IAS/IFRS and Goodwill Accounting: Challenges for European Companies

Introduction

As the months go by, European listed companies are discovering the upheavals involved in implementing IAS/IFRS from fiscal year 2005. The controversy surrounding IAS 39 (recognising and measuring financial instruments) has been a case of missing the forest for the trees. Although there is no doubt that this standard is likely to have a major impact on companies in the financial sector, other IAS/IFRS standards are likely to impact just as much on the balance sheets of large industrial or retail groups. For example, IAS 22 (business combinations) and IAS 36 (impairment of assets) will completely overhaul the way goodwill is treated — depreciation is replaced with the impairment test, which means a strict definition of a model for valuing assets acquired, making it possible to monitor the assets over several years. Both standards issue a series of recommendations — for the most part indicative — certain aspects of which may be somewhat baffling to valuation experts, but which most importantly are likely to usher in significant changes in the relationship between a company and its auditors.

The aim of this study is to analyse the scope of the methodology recommended by these two standards in terms of valuation, and the implications of their imminent introduction for the various actors involved — including finance and accounts departments within companies, auditors, market authorities, and financial analysts — and their relationships with each other. To this end, a critical review of the relevant peer-reviewed, scholarly, and organizational literature concerning how things have changed for listed European companies now that they must disclose their financial statements according to international financial reporting standards, with special emphasis on goodwill, is followed by a summary of the research and salient findings in the conclusion.

In recent years, policymakers at all levels of the European Commission have encountered unexpected and costly problems in their efforts to achieve convergence and harmony across the board. In this regard, Radig and Loudermilk (1998) reported early on that "business expansion beyond national boundaries is widespread today, and companies must function in countries where cultures and laws are different from our own. There is a need for uniformity in accounting principles used within multinational companies" (22). To this end, the International Accounting Standards Committee (IASC) was created in 1973 to achieve this goal, but the organization has encountered problems based on nationalistic pride and preference, different models already in place, and a dearth of authority when dealing with governmental bodies (Radig and Loudermilk 22).

Likewise, in her study "Large Firms Envision Worldwide Convergence of Standards," Street (2002) reports that "currently, the largest accounting firms are working diligently in conjunction with their partners in the International Forum on Accountancy Development (IFAD) to achieve their vision of raising national accounting and auditing standards worldwide to meet or exceed internationally recognized benchmarks. An awareness of the ongoing activities of the firms and their IFAD partners to improve financial reporting, accountability, and transparency worldwide is crucial if other members of the accounting community, including educators, are to support and, more importantly, actively participate in these efforts" (215).

Background and Overview of IAS/IFRS Convergence

The IFAD was created in 1999 based on "the premise that the expertise of the accounting profession and the financial resources of the World Bank and other international financial institutions, when combined, could be harnessed in the interests of enhancing accounting capacity and capabilities in developing and emerging nations" (Street 214). Over time, IFAD's objectives were expanded to include common global issues as well, and today more than 30 international institutions collaborate under its umbrella, including:

1. The International Monetary Fund (IMF) and International Federation of Accountants (IFAC);
2. The International Accounting Standards Board (IASB);
3. The International Organization of Securities Commissions (IOSCO);
4. The Organization for Economic Cooperation and Development (OECD); and
5. The International Association for Accounting Education and Research (IAAER) (Street 215).

All of these organizations and agencies are collaborating with member firms to support reform programs intended to improve the quality of financial reporting and auditing around the world (Street 215). The large firms and their partners agree that a framework for reforms in individual countries involves three steps: (1) determine the standards that should apply; (2) assess the extent to which the standards have been adopted and arrangements for ensuring compliance; and (3) implement an action plan to address identified gaps in performance (Street 215).

The large firms' "Vision" holds that "all general-purpose financial information must be prepared using a single worldwide framework using common measurement criteria and fair and comprehensive disclosure." The Vision asserts that the national standards of many countries should be raised, with the IASB's International Accounting Standards (IAS)/International Financial Reporting Standards (IFRS) and IFAC's International Standards of Auditing (ISA) serving as the benchmarks. In addition, the Vision emphasizes the importance of implementing IFAC's new global ethics standards and the significance of other issues that must be addressed if change is to materialize; these initiatives include (a) corporate governance, (b) financial accountability and reporting laws, and (c) education. The Vision concerns all countries, all companies, and all accountants and auditors (Street 215).

During this effort, the firms and their partners have also been actively addressing compliance with international standards. Analyses by Cairns (1999) and a study by Street and Gray (2001) identified instances of companies that claimed to have prepared IAS financials that clearly diverged from IAS in some cases. To address this issue, effective for 1999 year-end financial statements, the IASB revised IAS No. 1 to require that "financial statements should not be described as complying with International Accounting Standards unless they comply with all the requirements of each applicable standard." Additionally, the large firms worked with IFAC to launch the Forum of Firms, an organization of international firms that perform audits of financial statements used across national borders; members agree to several requirements, including undergoing a global independent quality review (Street 216).

To further address compliance, the large firms are developing training programs, and several are proceeding on the premise that staff must pass an internal test before working on audits of IAS/IFRS financial statements. Additionally, the large firms are initiating quality controls for IAS/IFRS audits, similar to controls developed several years ago for non-U.S. companies reporting according to U.S. GAAP. Commenting on these efforts, IASB Chairman Sir David Tweedie stated: "The IASB's objective of having one single set of high-quality global standards to meet the worldwide aim of comprehensible, transparent and reliable financial statements would be rendered pointless if the auditing firms did not apply rigorous, high-quality global auditing standards to ensure that a fair presentation is given in these statements" (quoted in Street 216).

While "goodwill" may appear to be an ephemeral and nebulous concept, there are definitions and tests available to help place a monetary figure on it. According to Black's Law Dictionary (1990), goodwill is "the favor which the management of a business wins from the public. The favorable consideration shown by the purchasing public to goods or services known to emanate from a particular source. . . . The excess of cost of an acquired firm or operating unit over the current or fair market value of net assets of the acquired unit. Informally used to indicate the value of good customer relations" (694). By contrast, the term "consolidated goodwill" refers to the difference between the fair value of the consideration given by an acquiring company when buying a business and the aggregate of the fair values of the separable net assets acquired; goodwill is generally a positive amount that should be eliminated by writing it off immediately to the reserves or alternatively by amortization to the profit and loss account over its useful life, in compliance with "Statement of Standard Accounting Practice 22, Accounting for Goodwill" (Pallister et al. 118).

The term "purchased goodwill" describes the difference between the fair value of the price paid for a business and the aggregate of the fair values of its separable net assets. According to Butler, Butler, and Isaacs (1997), purchased goodwill "may be written off to reserves or recognized as an intangible asset in the balance sheet and written off by amortization to the profit and loss account over its useful economic life. Internally generated goodwill should not be recognized in the financial statements of an organization" (157). In their essay "Accounting for Goodwill: Are We Better Off?," Massoud and Raiborn (2003) report that:

Traditionally, purchased goodwill was capitalized (either in the investment account or as a separate intangible) and amortized over a period not to exceed 40 years. Some mergers and acquisitions (M&As) did not generate any goodwill because they were accounted for using the pooling-of-interests method. In 1969, Leonard M. Savoie (then Executive Vice President of the AICPA) stated that he expected the Accounting Principles Board (APB) to abolish the pooling-of-interests method. However, the death knell for this accounting method was not sounded until 2001 with the issuance of SFAS No. 141. Thereafter, whenever the purchase price of an acquisition exceeds the fair market value of the acquired company's net assets, the assignment of cost to goodwill is mandatory. (26)

According to Hake (2004), although the presence of goodwill on a balance sheet represents an expectation of higher profit, there is a cost associated with its accumulation: "Because goodwill is currently treated as a nonregenerating asset, accounting practice requires that it be removed from the balance sheet as it depreciates. The consequent depreciation of goodwill results in a direct charge against a firm's annual earnings. Given the difficulties in measuring goodwill, recent practice has been a straight-line amortization over a maximum forty-year horizon" (389). It is reasonable to assume that most observers would agree that goodwill is unlikely to depreciate as predictably as hard goods; however, this precept has previously been accepted as a viable solution to the problem of accounting for goodwill. In sum, "According to this logic, goodwill doesn't last forever, and it doesn't evaporate immediately upon acquisition" (Hake 389).

According to Hake, an alternative to the earnings drain of goodwill is the pooling method of acquisition: "By merging the two firms' balance sheets, there is no recording of the acquisition price minus the target's numerable assets. The effect is no recording of goodwill, no drain on earnings. This practice was most common among firms with high market valuations relative to tangible assets (e.g., three MBAs and a laptop) because the charges needed to depreciate goodwill would be ruinous to earnings" (390).

The Challenge Presented by Goodwill

A comparison of how goodwill is treated by the United States and several European countries is provided in Table 1 below.

Table 1. Comparison of International Goodwill Treatments.

Country / Amortization / Period of Time
United States / No / n/a
Canada / Yes / Life with maximum of 20 years
United Kingdom / Yes / Life with maximum of 20 years
Germany / Yes / Under HGB, maximum life is 15 years; under DRS #4 only amortization over a maximum of 20 years
IASB / Yes / Life with maximum of 10 years; rebuttable presumption to 20 years

Source: Massoud and Raiborn 27.

Table 2. Comparison of International Goodwill Treatments for Impairment.

Country / Impairment
United States / Yes: review annually and write off where necessary
Canada / Impairment review exception included
United Kingdom / Impairment review exception included
Germany / HGB (German Commercial Code) requires an annual impairment test; it is currently unclear whether the DRS (German Accounting Standard) is entitled to eliminate legal options
IASB / Impairment review exception included

Source: Massoud and Raiborn 27.

Although discussions of accounting for purchased goodwill are certainly not new, they have assumed new importance and relevance in recent years as the march towards international convergence in accounting continues. In his chapter "New Accounting for Goodwill: Application of American Criteria from a German Perspective," von Colbe (2004) reports that the Financial Accounting Standards Board (FASB) published its revised exposure draft on accounting for business combinations and intangible assets in February 2001, followed on June 29, 2001, by Statement of Financial Accounting Standards (SFAS) 141, "Business Combinations," and SFAS 142, "Goodwill and Other Intangible Assets" (201). The introduction of these new standards meant that the FASB eliminated the pooling-of-interests method of acquisition accounting and substituted the so-called impairment-only approach to goodwill accounting for the previously mandatory amortization of this intangible asset (von Colbe 201). The new standards resulted in heated controversy in Germany concerning the compatibility of the impairment-only approach with traditional rules and legal regulations of accounting and its usefulness for investor decision-making (von Colbe 201).

A few months later, the German Accounting Standards Board (GASB) promulgated its exposure draft No. 1a on the compatibility of SFAS 141 and 142 with accounting directives issued by the European Economic Community (EEC). At that time, the GASB announced that, despite the fact that EEC directives require amortization of goodwill within four years following the acquisition or over its useful life, group accounts prepared according to internationally accepted accounting standards — including SFAS 141 and 142 — were deemed consistent with the EEC directives (von Colbe 201).

The GASB maintained that, according to Section 292a HGB (Handelsgesetzbuch, the German commercial code that regulates accounting standards), listed corporations following U.S. Generally Accepted Accounting Principles (GAAP) were exempt from the obligation to set up group accounts in accordance with HGB regulations (von Colbe 201). In their comments on exposure draft No. 1a, the majority of accounting academics denied its compatibility with the EEC directives and with German law, and questioned the usefulness of the impairment-only approach (von Colbe 202).

Although some firms and professional associations were in favor of the proposals, others were skeptical concerning its legitimacy and the usefulness of the proposed approach to goodwill accounting. By contrast, the German Institute of Chartered Accountants (IdW) did not comment on this issue directly, but in its comment on the FASB's revised exposure draft it had expressed "doubts whether the requirement not to amortize purchased goodwill can be based upon the argument that goodwill — in its entirety or to a large extent — is not a wasting asset" (von Colbe 202). Simultaneously, the GASB's standard No. 1a had been promulgated and affirmed by the German Ministry of Justice; as a result, von Colbe suggests that it can be assumed that standard No. 1a is part of German generally accepted group accounting principles today (202).

In this regard, von Colbe cites Pellens and Sellhorn, who found that some German parent companies — especially those listed on the NYSE and approximately 50 percent of those listed on the Frankfurt exchange's "Neuer Markt" segment — prepare their group accounts according to U.S. GAAP, in application of Section 292a HGB (Pellens and Sellhorn 2001: 1681–9). It is quite likely that the IASB and the British ASB will to some extent follow the example of FASB by banning goodwill amortization in the future (von Colbe 201). As von Colbe observes, "When we observe the frequent changes made to goodwill accounting rules in the United Kingdom (and not only there), we can conclude: 'If history is any guide, [the impairment-only approach] is likely to last for a few years until its shortcomings are demonstrated by some future accounting scandal. At that point, whoever is setting standards at the time will no doubt revert to one of the previous treatments of goodwill. And so the wheel will continue to turn'" (Paterson 2002: 101, in von Colbe 201).

Conclusion

Complex problems require complex solutions, and the development of a standardized approach to accounting for goodwill among the international community is no exception. The research showed that accounting for goodwill has become a challenging endeavor for European-listed enterprises seeking to compete in the international marketplace, and the recently promulgated provisions of the IAS have muddied rather than cleared the accounting waters from the perspective of many observers. The research also showed that it is more likely a matter of when than if that these issues will continue to be debated in the coming years, as the nations of Europe continue to harmonize their accounting procedures with those commonly used in the United States. In this regard, identifying mutually acceptable methods of accounting for goodwill appears to represent a good starting point, but much work remains to be done before this level of convergence and harmonization is achieved.