Recent analysis undertaken by the UK Endorsement Board (UKEB) shows that, at £391bn, goodwill represents 51% of net assets for UK FTSE 350 and AIM reporters. So it is perhaps unsurprising that the reporting and measurement of goodwill after its initial recognition remains a topical issue, featuring on the International Accounting Standards Board’s (IASB) current agenda and the focus of a recent global report by the CFA Institute. Also, in December 2020, the Financial Accounting Standards Board tentatively decided to reintroduce amortisation of purchased goodwill to alleviate pressure on the impairment test.
In May 2021, the UKEB was delegated statutory powers to play a pivotal role in influencing the development of International Financial Reporting Standards (IFRS), as well as being responsible for the endorsement and adoption of IFRS for use by UK companies. As part of its contribution to the international debate, the UKEB initiated a research project on the subsequent measurement of goodwill in November 2021.
The UKEB’s research project demonstrates its evidence-based approach to its thought leadership work. The project explored what the potential impact on UK stakeholders would be if the IASB’s current impairment-only model for the subsequent measurement of goodwill was to change to a hybrid model. The model would supplement indicator-only impairment testing with a requirement for annual amortisation over a useful economic life together with additional supporting disclosure.
Giles Mullins, UKEB board member, says: “Through original research and extensive stakeholder consultation, the UKEB’s research project will contribute thought leadership to influence the international debate on the subsequent measurement of goodwill.”
Inflated balance sheets under impairment-only model
Empirical evidence included in the UKEB Secretariat’s comment letter on the IASB’s 2020 Discussion Paper DP/2020/1 Business Combinations – Disclosures, Goodwill and Impairment showed that goodwill had increased by 69% for the FTSE 350 since the introduction of an impairment-only model for IFRS reporters in 2005. In addition, evidence showed that under the impairment-only model, goodwill was not impaired as might have been expected under challenging economic conditions, such as the 2007-08 global financial crisis.
The comment letter (summarised in the box, below) concluded that the impairment-only model could be resulting in the balance sheets of some companies being over-inflated. It also recommended that a hybrid model should be explored, as an alternative to the IASB’s recommendation to retain the impairment-only model.
UKEB Secretariat response to IASB’s Discussion Paper |
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| The UKEB Secretariat’s 2021 comment letter on the IASB’s Discussion Paper DP/2020/1 Business Combinations – Disclosures, Goodwill and Impairment recommended exploring a hybrid model for the subsequent measurement of goodwill. This extract explains why. | |
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Our research shows that goodwill is a significant and increasing balance for UK companies and that goodwill balances did not fluctuate as might have been expected given changing economic conditions between 2005 and 2019. |
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The widespread concern about the reliability of increasing goodwill balances is evidenced by the Discussion Paper’s proposal to present a subtotal of total equity less goodwill in the balance sheet. The rationale for the proposal is that there are unavoidable limitations of impairment testing when goodwill is allocated to groups of cash-generating units. |
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We believe that addressing the measurement of goodwill, in conjunction with providing useful information, would be a better solution than highlighting its riskiness. |
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The risks of management optimism and shielding (through allocation of goodwill to large cash-generating units and large groups of cash-generating units), which are inherent in the impairment-only model have the potential to cause over-inflation of balance sheets. Without the introduction of amortisation as part of a mixed model, we anticipate that goodwill balances will continue to grow, risking faithful representation through the potential overstatement of goodwill. |
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A mixed model would provide more reliable measurement of goodwill than an impairment-only model because amortisation is applied to individual goodwill balances, thus removing the shielding effect, and a sufficiently robust impairment test would ensure that balances are not carried above their recoverable amount. |
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A mixed model would provide a more faithful representation by showing goodwill as a wasting asset and amortising goodwill through profit or loss over the period in which benefits are consumed. A further potential benefit would be reduced risk of financial shock caused by delayed recognition of impairment. |
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An amortisation-only model could mask risk by simply applying a mechanical amortisation charge over a set period. |
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When combined with our recommended disclosure of goodwill movement, which would provide insight into the age of goodwill balances and the acquisitions they relate to, a mixed model would improve the usefulness of information for investors. |
The UKEB’s research project
The initial phase of the UKEB’s research project on the subsequent measurement of goodwill was in response to a request from the IASB project team and explored potential impacts on financial stability in the UK if amortisation of goodwill were to be reintroduced. Areas such as regulatory compliance, distributable profits and ability to comply with debt covenants were explored, including via a public survey. The UKEB’s response concluded that a potential transition to a hybrid model for subsequent measurement of goodwill would be unlikely to have a major impact on the financial stability of UK-based IFRS reporters because the subsequent measurement of goodwill does not typically impact regulatory compliance, distributable profits or the ability to comply with debt covenants. The majority of survey respondents did not anticipate major operational changes if there were to be a transition.
Material impact
While the research identified that a transition to a hybrid model would be unlikely to have a major impact on financial stability, it did identify that such a transition could have a material impact on the financial statements of UK-based IFRS reporters, given the size of some goodwill balances. However, the research concluded that this was not a compelling reason to defer any potential transition. If the growth trend in goodwill were to continue, transitional impacts would only increase in future.
Determining the useful life of goodwill
The initial phase of the research also explored how the useful life of goodwill is determined for amortisation purposes. Under UK GAAP, goodwill is subject to annual amortisation and indicator-based impairment testing. The UKEB analysed the financial statements of the UK’s largest UK GAAP reporters to identify how they determine the useful life of goodwill for amortisation purposes. The project team found that a range of specific and relevant factors are considered by management. In some cases, the period over which synergies are expected to be realised is considered. In other cases, the strength of acquired brands is a significant factor.
Further examples noted legal, regulatory and contractual provisions are considered in determining the useful life of goodwill. As well as exploring the factors that management could consider in determining the useful life of goodwill for amortisation purposes under a hybrid model, the UKEB also considered how they might vary for different acquisitions and components of goodwill.
Useful information for investors
The UKEB subsequently undertook a field-test and further desk-based research, with the aim of understanding how a hybrid model can provide information that is useful for investors and users of financial statements. Outreach to investors identified that disclosures on assumptions underpinning the useful life of goodwill and on the age of goodwill balances could provide useful insights, which would help foster debate with companies on the rationale for and subsequent performance of acquisitions. Field-test participants also shared their views on the relative merits of prospective and retrospective application, and the cost and resource implications of a potential transition.
Research paper
The UKEB’s project on the subsequent measurement of goodwill will culminate in a research paper, which, at the time of writing, the UKEB intends to publish in July 2022. To receive a copy, email contact@endorsement-board.uk
Project on wider intangibles
The UKEB is also commencing a research project on the larger issue of accounting for intangibles. The increasing importance of intangibles to the modern economy is widely recognised. At the same time, there has been significant discussion about the shortfalls of IFRS in relation to accounting for them. The IASB has acknowledged these concerns and a project on intangibles will be added to the IASB’s research pipeline. The UKEB will be talking to stakeholders and undertaking desk-based research to support its influencing work on the future accounting for intangibles to ensure it is for the UK’s long-term public good.
The UKEB welcomes input from UK IFRS preparers, auditors and users of financial statements. Find out more about how you can participate in the research project on intangibles and other UKEB projects by registering for the UKEB subscriber alert at contact@endorsement-board.uk and visiting endorsement-board.uk
The full response can be found here.
By All Accounts July 2022
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