the IASB discussed concerns that unrecognised internally-generated goodwill shields the goodwill recognised in an acquisition from impairment. Or more simply put, that cash flows from existing businesses are used to support acquired goodwill.
The ‘shielding effect’ arises because acquired goodwill is tested for impairment as part of a CGU (or group of CGUs). The unrecognised goodwill relating to that CGU, whether pre-existing or subsequently generated, enhances the value of the CGU as a whole. The contribution of unrecognised goodwill to this enhanced value masks any decline in the value of the recognised acquired goodwill up to the amount of the unrecognised goodwill (see diagram).
After much debate, the IASB concluded that including unrecognised goodwill in the calculations would not be feasible to implement. However, some readers might recall that the previous UK standard setter, the Accounting Standards Board, put into practice a comparable approach under UK GAAP in the late 1990s. Would it really be infeasible in an international arena?
Identification and fair value measurement of intangible assets
Acquirers will probably be required to continue to recognise acquired intangible assets separately from goodwill and measure them at fair value. This is despite concerns that identifying and measuring such intangibles results in information that is both costly to obtain and may be unreliable.
The IASB says that there is insufficient evidence to justify not separating intangibles from goodwill. However, this leaves the challenges of measuring such intangible assets unaddressed. The IASB is not proposing to provide any additional guidance on fair value measurement beyond that which already exists in IFRS.
Non-amortisation of goodwill
Perhaps the most controversial change introduced by IFRS 3 was that goodwill should no longer be amortised over its useful life, but instead be tested annually for impairment. Research by the IASB during the PIR identified strong views both for and against amortisation. The arguments were much the same as when IFRS 3 was developed. As a result, the IASB proposes no change to the current requirements on this topic, but it is keen to see if anyone has any new arguments.
Where to now?
The IASB expects to publish the DP in February 2020, with a 180-day comment period. As a package, the IASB’s proposals offer information improvements for users and some efficiency gains for preparers. But do they go far enough?
The shielding effect
If recoverable amount reduces from RA1 to RA2, no impairment is recognised. In other words the unrecognised goodwill ‘shields’ the recognised goodwill from impairment. Only if the recoverable amount falls to less than the total of the recognised goodwill plus identifiable net assets, for example to RA3, will an impairment charge be recognised.
About the author
Michael Stewart is senior expert of financial reporting, Huawei Global Finance (UK) Limited