BS- Thesis

In Business Administration

Good Will

Callista

Bjarni Frímann Karlsson, lektor

June 2018

Good Will

Callista

Bs-Thesis

In Business Administration

University of Iceland

Faculty of Business Administration

Instructor: Bjarni Frímann Karlsson

June 2018

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Good Will.

This thesis is 6 credit final project to BS of Business Administration,

University of Iceland.

© 2018 Callista

This Thesis may not be reproduced without the author’s permission.

Print: Háskolaprent.

Reykjavík, 2018

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Abstract

As a growing concern about a trend of international accounting standards, this paper

focuses on analyzing the accounting for intangible assets, especially goodwill. There are some

questions that need to be addressed are (1) whether there should be any difference in the

accounting treatment for tangible and intangible assets; (2) whether it is different from

intangible assets which makes a separate accounting standard, or accounting rules. To do so, I

identify and explain the major concepts and principles of International Financial Reporting

Standards (IFRSs) and current issues related to intangible assets with the specific view on

goodwill in various aspects. Particularly, key regulatory, concepts, current issues of goodwill are

summarized, analyzed and discussed to give recommendations. How to measure internally

generated goodwill in proper ways, goodwill allocation or impairment tests of goodwill are

typical are noticeable issues in this paper.

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TABLE CONTENT

INTRODUCTION ............................................................................................................................... 6

1. Overall view of International Accounting Standards (IASs) and International Financial

Reporting Standards (IFRSs) ............................................................................................................ 8

2. Goodwill and relating accounting framework ......................................................................... 8

2.1. The nature of intangible assets – IAS 38 .......................................................................... 9

2.2. Goodwill and internally generated assets ........................................................................ 9

2.3. Why have intangible assets as well as goodwill become important? ........................... 12

3. Goodwill and accounting treatments and rules .................................................................... 14

3.1. Recognition and initial measurement ............................................................................ 14

3.2. Measurement subsequent to initial recognition ........................................................... 16

3.3. Application of IFRS 3 in practice – Goodwill only........................................................... 19

3.4. Impairment ..................................................................................................................... 19

3.5. Disclosure ....................................................................................................................... 24

4. Discussions on accounting treatment for goodwill ............................................................... 26

4.1. Techniques for recognition for internally generated intangible assets ......................... 27

4.2. Impairment issues related to good will.......................................................................... 28

CONCLUSION ................................................................................................................................. 30

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Table of Figures

Figure 1: the trend of price-to-book ratio of S&P 500 from 2000 to 2017 .................................. 12

Figure 2: Mergers and acquisition transactions in the business world ........................................ 13

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INTRODUCTION

In current years, there has been a growing concern expressed over a trend of globalization.

Consequently, business activities have been taking place not only within its home country but

also other countries following global business transactions. Generally, making economic

decisions require to concentrate on multiple international factors such as differences in

regulation and law, which definitely have impacts on business risks of legal entities. Particularly,

international standards can offer lower cost of preparing and reviewing companies’ financial

statements, and as a consequence, may robust investors’ decisions. However, because of

different interests between different groups, entities, and countries including government

officials, investors, creditors, accountants, and auditors, there are controversial discussions

around the standardization process of international accounting framework (Radebaugh and

Gray, 2006). Additionally, all factors comprising culture, legislation, accounting bodies can also

be challenges. Therefore, the problem that confronts businesses, users of business and financial

reporting, standard-law makers and regulators is how best to understand and communicate the

value of a company (both book value and fair value).

In analyzing the accounting for intangible assets, especially goodwill, there are some

questions that should always kept in mind are (1) whether there should be any difference in the

accounting treatment for tangible and intangible assets; (2) whether it is different about

intangible assets which makes a separate accounting standard, or accounting rules. The

International Accounting Standards Board (IASB) believes it is necessary to distinguish these

questions (Picker R., Leo K., Loftus J, Wise V., Clark K, Alfredson K., 2013).

One of the most common examples is the case of Enron. At as 31 December 2000, the

market-to-book gap of Enron’s intangible assets was approximately $64 billion. Nonetheless,

Lev (2002, pp. 133-4) argued that this was not reflected intangibles. Based on his argument, the

appropriate evidence that there was a lack of substantial intangible assets which its demise

made hardly a ripple in the trading market of energy and had practically no impact on electricity

cost. “Intangibles, by definition, are unique factors of production that cannot be quickly imitated

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by competitors. The fact that Enron’s competitors quickly stepped in to fill the gap is

inconsistent with the existence of intangibles conferring on their owners sustained competitive

advantages” (Lev, 2002). Nowhere Enron did not have substantial intangible assets, and

earnings manipulation does not count as intangible ones.

The purpose of this essay is to identify and explain the major concepts and principles of

International Financial Reporting Standards (IFRSs) and current issues related to intangible

assets with the specific view on goodwill in various aspects.

The essay proceeds as follows. Part 1 briefly reviews the regulatory and IASB conceptual

framework. Part 2 introduces the related key characteristics of an intangible asset and goodwill

particularly. Criteria relating to recognition, measurement, and retirement and disposal,

including fair value, distinguishing between acquired and internally generated goodwill, and the

amortization principles are discussed in part 3. Applying the disclosure requirements of

International Accounting Standards in financial reporting relating to goodwill is presented in

part 4. Part 5 gives my conclusion.

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1. Overall view of International Accounting Standards (IASs) and International

Financial Reporting Standards (IFRSs)

Most of the developed countries have their own standard-setting bodies who are

responsible for devising and publishing accounting standards for the use of its own country. For

example, in the U.K, it is Accounting Standard Board (ASB), while the U.S has a Financial

Accounting Standard Board (FASB). The Boards are also available in other countries such as

Germany, Japan, Australia etc. Much as how strong each of the Board is, the increasing

globalization of business has sought a single set of accounting standards. Eventually, the

International Accounting Standards Board (IASB) has introduced and is continuing to set and

develop a single set of international accounting standards. These standards are actually used in

a number of countries.

IASB was formed in 2001 as a board of international standards’ setting and a replacement

for the International Accounting Standards Committee (IASC). IASB published standards which

are well-known as International Financial Reporting Standards (IFRSs), and International

Accounting Standards (IASs) were originally issued by IASC. Many of these IASs are still practical

due to the adoption of the IASB on its inception. As mentioned earlier, accounting standards

aim to reduce or eliminate gaps in accounting practice and to introduce the applying of

financial reporting under a degree of uniformity. Particularly, accounting standards usually set

out requirements regarding the recognition, measurement, presentation and disclosure of

transactions in financial statements. These requirements are satisfactory for faithful

representation and comparability.

2. Goodwill and relating accounting framework

Basically, goodwill is covered by few accounting standards including

▪ IAS 38 – Intangible assets for definition and basic accounting treatment;

▪ IFRS 3 – Business combination for goodwill purchase;

▪ IFRS 13 – Fair value measurement;

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▪ IAS 36 – Impairment of assets;

2.1. The nature of intangible assets – IAS 38

IAS 38 covers the accounting for most of the intangible assets excluding financial

assets, mineral resources’ rights. IAS defines an intangible asset as “an identifiable, non-

monetary asset without physical substance” (IAS 38, 2004, paragraph 12). In particular,

an item must satisfy these main features to be defined as an intangible asset: (1) being

an asset, which can generate future economic benefits and can be controlled; (2)

without physical substance; (3) non-monetary holding feature to distinguish from

financial assets; (4) identifiable.

Based on business practice, business intangible assets can be obtained from outside

purchase or internally generated within the company. IAS 38 does require the

separation between these two types of intangible assets. Following the practice,

goodwill can be obtained based on the two ways as well.

However, due to the fourth requirement of IAS 38, goodwill is outside the scope of

IAS 38, which is not identifiable. Generally, goodwill acquired in a business combination

is described in IFRS 3 – Business Combinations. These specific characteristics relating to

internally generated goodwill which are presented the next part.

2.2. Goodwill and internally generated assets

a. Internally generated goodwill

Overall, goodwill arises from factors such as an entity’s good reputation or strong

customer relationships, which is defined as internally generated goodwill.

Goodwill is definitely a very significant asset to many entities, especially research

and innovation ones, but accounting for goodwill leads to two main difficulties:

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(1) The initial recognition of goodwill

It is usually impossible to define reliably the cost or value of internally

generated goodwill, even if the fair value can be fairly measured. Based on IFRS

13, the fair value of goodwill could be measured by comparing the fair value of

a whole entity and subtracting the sum of fair value of assets and liabilities

relating to that company. However, under IAS 38, identifiable intangible assets

as well as goodwill must initially be recognized at cost, not fair value.

Therefore, internally generated goodwill fails one of the recognition criteria

specified in the Conceptual Framework – having a cost or value that can be

measured with reliability (IAS 1, 2007). This challenge does not arise if goodwill

is purchased in case of business acquisition, or put it another way, goodwill can

be recognized only when it is acquired as part of a business combination,

which is measured in accordance with IFRS 3 – Business combination.

(2) The measurement of fair value

It may be easy to damage or destroy the value of goodwill as it is vulnerable

asset.

Therefore, it is noted in paragraph 11 of IAS 38 in this regard: “The definition of an

intangible asset requires an intangible asset representing to be identifiable to

distinguish it from goodwill. Goodwill recognized in a business combination is an

asset representing future economic benefits arising from other assets acquired in a

business combination that are not individually identified and separately

recognized. The future economic benefits may result from synergy between the

identifiable assets acquired or from assets that, individually, do not qualify for

recognition in the financial statements.” (IAS 38)

b. Goodwill in a business combination

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In general, accounting relating to “business combinations” must be required to

follow the application of IFRS 3 – Business combination. The business combination

transaction can happen following two cases:

(1) The acquirer buys net assets which together from a business;

(2) The acquirer buys the shares of other companies and so forms a parent-

subsidiary relationship.

Following IFRS 3, goodwill is considered as “an asset representing the future

economic benefits arising from assets acquired in a business combination that are

not individually identified and separately recognized” (IFRS 3, 2004). The goodwill

under case (1) should be recognized as an asset in the financial statements of the

acquirer. The goodwill under case (2) should be represented in the consolidated

financial statements of the acquirer. IFRS 3 also requires the value of goodwill at

fair value, which is repeated in the definition of fair value in IFRS 13 “the price that

would be received to sell an asset or paid to transfer a liability in an orderly

transaction between market participants at the measurement date” (IFRS 13,

2004).

Goodwill is, as a result, a residual after recognition of identifiable intangible asset,

tangible assets, and liabilities of the acquiree.

It can be stated that:

Goodwill = Consideration transferred – Net fair value of identifiable assets and

liabilities

The components of fair value measure of goodwill will be discussed in part 3.

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c. Negative goodwill

Under an acquisition, if the offer price is lower than the net fair value of the

identifiable assets and liabilities acquired, it would incur a “negative goodwill”.

There are two potential causes of the situation as follows.

(1) Errors in determining the fair value of target company;

(2) The acquirer may have got a “bargain purchase”.

According to the first paragraph of IFRS 3, it should be a reassessment of offered

fair value and the fair value observed from market when incurring negative

goodwill. Furthermore, any negative goodwill which remains after the

reassessment should be treated as income and comprised in the acquirer’s profit

and loss statement.

2.3. Why have intangible assets as well as goodwill become important?

For quite some time, an analysis of the price-to-book ratio can reveal the importance of

intangible assets. The chart below shows the trend of price-to-book ratio of S&P 500

from 2000 to 2017. It can be seen that the ratio is great higher than one (1), which

meant that the market capitalization increased relative to book values. This economic

phenomenon occurred despite the development of a growing number of accounting

standards striving to insure reported financial information would be true and fair

represented.

Figure 1: the trend of price-to-book ratio of S&P 500 from 2000 to 2017

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Source: S&P 500

In an analysis of Karsan (2009), there was a shift regarding to industries in the S&P 500,

with a decline in manufacturing companies while knowledge-based companies (e.g.

software, consulting, services etc.), where soft-asset are a determining factor, comprise

a larger portion of the index. Additionally, the increasing investment in intangible assets

was also noted in paper of Corrado and Hulten (2010). Particularly, there was a drop in

tangible investment from 11.1% to 10% in 2007, meanwhile intangible enjoyed a sharp

increase from 4.5% to 13.7% during the same period.

What is more, there have been more and more mergers and acquisition transactions in

the business world. As a consequence, there is an increasing value of goodwill arising

from business combinations.

Figure 2: Mergers and acquisition transactions in the business world

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3. Goodwill and accounting treatments and rules

This part will focus on discussions about accounting method and accounting rules for

goodwill. An example of goodwill calculation under a case of acquisition is provided in this

part as well.

3.1. Recognition and initial measurement

a. Measurement and relevance issues

In the work of Johnson and Petrone (1998) they define six components of goodwill for

measurement and recognization. The six components are:

(1) “Excess of the fair values over the book values of the acquiree’s recognized

assets”. Particularly, there should not be any excesses since acquired assets are

measured at fair value in an acquisition transaction. However, the goodwill from

acquisition should include such excesses if these assets are measured at book

value.

(2) “Fair values of other net assets not recognized by the acquiree.” The assets which

are taken into account are those intangible assets which cannot be observed

reliably, and non-physical assets that are not satisfied the identifiability

requirement of intangible assets.

(3) “Fair value of the ‘going concern’ element of the acquiree’s existing business”.

This element shows the ability of the acquired assets to create a higher return on

an assembled collection of net assets than the one from operating net assets

separately. This also reflects the strength of synergies from acquisition.

(4) “Fair value from combining both of the acquirer’s and acquiree’s business and

net assets”. The fair value created from the synergies is unique to each

combination.

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(5) “Overvaluation of the consideration paid by the acquirer”. This component is

related to errors in valuation of any transactions related to business

combination.

(6) “Overpayment or underpayment by the acquirer.” This may incur under a case of

bidding, and in contrast, goodwill could be understated if the net assets of the

acquiree were defined through distress or fire sale.

Note that the two components (3) and (4) are described as “going-concern goodwill”

and “combination goodwill” by Johnson and Petrone (1998). Moreover, the combination

of the two components above is referred to as “core goodwill” about which IASB

concerns determining which way to account. However, IASB recognized these other

components are not conceptually part of goodwill in paragraph BC130 and BC 131 of the

Basis for Conclusion on IFRS 3. Therefore, in paragraph BC137 of the Basis for

Conclusion on IFRS 3, IASB concludes how IFRS 3 tries to avoid subsuming the (1), (2), (5)

components into defining goodwill by requiring an acquirer to make every effort to:

• Accurately measure the consideration to eliminate or reduce problems related

to component (5);

• Point out fair values of identifiable assets rather than their book value to

eliminate or reduce problems related to component (1);

• Recognize all intangible assets of the acquisition transaction to reduce

component (2).

After considering all the components of goodwill suggested and discussed by Johnson

and Petrone (1998) and IASB, it is natural to claim that whether goodwill is an asset. In

practice, this question raises many controversial discussions. Particularly, based on IFRS

3, goodwill is accounted as an asset, but “core goodwill” is still in question. There are

various papers in the accounting literature review that discuss this issue due to its

various source of debating. One of the key issues of debating is whether the firm has

control over the benefits which are generated from goodwill.

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One of the accounting standard-setting bodies – the Accounting Standard Board in the

U.K in 1997 – harbors the view that goodwill is not an asset (Financial Reporting

Standard 10 Goodwill and Intangible Assets). It is stated that: “Goodwill arising on

acquisition is neither an asset like other assets nor an immediate loss in value. Rather, it

forms the bridge between the cost of an investment shown as an asset in the acquirer’s

own financial statements and the values attributed to the acquired assets and liabilities

in the consolidated financial statements. Although purchased goodwill is not in itself an

asset, its inclusion amongst the assets of reporting entity, rather than as a deduction

from shareholders’ equity, recognizes that goodwill is part of larger asset, the

investment, for which management remain accountable.” Similarly, the IASB states, in

its paragraph BC323 of the Basis for Conclusion on IFRS 3, that goodwill arising from

uncontrolled factors such as having well-trained workforce or loyal customers is not

seen as controllable by the firms and thus the goodwill is not an asset.

Moreover, in the work of Leo, Hoggett and Radford (1995), the measurement of

goodwill is seen as the key difference between identifiable net assets and goodwill. The

authors claim unidentifiable assets as those assets that meet the recognition

characteristics and cannot be measured without measurement of total net assets of the

business entity. Therefore, the existence of goodwill depends on how the entity is

measured as a whole. With regard to this recognizing, the IASB argues in its work BC323

of the Basis for Conclusion on IFRS 3 that: “control of core goodwill is provided by means

of the acquirer’s power to direct the policies and management of the acquiree.

Therefore, both of the IASB and the FASB concluded that core goodwill meets the

conceptual definition of an asset.”

3.2. Measurement subsequent to initial recognition

This part focuses on accounting treatment for goodwill when an acquisition transaction

incurs. As mentioned earlier, goodwill is defined as the excess of offered value in

business combination over the acquirer’s interest in the net fair value of the identifiable

assets and liabilities.

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For example, the acquisition between ABC Ltd and XYZ Ltd is considered as at 1st January

2013. At this date, XYZ is acquired by ABC, with XYZ going into liquidation (Bloom, 2009).

The terms of acquisition are as follows:

• ABC is to acquire all the assets of XYZ Ltd as well as the account payable of XYZ

Ltd.

• Costs of liquidation of $450 are to be covered by XYZ with supported fund from

ABC Ltd.

• Preference shareholders of XYZ are to receive two fully paid preference shares in

ABS Ltd for every three shares held, or alternatively, $1 per share in cash payable

at acquisition date. There were 6,000 fully paid shares.

• Ordinary shareholders of XYZ are to receive two fully paid ordinary shares in ABC

Ltd for every share held, or alternatively, $3.5 in cash, payable half at the

acquisition date and half on 31 December 2013. There were 30,000 fully paid

shares and discounted rate was 10% per year.

• Debenture holders of XYZ Ltd are to be paid in cash out of funds provided by ABC

Ltd. These debentures have a fair value of $103 per $100 debenture. Debenture

account was $4,000 as at 1/1/2013.

• All shares being issued by ABC Ltd have a fair value of $1.15 per share. Holders of

3,000 preference shares and 5,000 ordinary shares choose to receive the cash as

well.

• Fair values of identifiable assets and liabilities are as follows:

Equipment 35,000

Inventory 22,000

Account receivable 9,500

Patents 10,000

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76,500

Account payable (8,000)

Net fair value 68,500

As at 1/1/2013, consideration transferred is calculated as follows:

Cash Cost of liquidation 450

Preference shareholders (3,000 x

1.0) 3,000

Ordinary shareholders

- payable immediately (*) 8,750

- payable later (**) 7,955

Debentures, including premium 4,120 24,275

Shares Preference shareholders 2,300

Ordinary shareholders 57,500 59,800

84,075

(*) 0.5 x 5,000 x 3.5

(**) 0.5 x 5,000 x 3.5 x 1/1.01

Goodwill acquired calculation

Net fair value acquired 68,500

Consideration transferred 84,075

Goodwill 15,575

The Journal entry for ABC Ltd. at acquisition date are recorded as follows:

Items Debit Credit

Equipment 35,000

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Inventory 22,000

Account receivable 9,500

Patents 10,000

Goodwill 15,575

Account payable

8,000

Consideration Payable

24,275

Share Capital - Preference

2,300

Share Capital - Ordinary

57,500

3.3. Application of IFRS 3 in practice – Goodwill only

Based on paragraph BC158 of the Basis for Conclusions on IFRS 3, both the IASB and

FASB harbor the view that the quality of information in financial statements could be

enhanced if there is a distinction between intangible assets and goodwill in a business

combination. The reason behind the fact of not wanting to reduce goodwill and increase

the recognition of identifiable intangible assets can be not simply because of

amortization. In fact, goodwill is not subject to amortization under IFRS standards

although most identifiable intangible assets do not have reliable useful lives.

3.4. Impairment

After initial recognition of goodwill, impairment test is required in subsequent periods.

The subsequent accounting is directly mentioned in these accounting standards:

• IAS 36 – Impairment of assets. Much as goodwill is not subject to amortization

but it is required an annual impairment test.

• Note that goodwill cannot be revalued because of IAS 38 – Intangible assets –

does not accept the recognition of internally generated goodwill.

According to accounting standards, impairment test gets involved in comparison

between the carrying amount of an asset with its recoverable amount. In terms of

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recoverable amount, there are two noticeable amounts against carrying amount for

impairment test including (1) fair value less disposal value and (2) value in use. Following

the definition of recoverable amount, it refers to higher of the two amounts, but an

impairment test incurs when the carrying amount is higher than recoverable amount.

None the less, the measurement of both amounts is not always required for every

impairment test. In practice, the asset is not impaired when there is either one of the

two amounts which is higher than carrying amount. Under an active market condition, it

is probably easier for the firm to determine fair value less costs of disposal than to

calculate value in use. However, it is necessary to calculate the value in use if the

carrying amount exceeds the fair value less costs of disposal. To sum up, it should be

noted that:

• If recoverable amount < carrying amount, an impairment loss has incurred.

• If recoverable amount > carrying amount, there is no further action required.

a. Determining fair value less disposal value

It is clear that there are two parts in this determination including (1) fair value and

(2) cost of disposal.

• According to IFRS 13, fair value is defined as an exist price and can be

calculated by using various valuation methods.

• According to IAS 36, disposal costs are those costs which are directly related

to the sale of asset or getting the asset to be ready for sale. Any costs which

arise after the sale of the asset are not considered as costs of disposal.

b. Calculating value in use

In terms of value in use, it is generally accepted to define the term as the present

value of future cash flows which are generated by the asset being measured. As IAS

36, there are five (5) elements to be reflected in the calculation:

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• An estimation of the future cash flows related to the asset from which the

entity expects to derive;

• Expectations about possible variations in the amount or timing of these

future cash flows;

• The time value of money;

• The price for bearing the uncertainty inherent in the asset;

• Other factors.

In accounting for impairment losses of cash-generating units (CGU), IAS 36 has a specific

part for goodwill impairment test and how its existence affects the allocation of

impairment losses across the assets of a cash-generating asset. As mentioned earlier, it

is not easy to determine a reliable value for specific assets to be included in goodwill, or

to make it clearer, either the cash flows in association with that asset cannot be

measured in a reliable way or the cash flows are earned in conjunction with these other

assets. Therefore, the two common methods of impairment tests are not possible for

goodwill (determining fair value less disposal value, and value in use).

In a business combination, the goodwill acquired is allocated to one or more cash-

generating units, and thus goodwill impairment test is in accordance with the cash flows

generated by those assets. Making decision which units or assets should have goodwill

allocated to them is based on how the management team monitors that goodwill.

However, according to IAS 36, the goodwill should be allocated at the lowest level which

management monitors them. It is possible that the allocation of goodwill could be made

to each of the segments which are identified by managers. Nonetheless, once again, in

IAS 36, it is stated that the units to which goodwill is allocated should not be higher than

a segment based on either the firm’s primary or secondary reporting format.

Consistently, in the response to the FASB in relation to the impairment testing of

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goodwill, it is suggested that goodwill should be tested at the firm level in all cases, or at

least that option should be permitted.

If the recoverable amount exceeds the carrying amount (including goodwill), there is no

impairment loss, and vice versa when the carrying amount exceeds the recoverable one.

IAS 36 states that the impairment loss must be allocated to reduce the carrying amount

of the assets of the unit, or the group of units, in the following order:

• Firstly, to reduce the carrying amount of the goodwill allocated to that CGU;

• Second, to the other assets if the unit pro rate on the basis of the carrying

amount of each asset in the unit.

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For example, an entity has two CGUs, A and B. The impairment test of the two assets

are as follows:

Unit A Unit B

Identifiable assets 2000 1900

Goodwill 200 50

2200 1950

Recoverable amount 2500 1800

Impairment loss 0 150

When there is an impairment loss, the first step is to write-off the goodwill.

Debit Credit

Impairment loss 50

Goodwill

50

The remaining $100 impairment loss would be allocated across the identifiable assets of

unit B on a pro rata basis.

When it comes to timing of impairment test for goodwill, as noted earlier, goodwill has

been tested for impairment annually. Nonetheless, the test is not compulsory at the end

of reporting period. IAS 36 states that the test may be performed at any time during the

year, and consistently tested at the same time every year.

Reversal of an impairment loss for goodwill

Unlike other impairment loss, the treatment of a reversal of an impairment loss for

goodwill shall not be allowed in the later period, which is stated in paragraph 124 of IAS

36. The reason behind this decision is presented in paragraphs BC 187 – BC 191 of the

Basis for Conclusion on IAS 36.

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However, the main reason is because of the nature of goodwill. Specifically, it seems to

be impossible to define how much of any existing goodwill which is remaining acquired

goodwill or goodwill internally generated since the acquisition. The practice of allowing

an impairment reversal to increase the carrying amount of goodwill seems to be

considered as allowing the recognition of internally generated goodwill, or, “backdoor”

capitalization of internally generated goodwill (paragraph BC190, the Basis for

Conclusion on IAS 36). Note that according to IAS 38 – Intangible Assets, internally

generated goodwill is not allowed to be recognized.

On the other hand, some IASB members pointed out a potential inconsistency with

prohibiting the reversal of goodwill according to the ground of non-recognition of

internally generated goodwill and the allowance of IAS 36 of internally generated

goodwill. The standard setters come with the conclusion that the practice of shielding or

cushioning an impairment loss is not as bad as direct recognition of internally generated

goodwill under a condition of a reversal. However, it could be argued that some truth in

the accusation may exist where inconsistent accounting is allowed. In reality, the entity

that has acquired goodwill is effectively allowed to recognize internally generated

goodwill through the cushion effect in the test of impairment, while simultaneously

those companies that do not hold any acquired goodwill are not allowed to recognize

the internally generated goodwill.

3.5. Disclosure

Under a business combination case, it is required to disclose information related to

where the synergies exist will help management teams in controlling the earning from

goodwill as well as impairment test. In paragraph 134 of IAS 36, it is required to disclose

the estimation used to measure the recoverable amount of a cash-generating unit when

goodwill is consisted in the carrying amount of the CGU. If the carrying amount of

goodwill or intangible assets is not significant for a unit value, the fact is required to be

disclosed in paragraph 135 of IAS 36.

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Impairment disclosure for goodwill and intangible assets Paragraph

As impairment testing purposes, goodwill has been allocated into three

individual CGUs – two in the EU (units A and B) and one in the U.S. (unit

C) – and to one group of CGU (XYZ) in China. The carrying amount of

the goodwill which is allocated to unit C and XYZ is significant

compared with the related total carrying amount of goodwill, but such

a number of amount allocated to unit A and B is not. However, the

recoverable amounts of unit A and B are defined based on some of the

similar key assumptions, and the aggregated carrying amount of

goodwill which is allocated to those units is significant.

135

Operation XYZ

Assume that the carrying amount of goodwill allocated to the CGU is

$1,200. The recoverable amount of operation XYZ has been determined

to be $2.4m which is based on a value-in-use estimation, the

recoverable amount calculations are most sensitive to changes in these

assumptions as follows:

• Gross margin during the budget period (assuming 5 years)

• Exchange rate during the budget period

• Market share during the budget period

• Growth rate used to estimate cash flows within the period

These key assumptions are depended on the previous experience of

management team and reference to published market indicators and

economists’ forecasts.

The calculation of recoverable amount uses cash flow projections

based on financial budgets covering a 5-year period, and a discounted

rate of 8.4%.

Cash flows beyond that 5-year period have been estimated using a

steady 5% growth rate. This growth rate is not higher than the long-

term growth rate where XYZ operates. Management team believes that

134

(a)

(c)

(d)(i)

(d)(ii)

(d)(iii)

(d)(v)

(d)(iv)

(f)

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any reasonably possible change in these above key assumptions on

which XYZ’s recoverable amount is depended would not cause XYZ’s

carrying amount to exceed its recoverable amount.

Unit A and B

The two units A and B have an aggregate carrying amount of goodwill

of $700 which is allocated to them.

The recoverable amount of unit A and B have been calculated on the

basis value-in-use estimations. Those units produce complementary

products and their recoverable amounts are based on some of the

above assumptions, except for:

• Gross margin during the budget period (4 years)

These key assumptions are depended on the previous experience of

management team and reference to published market indicators and

economists’ forecasts

Management believes that any reasonably possible change in any of

these key assumptions would not cause the aggregate carrying amount

of A and B to exceed the aggregate recoverable amount of these units.

135

(a)

(c)

(d)

(e)

4. Discussions on accounting treatment for goodwill

Up to now, the accounting for internally generated intangible assets, including goodwill

is a controversial area for study. The AASB published a discussion paper “Initial

Accounting for Internally Generated Intangible Assets” in 2008.

This part shows some discussions on the proposals for change in accounting treatment

for intangible assets which are suggested in the discussion paper. Specifically, the

accounting treatment for internally generated intangible assets is the main

27

concentration of the discussion paper. One of the most considerable issues of IAS 38 –

Intangible Assets is that the requirements for recognition of intangible assets acquired

from a business combination are less limiting than the ones which are currently required

for internally generated assets’ recognition.

4.1. Techniques for recognition for internally generated intangible assets

Due to some definable difficulties in internally generated intangible assets’ recognition,

including goodwill, it is necessary to spend more efforts to improve such challenges. The

discussion paper studies various ways in which internally generated assets could be

recorded and suggests three technical methods that could be used: planned versus

unplanned assets, a hypothetical business combination or the use of indicators.

Planned versus unplanned assets

The discussion paper suggests that internally generated assets could be grouped into

planned and unplanned assets’ group. The definition of such division is mentioned in

paragraph 41 of the discussion paper.

• “planned internally generated intangible assets”, being the ones created out of a

discrete plan, the primary goal of which is to create the assets;

• “unplanned internally generated intangible assets”, being other internally

generated intangible assets that incur from the day-to-day operational activities

of a business.

A hypothetical business combination

This technique requires the company to be assumed as an acquirer at reporting date,

and hence, it acts as the acquirer who would acquire the company as a whole under a

business combination. The main objective is to apply the accounting treatment for

acquirers in a business combination.

Use of indicators

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This discussion paper suggests that such intangible assets would be recorded if there is a

signal that such assets exist at reporting date. Some possible indicators are as follows.

• A verified discrete plan

• An authorized strategy of managing assets

• Any external source

If the standard setters are allowed to apply any of the above techniques, paragraph 63

and 64 of the current IAS 38 would be removed.

4.2. Impairment issues related to good will

In fact, there are several issues arising from IAS 36 that need to be taken into account in

accounting for impairment tests of goodwill.

First to be mentioned is the problem related to disposal of an operation within a CGU.

Particularly, under a case that the goodwill has been allocated to the unit which has a

number of distinct operational activities, if one of the operations is disposal, it must be

necessary to consider whether any of the goodwill relates to the operation disposed of.

If it does, the amount of goodwill should be calculated based on the relative values of

the operation disposed of and the portion of the CGU retained. Therefore, in the step of

calculating the gain or loss on disposal of the operational assets, the allocated portion of

the goodwill is included in the carrying amount of the assets that have been sold. For

example, if part of a CGU was sold for $250 and the recoverable amount of the part

remained of the unit is $600, then it is assumed that 30% (250/ (250+600)) of the

goodwill is being sold.

Another issue is in relation with reorganization of the entity (Austin, 2007). When the

company restructures its CGUs, or change in the composition of the CGUs, and where

goodwill has been allocated to the original units, IAS 36 requires the reallocation of the

goodwill to the new units. The allocation is based on a relative value basis which is

29

similar to that used where a CGU is disposed of, again if the firm cannot demonstrate

that some other methods better reflects the associated goodwill.

30

CONCLUSION

Intangible assets in general and goodwill in particular are seen to be sufficiently different

from other kinds of assets such as property, plant and equipment (PPE) for the standard setting

bodies to provide completely separate standards. IAS 38 – Intangible Assets provides the

definition, recognition, measurement and disclosure of intangible assets. Within this standard,

the term of ‘identifiability’ is one of the central concepts related to identification of any

intangible assets which are allowed to use IAS 38. However, it would be impossible to apply the

term of ‘identifiability’ to goodwill. Consequently, goodwill acquired from a merger and

acquisition is guided in IFRS 3 – Business Combination.

IFRS 3 was introduced in January 2008 focusing on business combinations undertaken by

the IASB. According IFRS 3, goodwill is determined as a residual value which is generally defined

by comparing the consideration transferred and the net fair value of the identifiable assets and

liabilities acquired. With the existence of the accounting standard on impairment tests of

assets, goodwill is not subject to amortization.

On the other hand, internally generated goodwill is not allowed to be recorded according to

IAS 38. In general, intangible assets, goodwill included, which are acquired from a business

combination seem to be easier to recognize than the ones which are internally generated

goodwill. This is because within a business combination, the estimation issues are restricted by

the offered cost of the combination.

Therefore, in considering the accounting for intangible assets as well as goodwill, it is crucial

to consider the difference in accounting depending on the sources and conditions of each asset.

Up to now, although the standard setters and researchers have spared no effort to study

such a controversial area related to accounting for goodwill, there still remains many potential

issues which do need to be addressed as soon as possible. Some noticeable issues could be

named related to how to measure internally generated goodwill in proper ways, goodwill

allocation or impairment tests of goodwill. Under conditions of a sharp increase in merger and

31

acquisition, as well as technology companies, these issues have sparked lively economic

interests.

32

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