IFRS... a sense of déjà vu?

Dec 03, 2018
A shake-up could be on the way for IFRS rules on accounting for goodwill and the presentation of the income statement.
 
As listed companies and their subsidiaries throughout the European Union (EU) grapple with the International Accounting Standards Board’s (IASB) recent accounting standards on revenue and financial instruments, the IASB itself has turned its attention to other accounting topics. Two of the topics that are currently occupying the IASB are accounting for goodwill and the presentation of the income statement/profit and loss account.

It may seem surprising that these topics are on the IASB’s agenda because the existing requirements of IFRS on these areas appear quite settled. However, both topics have given rise to debate and controversy and, consequently, the IASB has been exploring whether and how the existing requirements should be improved to address the criticisms.

Goodwill

Let’s look at goodwill first. As far back as 2004, IFRS stopped amortising goodwill. This was in line with US GAAP but unlike local GAAP in other jurisdictions, such as Japan and the UK, which continued to amortise goodwill. The IFRS approach reflected the view that the income statement expense for goodwill amortisation had little information value for investors and analysts, who tended to add it back in assessing corporate earnings. Instead, IFRS requires management to make an annual assessment of the value of the business unit to which the goodwill belongs in order to determine if the goodwill needs to be written down/impaired.

Preparers of IFRS accounts point out that the annual valuation exercise can be complex and costly, as well as being unnecessary when the valuation shows plenty of headroom over the book value. As the IFRS rules prohibit taking into account the enhanced cash flows from planned restructurings or capital expenditure in assessing the value in use, they are regarded as unrealistic as the full potential of the business unit is not being included.

Investors and regulators, too, identify serious flaws in the current rules. It has become apparent that the internally generated goodwill of the business into which the acquired business has been integrated acts as a shield that protects the acquired goodwill from requiring impairment. Indeed, that internally generated goodwill, which is not recognised in the accounts, has to be completely “burned through” before the acquired goodwill needs to be impaired.

In addition, management’s assessment of the future cash flows on which the value in use is based can often reflect management’s optimism about its future prospects. Consequently, many commentators have criticised this approach to impairment testing as giving rise to impairment charges that are too little and too late.

As acquired goodwill is brought onto the balance sheet but internally generated goodwill is not, there is an inevitable inconsistency between the results achieved by acquisitive groups and those that have grown organically. The balance sheet value of acquisitive groups will tend to be higher while their post-acquisition profits will be reduced where intangible assets recognised on acquisition are being amortised against profit. Some academics suggest that internally generated intangible assets should be capitalised, in the same way as certain development expenditure
is capitalised.

None of these problems or inconsistencies with goodwill accounting are new, but the vastly increased importance of goodwill and intangible assets on balance sheets throughout the world means it is opportune for the IASB (and the Financial Accounting Standards Board (FASB) in the US) to explore various avenues to address them.
For example, if the amount of acquired goodwill should eventually be reduced to zero, rather than continuing to be recognised on the balance sheet at its cost – potentially in perpetuity – would the reintroduction of some form of amortisation be appropriate?

Amortisation is, of course, open to the criticism of the arbitrariness of estimating the useful life of goodwill, but some point out that estimating future cash flows in order to assess value in use is subject to similar uncertainty. Alternatively, should the value in use of the business unit be restricted by the internally generated goodwill in order to focus solely on whether the value of the acquired goodwill has been maintained above its book value? These and many other accounting possibilities have been raised at recent IASB meetings. Some of you may recall that goodwill on acquisition was once regarded with such scepticism that it was written off to reserves immediately. I think it’s unlikely that the IASB will revert to such a drastic approach.

There is also growing criticism that the current goodwill accounting rules and disclosures provide little information on whether the acquisition has been successful and has fulfilled its promise. This is regarded as a shortcoming in the degree to which the accounts provide a measure of management’s stewardship of their resources. The IASB is therefore also considering how the requirements on disclosure of post-acquisition performance can be enhanced – for example, a table showing the year-on-year change in profits analysed between organic growth and acquisitions.

Income statement presentation

Having issued its recent standards on key measurement issues including revenue, financial instruments and leases, the IASB sees the need for a period of calm while we all get used to the new standards. Nonetheless, the IASB is conscious that the rules of IFRS on how the income statement should be presented are relatively form-free, with few hard and fast rules on which line items should be presented. The absence of such rules has, of course, led to management exercising its discretion on what to present, including non-IFRS measures of performance and a significant level of diversity in practice. Although the IASB acknowledges the usefulness of management measures of performance as evidenced by their use in the market, it considers that a greater degree of regulation, consistency and comparability is desirable.

It is perhaps surprising that it has taken the IASB so long to open up this area for detailed consideration, given how prescriptive IFRS is in many other areas. The lack of IFRS rules in this area contrasts with the very prescriptive formats of the EU Accounting Directives that are followed in UK and Irish GAAP profit and loss accounts.
A key item of debate is the term ‘operating profit’, which is presented on many, if not most, IFRS income statements and is regarded as a key metric. IASB is conscious that there is considerable variation in what companies include in operating profit. For example, there is significant diversity in whether the equity-accounted results of associates and joint ventures are part of operating profit. IASB currently appears to be tending to the view that they are more in the nature of an investment return than an operating return, while acknowledging that some associates and joint ventures are integral to the group’s business and thus deserve separate disclosure on the face of the income statement in proximity to operating profit. The extent to which gains and losses on derivatives and other financial instruments are regarded as part of operating profit rather than financing is also subject to inconsistency.

The IASB appears to be intent on “owning” the term ‘operating profit’ rather than leaving it to the discretion of management to decide what it should and should not include. Nonetheless, the IASB is also considering permitting or requiring a ‘management performance measure’ to be presented in the accounts together with a reconciliation to an IFRS line item. This would facilitate the familiar practice of providing adjusted profit numbers to exclude once-off, unusual or exceptional items. This approach would also be consistent with the requirements of IFRS 8 Segment Reporting that segmental results should be presented as seen “through the eyes of management”.

The IASB is also conscious of the growth of automated investing and the related digital consumption of financial information. Accordingly, it considers it desirable that the sub-totals and line items in the income statement should be defined and regulated, or at least rigorously reconciled to line items that are defined by IFRS standards.

Conclusion

Given the level of research and debate the IASB has already devoted to these two topics, it seems very unlikely that the status quo will remain unchanged. I think IFRS can be expected to become more demanding and rigorous in terms of what is presented on the income statement and how the performance of acquired businesses is disclosed while, hopefully, simplifying some aspects of goodwill impairment testing. However, there seems to be some way to go before the IASB achieves a consensus on what proposals to make.

We can also expect companies, investors and analysts to have strong views about the IASB’s eventual proposals, not to mention contributions from regulators and audit firms on whether those proposals provide enhanced investor protection and are auditable. I think widespread feedback from all classes of stakeholders will be important in ensuring that the standards on these two key areas of financial reporting are taken forward appropriately.

Terry O'Rourke is Chairperson of the Accounting Committee at Chartered Accountants Ireland.