Accounting

Better Information on Business Combinations: Disclosures, Goodwill and Impairment

The Chartered Accountant • June 2020 • pp. 63–70 (Journal pp. 1595–1602)

CA. Ekta Gurnasinghani & CA. Anjali Butani

The authors are members of the Institute. They can be reached at asb@icai.in and eboard@icai.in.

Written under guidance of CA. Vidhyadhar Kulkarni

“Few years after issuing IFRS 3, Business Combinations, the International Accounting Standards Board (IASB)¹, initiated an assessment called as Post-Implementation Review (PIR) to understand whether the standard was working as intended. Business combinations referred to as mergers and acquisitions are often large transactions and play central role in the global economy. Hence, it was important for the IASB to understand the stakeholders’ concerns in regard to the said standard. Basis the feedback received during the PIR of IFRS 3, the IASB decided to initiate a research project called ‘Goodwill and Impairment’ to explore the possible improvements in IFRS 3 and IAS 36, Impairment of Assets.

In March 2020, the IASB published the Discussion Paper (DP) Business Combinations: Disclosures, Goodwill and Impairment. Read on…”

Background and History

A common way for an entity to expand its operations is by acquiring another company or business i.e. mergers and acquisitions. However, acquisitions do not always perform in subsequent years as per management’s initial expectations and hence, investors would like to know more about how an acquisition is performing in relation to such expectations. It is important that entities disclose requisite information of these transactions to the users of financial statements in their annual reports. In 2004, the IASB issued revised version of IFRS 3, replacing IAS 22, thereby setting out the accounting aspects of these transactions. The IASB noticed that, the users of financial statements claim that disclosures required by IFRS standards about business combinations do not provide sufficient information for them to understand how the acquired business is performing post-acquisition. In 2013, the IASB, sought stakeholders’ feedback on specified matters as part of Post-Implementation Review (PIR) of IFRS 3.

Due Process Note: As part of the IASB’s due process, a PIR is performed after a new Standard or major amendment to a Standard has been applied internationally for at least two years. The purpose of a PIR is to identify whether the Standard or amendment is working as intended by the IASB.

In 2015, having reviewed the stakeholders’ feedback and academic research, the IASB identified the issues/ topics for further research and follow up. In 2018, based on the key findings from their research, the IASB decided to pursue identified objectives for follow-up work for the project. In March 2020, the IASB issued the Discussion Paper – Business Combinations: Disclosures, Goodwill and Impairment.

Through this project, the IASB is investigating how companies can provide users of financial statements with better information about mergers and acquisitions (business combinations) at a reasonable cost. This investigation includes the challenging question of how companies should account for goodwill after the business combination. Better information on the transactions of mergers and acquisitions will help users and investors assess the performance of the companies entering such transactions and hold management to account more effectively for their decisions to acquire those businesses.

Through the stakeholders, the IASB learned that impairment losses of goodwill are often not recognised on a timely basis and that impairment testing is complex and costly to perform. Few stakeholders were of the view that amortisation of goodwill should be reintroduced. Further, some stakeholders also pointed that the separate recognition and measurement of some intangible assets can be challenging. The Discussion Paper sets out IASB’s preliminary views on how to respond to the concerns raised by the various stakeholders.

Summary of Key Proposals – Improving Disclosures About Business Combinations

Stakeholders highlighted the fact that entities entering into transactions of mergers and acquisitions do not typically provide enough information about the performance of acquired business post its acquisition. Such information is important as this would help investors to access how effective company’s management is at acquiring businesses viz. identifying targets; paying the right price; integrating the acquired business and realising the benefits from the transactions. This will also enable the investors to hold management to account for its future acquisition decisions. Currently, IFRS 3, does not specifically require companies to disclose information about the subsequent performance of the acquisitions made by the entities. Hence, the IASB’s preliminary view is that it should develop proposals to help investors with the information they need about the acquired business including management’s objectives for acquisitions and mention how acquisitions have performed against those objectives. The IASB has also proposed some targeted improvements to some of the existing disclosures objectives and requirements in IFRS 3.

Further, the IASB in their preliminary views, also discussed the information entities must be required to provide that prove whether the objectives of business acquisition are met. IASB was of the view that no single metric could provide investors with adequate information for evaluating the subsequent performance of the acquisitions. As the acquisition cost is often relatively large, it is significant for the management of the acquiring company to internally monitor the acquisition. The IASB proposes the following disclosures about performance of acquisitions:

Proposed Performance Disclosures for Business Combinations
At the Acquisition date
  • Strategic rationale for acquisition
  • Objectives for the acquisition
  • Metrics for monitoring achievement of objectives
After the Acquisition date
  • Progress towards meeting acquisition objectives

The IASB further proposes to amend paragraph B64(d) of IFRS 3, wherein instead of disclosing the primary reasons for an acquisition, the entity should rather disclose the strategic rationale for undertaking an acquisition and management’s (Chief Operating Decision Maker (CODM)) objectives for the acquisition.

Therefore, the IASB’s preliminary view for the entities to disclose the following:

  • in the year in which an acquisition occurs, the metrics that management (CODM) will use to monitor whether the objectives of the acquisition are being met;
  • the extent to which CODM’s objectives for the acquisition are being met using those metrics, for as long as CODM monitors the acquisition against its objective;
  • if CODM does not monitor whether its objectives for the acquisition are being met, that fact and the reasons why it does not do so;
  • if CODM stops monitoring whether its objectives for the acquisition are being met before the end of the second full year after the year of acquisition, that fact and the reasons why it has done so;
  • if CODM changes the metrics it uses to monitor whether management’s (CODM’s) objectives for the acquisition are being met, the new metrics and the reasons for the change.
At Acquisition Date

Monitored by CODM: Disclose Objective

Not Monitored: Disclose reason for not monitoring

Within Two Years

Monitoring Continues: Disclose Progress

Monitoring ceases: Disclose reason for ceasing to monitor

After Two Years

Monitoring Continues: Disclose Progress

Monitoring ceases: No further action needed

Goodwill: Impairment and Amortisation

Before we understand the proposals stated by the IASB in the said context, let us first re-visit the concepts of Goodwill, Impairment and its accounting:

Goodwill and Impairment Explained

  • Goodwill is an asset recognised when one company acquires another company.
  • Goodwill reflects expected future economic benefits produced by acquired assets and liabilities in a merger or acquisition that are not recognised separately.
  • Each year, the company that makes the acquisition assesses whether the goodwill is impaired.
  • Applying IAS 36, Impairment of Assets, the impairment test of goodwill compares the carrying amount of the group of assets containing the goodwill to the recoverable amount of that group of assets (Cash-generating unit or CGU).
  • CGU is the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or group of assets.
Goodwill does not generate its own cash flow
Goodwill is tested for impairment as part of a CGU/group of CGUs
Any reduction in recoverable amount of CGU(s) is first charged against goodwill

Proposals in the Discussion Paper

During the feedback received on the PIR of IFRS 3 stakeholders were of the view that recognising impairment losses on goodwill provides useful information about the acquisition. However, the impairment losses on goodwill are often recognised too late, long after events that caused these losses. They also reported that impairment test is considered to be difficult and costly to perform.

In view of these concerns, the IASB considered:

(I) Whether the impairment test could be made more effective?

Few stakeholders informed the IASB that the impairment test does not identify impairment of goodwill on a timely basis. Upon analysis, the IASB identified two broad reasons for concerns about the possible delay in recognising impairment losses on goodwill:

  • Management optimism: Management’s estimates of future cash flows may be too optimistic. In the said regard, the IASB decided that the risk of over-optimism exists in any impairment test of CGUs and is not just restricted to CGUs that contain goodwill and it is an application issue that would not be resolved by amending the standard.
  • Shielding: Goodwill is ‘shielded’ from impairment by, for example, the headroom of a business with which an acquired business is integrated. Before we state the IASB’s preliminary views on shielding, it is important to understand “Shielding” and how it impacts the impairment testing and goodwill accounting.

Shielding – Illustration & Concept

Headroom is the amount by which the recoverable amount of a CGU exceeds the carrying amount of its recognised net assets. Headroom largely arises because not all of the value of a business is recognised on a company’s balance sheet. For example, a company’s balance sheet does not include some intangible assets that the company generates internally.

If the acquired business were run independently of the acquirer and tested for impairment separately, an impairment loss on goodwill would be recognised because the value (recoverable amount) of the acquired business is lower than its carrying amount.

However, if the acquired business is integrated with the acquirer’s business, as is often the case, the impairment test looks only at the combined business. In that case, despite the poor performance of the acquired business, no impairment loss is recognised because the recoverable amount of the combined business is higher than its carrying amount. The headroom of the acquirer’s business absorbs the decline in the recoverable amount of the acquired business, thus shielding the goodwill from impairment.

The IASB’s Preliminary Views on Reducing the Effect of Shielding:

  • The IASB explored whether it could design an impairment test that reduces the effect of shielding, resulting in earlier recognition of impairment losses on acquired goodwill.
  • The IASB’s preliminary view is that it is not possible to eliminate shielding from the impairment test because goodwill has to be tested for impairment together with other assets and these groups of assets could contain headroom.
  • If the impairment test is performed well, the test can be expected to achieve its objective of ensuring that the carrying amount of a group of assets containing goodwill as a whole is not higher than its recoverable amount.
  • Therefore, the impairment test cannot always signal how well the acquired business is performing. The IASB has developed the disclosures discussed above to meet investors’ need for timely information about the performance of acquisitions.
  • After extensive work, the IASB’s preliminary view is that significantly improving the effectiveness of the impairment test for goodwill at a reasonable cost to companies is not feasible. However, the IASB would welcome any suggestion stakeholders have for making the impairment test more effective.

(II) Whether goodwill should be amortised?

After deciding that the approach in IAS 36 for testing goodwill for impairment cannot be significantly improved at a reasonable cost, the IASB considered whether to develop a proposal to reintroduce amortisation of goodwill. In this context, the IASB has heard the following arguments from stakeholders who support either of the two approaches:

Amortising goodwill Retaining the impairment-only model
  • Feedback from PIR of IFRS 3 suggests that impairment test is not working as the IASB intended.
  • Carrying amounts of goodwill are overstated and, as a result, a company’s management is not held to account.
  • Amortisation is simple because it targets acquired goodwill directly, which the impairment-only model cannot.
  • Goodwill is a wasting asset, which reduces as the benefits are consumed. Amortisation is the only way to show the consumption of goodwill.
  • Amortisation would eventually make impairment testing easier and less costly because amortisation would reduce carrying amount of goodwill, making a large impairment less likely.
  • The impairment-only model provides more useful information than amortisation which is arbitrary—many investors would ignore it and many companies would adjust it from their results.
  • If applied well, the impairment test achieves its purpose of ensuring the combined carrying amount of the cash-generating unit (or group of units) to which goodwill has been allocated is not higher than the combined recoverable amount.
  • Benefits of goodwill are maintained for an indefinite period of time, so goodwill is not a wasting asset with a finite life.
  • Amortising goodwill would not significantly reduce the cost of impairment testing, especially in the first few years.

There have always been divergent views on whether goodwill should be amortised or should only be tested for impairment. The IASB understands that both accounting models for goodwill—an impairment-only model and an amortisation model—have limitations. No impairment test has been identified that can test goodwill directly, and for amortisation it is difficult to estimate the useful life of goodwill and the pattern in which it diminishes. The IASB reached a preliminary view that it should retain an impairment-only approach, but this was by a small majority and so the IASB would particularly like stakeholders’ views on this topic. The IASB have stated that stakeholders are invited to provide new arguments to help the IASB decide how to move forward on this topic.

(III) Whether the impairment test could be simplified?

Having reached a preliminary view that it should retain an impairment-only approach, the IASB thought to simplify the impairment test to address some of the concerns raised by stakeholders, without making the test significantly less robust. The IASB considered proposals intended to make the impairment test less costly and less complex, while improving some aspects of the information it provides:

1. Relief from the Annual Impairment Test

A company is required to perform annual quantitative impairment test of CGUs containing goodwill, even if there is no indication that the CGUs may be impaired. Some stakeholders have informed the IASB that performing the impairment test is complex, time-consuming and costly because it has to be done annually, irrespective of whether there is any indication of impairment. Stakeholders have also stated that the impairment tests requires significant judgements and that the benefits are limited as goodwill is not tested for impairment directly and thus, may not always justify its cost. Stakeholders have suggested that impairment testing of goodwill should be necessitated only when there is a triggering event to indicate possible impairment.

The IASB considered the feedback of stakeholders and thereby deliberated factors such as the cost savings from providing that relief, whether that relief would make the impairment test less robust and whether the same relief should apply for intangible assets with indefinite useful lives and intangible assets not yet available for use.

The IASB’s preliminary view is that it should remove the mandatory annual quantitative impairment test of CGUs containing goodwill. Instead, companies would be required to perform quantitative tests only when there is an indication of impairment. This change would reduce the cost of performing the impairment test. This proposal would also apply to intangible assets with indefinite useful lives and intangible assets not yet available for use. As a company is required to assess at the end of each reporting period whether there is any impairment indication, this would place more reliance on identifying indicators of impairment. Hence, the IASB plans to evaluate whether the list of indicators in paragraph 12 of IAS 36 needs to be updated.

2. Value in Use – Future Restructuring or Enhancement

In measuring value in use, IAS 36 requires a company to estimate cash flow projections for an asset in its current condition. IAS 36 restricts these cash flow projections in a manner that they are required to exclude future cash flows expected to arise from a future restructuring to which the company is not yet committed, or to arise from improving or enhancing the asset’s performance. Stakeholders have explained to the IASB that determining which cash flows to exclude makes the test costly and complex. Moreover, excluding such cash flows requires management to adjust its financial budgets or forecasts.

The IASB considered this request and expects that removing the restriction on these cash flows would reduce cost and complexity, make the impairment test less prone to error and make the impairment test easier to understand and perform. Accordingly, the IASB’s preliminary view is that it should develop a proposal to remove from IAS 36 the restriction on including cash flows arising from a future restructuring to which a company is not yet committed or from improving or enhancing an asset’s performance. The cash flow forecasts would still need to be reasonable and supportable. This proposal would apply to all assets and CGUs within the scope of IAS 36.

3. Value in Use – Post-Tax Cash Flows and Discount Rates

In measuring value in use, IAS 36 requires a company to estimate pre-tax cash flows and discount them using pre-tax discount rates. It also requires disclosure of the pre-tax discount rates used. Stakeholders have indicated that determining pre-tax discount rates is costly and complex. Further, pre-tax discount rate is hard to understand, is not observable and does not provide useful information because in practice, valuations of assets are generally performed on a post-tax basis.

The IASB expects removing the requirement to use pre-tax cash flows and pre-tax discount rates would provide more beneficial and understandable information that can be aligned with management estimates and industry practices. This would also better align value in use in IAS 36 with fair value in IFRS 13 Fair Value Measurement and maintain consistency with an amendment made in 2008 to IAS 41 Agriculture (for the discount rate) and an amendment to IAS 41 (for cash flows) proposed in 2019. The IASB’s preliminary view is to develop a proposal to remove the explicit requirement to use pre-tax cash flows and pre-tax discount rates in estimating value in use. The IASB would require an entity to use internally consistent assumptions for cash flows and discount rates and disclose the discount rates used, irrespective of whether value in use is estimated on a pre-tax or post-tax basis. This proposal will apply to all assets and CGUs within the scope of IAS 36.

Other Topics

Recognising Acquired Intangible Assets Separately from Goodwill

Paragraph B31 of IFRS 3 requires an acquirer to recognise, separately from goodwill, all identifiable intangible assets acquired in a business combination. The majority of other stakeholders—mainly preparers, auditors and standard-setters—responding to the PIR of IFRS 3 provided mixed views on recognising intangible assets separately from goodwill.

Useful Information Arguments:
  • The information provides a better basis for understanding what a company has paid for; and
  • Separate recognition also ensures that intangible assets with a finite useful life are recognised separately and amortised.
Not Useful Information Arguments:
  • Valuing intangible assets is complex, subjective and costly;
  • Some intangible assets such as brands and customer lists are difficult to identify and value;
  • Similar intangible assets are not recognised if they are generated internally.

The IASB, therefore, considered stakeholders’ feedback about recognising intangible assets separately from goodwill. However, in the IASB’s view there is no compelling evidence to change existing requirement. Further, aligning the accounting treatment for all intangible assets is beyond the scope of this project. Accordingly, the IASB’s preliminary view is that it should not develop a proposal to change the recognition criteria for identifiable intangible assets acquired in a business combination.

Total Equity Excluding Goodwill

Goodwill is different from other assets because it can only be measured indirectly and cannot be sold separately. Presenting total equity excluding goodwill on the balance sheet helps to draw attention to companies whose goodwill constitute a significant portion of their equity, and make this amount more prominent.

The IASB’s preliminary view is that it should develop a proposal to help investors better understand companies’ financial positions by requiring companies to present on their balance sheets the amount of total equity excluding goodwill. There may be some presentation issues in terms of accommodating the amount of total equity excluding goodwill into the balance sheet format. However, the IASB is deliberating other ways in which a company could present the amount on the balance sheet. For example, the amount of total equity excluding goodwill could be presented on the balance sheet as a free-standing amount.

XYZ Group – Extracts from Statement of Financial Position as at 31 March 20XX:
Total Equity INR 10,000 Crores
Goodwill INR 3,000 Crores
Total equity excluding goodwill INR 7,000 Crores

Overall Package of Preliminary Views & What Next

IASB’s package of preliminary views is intended to achieve a balance between: (1) reducing costs for companies; (2) providing more useful information; and (3) allowing investors to hold management to account.

Dimension Summary of Key Proposals
Overall Package of Preliminary Views
  • Better disclosures about business combinations
  • Cannot make the impairment test more effective at a reasonable cost
  • Should not reintroduce amortisation of goodwill but the IASB would welcome any new arguments or new evidence that stakeholders have on this topic
  • Should provide relief from the mandatory annual quantitative impairment test
  • Should improve the calculation of value in use
  • Should continue to require identifiable intangible assets to be recognised separately from goodwill
  • Should introduce a requirement to present total equity before goodwill
What Next
  • IASB’s deadline for comments on the Discussion Paper is 31 December 2020.
  • IASB is mainly seeking comments on: (a) the usefulness and feasibility of its new disclosure ideas; and (b) new evidence or arguments on how to account for goodwill.
  • IASB would undertake comment letter analysis and redeliberation in H1 2021 whether to develop an exposure draft containing proposals to implement any or all of its preliminary views.
  • IASB is also considering stakeholders outreach by way of (virtual) roundtables in various jurisdictions for all stakeholders and focused investor outreach.

What is ICAI doing?

  • On 30th April 2020, the Accounting Standards Board (ASB) of ICAI with the aim to provide an opportunity to the various stakeholders in India to raise their concerns at the initial International Standard-setting stage itself, has invited comments on the Discussion Paper issued by the IASB: https://www.icai.org/new_post.html?post_id=16468&c_id=219
  • Comments should be submitted using one of the following methods, so as to be received not later than 30th June 2020:
  • The ASB also proposes to organise webcasts on the said Discussion Paper, details of which would be announced in due course.

Is there a similar project at Financial Accounting Standards Board, US?

  • IFRS 3 was developed in a joint project with the FASB and is converged in many respects with US GAAP on this topic.
  • On July 9, 2019, the FASB staff issued an Invitation to Comment (ITC) to obtain input from stakeholders focusing on public business entities on the subsequent accounting for goodwill, the accounting for certain identifiable intangible assets, and the scope of the project on those topics.
  • The comment period for this ITC ended on October 7, 2019 and one-hundred three letters were received.
  • The FASB will consider comment letter feedback on the Invitation to Comment at a future Board meeting.
  • FASB’s updates on this project can be accessed at https://www.fasb.org/jsp/FASB/FASBContent_C/ProjectUpdateExpandPage&cid=1176171566054#. ■■■