As we addressed previously, the IASB has published “a Discussion Paper on possible improvements to the information companies report about acquisitions of businesses to help investors assess how successful those acquisitions have been.”
We noted before that the IASB “has concluded that there is no alternative that can target goodwill better and at reasonable cost.” Let’s look at that conclusion in a little more detail today. The discussion paper sets out “two broad reasons for concerns about the possible delay in recognising impairment losses on goodwill:
- (a) management over-optimism—some stakeholders have concerns that management may sometimes be too optimistic in making the assumptions needed to carry out the impairment test.
- (b) shielding—a cash-generating unit, or group of cash-generating units, containing goodwill, typically contains headroom. The headroom shields acquired goodwill against the recognition of impairment losses.
On the first point, of management over-optimism, the Board concludes after considering the issue: “The risk of over-optimism cannot be avoided, given the nature of the estimates required. If estimates of cash flows are sometimes too optimistic in practice, the Board considers that this is best addressed by auditors and regulators, not by changing IFRS Standards. Academic research suggests that the recognition of goodwill impairment losses tends to be more timely for companies in countries with high levels of enforcement, supporting the view that enforcement can play an important role.” Various of the enhanced disclosure requirements proposed in the discussion paper could help auditors and regulators in tuning into the possibility of unrecognized impairments.
On the second point, the IASB uses the term “headroom” to refer to the aggregate of “items not recognized on the balance sheet: internally generated goodwill, unrecognized assets, and unrecognized differences between the carrying amount of recognized assets and liabilities and their recoverable amounts.” The risk exists that: “An acquisition could therefore underperform against management’s expectations, but the company would recognize no impairment of acquired goodwill if it has sufficient headroom to absorb the reduction in value. Shielding of the acquired goodwill with, for example, headroom that was in the acquirer’s business before the acquisition and that is therefore unrelated to the acquired business, could be why some stakeholders say that impairment losses on acquired goodwill are not recognized on a timely basis.”
The Board considered the possibility of incorporating an estimate of this “headroom” into the assessment of impairment, but basically concluded that such a path – whatever route it took – would add cost and complexity, and would always inevitably depend on estimation and its vagaries. And even under such an approach, it notes: “if the acquired business is performing poorly, better performance from other elements of the combined business could still shield the acquired goodwill from impairment.”
The board also considered the merits of reintroducing a form of amortization for goodwill, concluding that it shouldn’t go that way, but only by the narrowest possible majority – eight out of fourteen members. These are the main arguments against such a move:
- (i) although the impairment test does not test goodwill directly, recognizing an impairment loss provides important confirmatory information, even if delayed, that confirms investors’ earlier assessments that those losses have occurred, helping hold management to account. The useful life of goodwill cannot be estimated, so any amortization expense would be arbitrary. Therefore, investors would ignore it and amortization could not be used to hold management to account for its acquisition decisions.
- (ii) the Board should not reintroduce amortization solely because of concerns that the impairment test is not being applied rigorously or simply to reduce goodwill carrying amounts. In the view of some Board members, goodwill could be increasing for many reasons—for example, because of the changing nature of the economy and greater value being generated by unrecognised intangible assets.
- (iii) the Board has no compelling evidence that amortizing goodwill would significantly improve the information provided to investors or, particularly in the first few years after an acquisition, significantly reduce the cost of performing the impairment test.
Given the division of views, the IASB says it’s particularly interested in receiving impact on this topic, noting drily that “simply repeating the well-known arguments for these views is unlikely to move the debate forward; therefore, the Board would welcome feedback that provides new practical or conceptual argument.”
Well, I certainly won’t be submitting any argument against their main conclusions, as I’ve never believed that any alternative approach can evade the inherent challenges of relying on complex estimation process, overseen by management who may be motivated in one direction or another. More disclosure may certainly be part of the answer, but so for that matter is more realism and skepticism on the part of users. Recall another recurring concern, that the average balance sheet inadequately captures a company’s real resources, for example by insufficiently recognizing internally-generated intangible assets. If we’re ever to make headway on that front (or to engage more fully with environmentally-related costs, for another example) we’re going to have to regard financial statements less as hermetic accounting mechanisms and more as a conversation about the future, with all the inherently well-intentioned imperfection of any other conversation…
The opinions expressed are solely those of the author.