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Karlstads universitet 651 88 Karlstad

Tfn 054-700 10 00 Fax 054-700 14 60 Information@kau.se www.kau.se

Faculty of Economic Sciences, Communication and IT Department of Business Administration

Erik Sunnerdahl

IAS 36 – Impairment on goodwill A critical view of the framework

International Financial Accounting 7,5 HP

Date/Term: 09-10-19

Supervisor: Berndt Andersson

Examiner: Berndt Andersson

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Abstract In March 2002 a big step towards total accounting harmonizing around the

world made its present. The IASB and EU decided that all the listed companies

within the union should establish their consolidated reports under the new

IFRS/IAS frameworks. The new rules applied from January 2005.

The purpose of this report is to with a critical view; review the rules of IAS 36

and IFRS 3 that touches the new goodwill valuation. The new framework

pronounce that goodwill shouldn’t be amortized over a specific time of years

like it did before January 2005, it must instead be up for a yearly impairment

test. The test checks if the acquired goodwill-value is reported to high, if that is

the case, impairment is made.

The analysis is build upon my own conclusions about the frameworks. My

concluded opinion is that the new framework of IAS 36 with impairment of

goodwill leaves too much “free-hands” to the companies. They can control the

value of the goodwill just with a positive vision of the future without breaking

any rules.

The IAS 36 impairment framework is building much of the information upon

future cash-flows and market position. This can lead to increased volatility on

the stock-market. In an economic boom you might not have to do any

impairment on goodwill. In a recession on the other hand, large impairment

have to be done because of the switched market conditions which will have a

significant negative effect at the income-statement. If the companies’ forecasts

about the future cash flows are negative there should be made impairments,

and the already attacked income-statement would get a second punch.

My concluded opinion about the new framework is that the theoretic thought is

good, but the implementation and design of IAS 36 have more disadvantages

than benefits. I vote to bring back the old amortizing system on goodwill over a

specified time, because the uncertainties weren’t that big when you always knew

what will come in the next income-statement. That would certainly facilitate the

users of the financial information. And after all, the financial information is

made for the users.

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Table of contents 1. Introduction ........................................................................................................... 4

1.1 Background ..................................................................................................... 4

1.2 Problem definition ........................................................................................... 5

2. Theory ................................................................................................................... 6

2.1 IFRS 3 – Business combination ...................................................................... 6

2.2 IAS 36 – impairment on goodwill ................................................................... 6

2.2.1 External sources of information: .............................................................. 8

2.2.2 Internal sources of information: ............................................................... 8

2.3 What do the experts say about the new goodwill framework? ....................... 8

3. Analysis/ Conclusion .......................................................................................... 10

3.1 Volatility ....................................................................................................... 10

3.2 Different view on terms ................................................................................ 12

3.3 Subjectivity ................................................................................................... 13

3.4 Agent theory .................................................................................................. 13

4. Reflections by the author .................................................................................... 15

References ............................................................................................................... 16

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1. Introduction

In the opening chapter, the background research will be described as part of the problem

definition that will be raised later in this chapter.

1.1 Background

World economy today’s is seeking total globalization in accounting. The biggest

step to harmonize the accounting rules made present in march 2002 when the

European union decided that all listed companies within the union would be

required to establish their financial reporting to the accounting frameworks

IASB/IFRS that’s created by IASB (International accounting standard boards).

Since then a number of countries have stated their interest about doing the

same thing, for example China, Japan and Russia (Barker 2003). The new rules

applied from January 2005 (Thorell 2004).

The main reason why IASBs framework was implemented was to enable a

better comparability between the listed companies within the union (Chiapello

et al. 2009).

Skeptics all over Europe meant that the new “global” accounting framework is

very hard to optimize and adopt in all countries, mainly because of the cultural

differences in accounting and business within the EU. These differences reveal

itself in example trough different tax-rates and meaning of specific words in

different countries. For example: the word probability can mean 60 % chance

in Germany but 80 % chance in Sweden. This of course makes the

interpretation of the framework far more complicated (Zeff 2007).

One of the biggest differences in due to the new accounting standards is the

subject regarding acquired goodwill. The new rules of IAS 36 and IFRS 3 imply

that acquired goodwill yearly should be set up for an impairment test, that will

be done to see whether indications on a impairment have occurred. If

indications tells the company that there could be a impairment under the year,

the test should be done more frequently. Preceding principles in goodwill

accounting intended that goodwill is an asset that should be amortized under a

maximum of twenty years, with the possibility to get longer amortization if the

rules of the yearly impairment test were implemented (Thorell 2004).

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The main objective of the new framework in form of IFRS 3 and IAS 36 was to

progress towards international convergence in the accounting rules, especially

with the US accounting rules of US GAAP. As a result of the new standards

IFRS 3 and IAS 36, made it possible to eliminate a number of differences that

had existed between IFRS and US GAAP in accounting for business

combinations before the year 2004. These new frameworks increased the

comparability of financial statements between the countries (Jerman 2008).

In a debate article in the biggest Swedish financial site “Dagens Industri” a

teacher at Handelshögskolan in Stockholm named Peter Malmqvist discuss the

problem with a properly accounting in acquired goodwill. He says that it always

has been a problem with acquired goodwill and it still is, many big companys in

Sweden have big goodwill posts and that they have to describe how the

afflicated companys (that have earned the goodwill) is evolving in the current

reporting, something that is very rare in today`s reporting system (Malmqvist

2009).

1.2 Problem definition

Is the accounting rules trough IAS 36 and IFRS 3 effective or does it relay to

much on the companies honestly, what can affect their decisions and how

precise is it?

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2. Theory

This section deals with the theories that are relevant and of interest to answer the problem

definition given above.

2.1 IFRS 3 – Business combination

IFRS 3 deals with the situation of business combinations. The framework`s

purpose is to increase the comparability, relevance and reliability in the

information that the company reports about business acquisition (FAR 2006).

The framework regulate how a company that acquire another company should

report and value the goodwill that can occur. Goodwill occurs when the

acquiring company pay a price that exceeds the acquired company`s total equity

(FAR 2006).

The definition of goodwill trough IFRS 3 is:

“An asset that represents future economic benefits arising from other assets acquired in

a business combinations that are not individually identified and separately reported.” (IFRS

3 Annex 1 FAR Förlag 2006 p 14)

When the business combination occurs, the acquiring company allocates the

cost to identifiable assets and liabilities, the value that cannot be allocated

become a residual post, in this situation you have to allocate this value

elsewhere, this is the moment when goodwill is formed. In IFRS 3 p 63 it is

said that IAS 36 explains the accounting policies that is used when deciding the

impairment of the goodwill (FAR 2006).

2.2 IAS 36 – impairment on goodwill

To get a better view over the new goodwill impairment rules it will follow a

brief description over when an impairment test occurred and recognizing

goodwill in a company.

IAS 36 primary objective is to show a variation of methods to ensure that no

assets value of is reported to high, if that is the case, it should be written down

trough impairment.

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A consistently principle in goodwill accounting trough IAS 36 is that, acquired

goodwill is an asset and it should never be valued higher than its recoverable

amount in the balance sheet. The recoverable amount defines as the highest

value of the asset in term of cash flow that it could bring in to the company.

This value is either the fair value or the value in use. Fair value is the amount

for which the asset could be sold between knowledgeable and willing parties,

less the cost to sell. Value in use on the other hand is the expected amount of

cash flow the asset will earn, discounted trough a discount factor to a present

value. In other words, what the asset could bring in to the company today

trough future cash flows (McDonnell 2005).

The calculation of fair value less cost to sell has different types of evidences.

The best evidence is to see the price in a binding sale agreement in an arm

length business deal. If no binding sale agreement is available you can look at

the assets market price (less the cost of disposal) in an active market. If neither

of the above information is obtainable the fair value should be calculated it

should be based on the best information available on the balance sheet day

(Dominique Rachez 2009 Lecture).

The value in use is based on future cash flows that the entity thinks they could

derive from the asset. It takes in consider the time value of money trough a

discount factor that the company calculate trough the market risk-free rate of

interest. So if the company happens to be wrong in their future evaluation, it

can certainly affect the goodwill value. The future cash flows that are used

when calculating “value in use” is based on the managements recently updated

budgets and forecasts and can cover a maximum of five years of future cash

flow (if not the circumstances motivates a longer judgment) (Dominique

Rachez 2009 Lecture).

If the recoverable amount (above described) is less that it’s carrying amount in

the balance sheet, the carrying amount shall be reduced to the recoverable

amount. This is an impairment loss. The impairment loss is affecting the

income-statement negatively and turns down the result of the company

(Dominique Rachez 2009 Lecture.

Down below follows a number of external and internal circumstances that

could be indicators of an impairment of a certain asset.

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2.2.1 External sources of information:

• The asset's market value has reduced significantly, for reasons other than

asset's age and normal use.

• Significant changes in the market that the asset is intended to use, for example

effects that are considered negative, in technology, market conditions,

economic or legal environment that have occurred, or are expected to occur.

• Market rates have risen over the period, which can affect the discount rate

used to calculate the asset's value and affect the recoverable amount of the

asset.

• A change in market capitalization, which means that the company's reported

equitycapital is higher than the company's total stock market value (McDonnell

2005).

2.2.2 Internal sources of information:

• Access occurs to be technologically outdated.

• The potential to use the asset for its intended purpose has somehow

changed.

• Asset returns imply of getting worse, or are expected to be lower than

previously assumed (McDonnell 2005).

2.3 What do the experts say about the new goodwill framework?

To get e deeper understanding about the new methods in valuing goodwill, it is

highly interesting of what the expert thoughts and voices about IFRS 3 and IAS

36.

The British company “Intangible Business” is the world`s biggest independent

company with consultancy in intangible asset valuation for balance sheet and

management. The experts meant that the purpose of IFRS 3 is to get a more

reality based picture of the intangible assets value in a company is good in

theory, in practical matters on the other hand, it`s not working in that way. So

what is the factor that causes the new framework to be ineffective?

Intangible business believes that one of the reasons is the lack of specialists in

valuation of the goodwill. They say further that it`s up to the accountancy

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profession to make sure that the future judgments and reports doesn’t spin out

of control, with poorly judge acquisitions and reports (Forbes 2007).

In another article created by the joint management director of Intangible

Business Thayne Forbes he presented a number of failures with the framework

of IFRS 3. He argues that reporting of business combination is, even if applied

the right way, “inaccurate and misleading for the unwary reader”. He mentions a

number of flaws that the IFRS 3 is responsible for. The first item that he

considers to be wrong is that only acquired goodwill is allowed on the balance

sheet. If you get goodwill internally from building a new machine or building

you cannot put that on the balance sheet. He argue that the reason for not

putting internally generated goodwill on the balance sheet is that you cannot get

a transaction value, and that the accounting profession think it`s to difficult

valuing the goodwill in a objective way, therefore their solution is to ignore it

(Forbes 2008).

IFRS 3 requires goodwill to be identified and explained to the users, however

Forbes argue that this only occurs in a minority of the occasions in practice,

and in those cases goodwill is explained, its poor and minimal. He argue for

that the company must know wherefrom the goodwill comes from and consist

of. “If they can’t explain it, why did they buy it? (Forbes 2008)

The third flaw Forbes point out is the undervaluing of intangible assets. The

standards say that the company must do an impairment when the goodwill

value is lower than its recoverable value in the balance sheet, to avoid doing an

impairment the companies value its goodwill to low so they avoiding the risk of

doing large impairments. Because if the impairment is done, it will affect the

income-statement and the owners and investors will react negatively. If the

value of goodwill increases, this increase will not be recognized in the balance-

sheet and the volatility of the income-statement is more stabilized (Forbes

2008).

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3. Analysis/ Conclusion

This section presents my own analysis and conclusion based on the theory I gathered and the

problem-definition

3.1 Volatility

Throughout the theory chapter we found that goodwill impairment is highly

affected to the entities own assumptions on the future. And if the company

follows the framework of IAS 36 right, the goodwill value should be written

down when they believe that the future cash flows of the certain asset is going

to decrease. With the old framework of amortizing over time on goodwill, you

always had the same amount of cost in the income statement in a fixed period

of time of maximum 20 year. But in the new system of goodwill accounting it

can be that in economic boom years they might not be any impairment at all. In

a recession or economic collapse period like the one we have and are

experience right now, there should be large impairment which will have a

greatly negative affect at the income-statement. If the companies forecasts

about the future cash flows is negative, there should be made impairments,

which will affect the income-statement even more than it’s already done trough

the recession.

My conclusion over this phenomenon is that the new IAS 36 goodwill

accounting frames are contributing to an increased volatility in the market than

if you compare to the old amortizing system. The new system may create even

lower downs in the recession and higher tops when the economy is in a boom

and in that way the volatility is affected. Thus isn’t said that the old system

worked better or showed a better picture of the reality but it didn’t quite give

the entity that much of “free hands”. Companies can fit in large impairments in

recession time, and then successive do new acquisitions when the market is

getting better.

Peter Malmqvist highlights this phenomenon in a debate article in the Swedish

newspaper in 2005, He discuss that the abolished amortizing rules on acquired

goodwill has led to increased results in the income-statement from the

companies, which will lead to overstated results in listed companies, until the

hangover reaches time. The new framework leads to a judgment of the acquired

goodwill value each and every year, the reason to this is that you wouldn’t get a

twisted value that’s too high. Malmqvist argue that in an economic boom, no

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uncertainties in showing that the value of goodwill is kept the same as the year

before. In a recession you will have no problems, showing the opposite.

Malmqvist continue to tell that a executive director standard lifetime in a

company last for business cycle, and leaves often in a recession. The new

executive director that takes over, will strive to write down the goodwill value

as much as possible to protect against future impairments, and can always

defend himself in blaming the earlier director if the stock-rate will decrease

dramatically. When a new executive director enters the company, the goodwill

impairment will increase significantly with falling stock-rates as result. Then no

more impairments will be done and the goodwill value will stay the same until

he drop off. This may not lead to more total impairment than it did before if

you see the whole period of time, but for sure it will lead to increased volatility

in the stock-market (Malmqvist, 2005).

You see in today’s economy that unexpected events could get monumental

impact on the owner’s future expectations about the company. If the new

system with the Impairment tests rules is adopted right and owners see that the

company does massive impairments in a recession, it should show that its

future economic situation isn’t looking good, and that could get owners into

sell-panic. Of course it will not affect companies that goodwill posts isn’t that

high, but a consistently trend in big entity`s is that the goodwill-post could be

as much as over 50 % over the total assets.

If you see these frames from owners point of view you don’t know exactly how

much of the company`s goodwill-post is going to be worth which can cause

concerns, and disorder. If you have in mind that the market is driven by

expectations it could cause an increased volatility because of the uncertainty. In

the old system you didn’t have these concerns in the same way. Users and

analytics of economic information always knew when and how much the cost

will affect income statement.

If these new rules are adopted the right way, there should be huge impairments

in a recession which will affect the income-statement negative with result

deteriorations and a decreased unrestricted equity due to this, the stock-owners

will be affected with less dividend.

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3.2 Different view on terms

To continue the above explained discussion about the volatility, it seems that

the volatility in the market is going to increase big times. That doesn’t need to

be happening, because another twist on the IAS 36 impairment framework is

that nothing at all happens.

In the IAS 36 framework it is as earlier said in the theory chapter that one of

the external indicators of impairment on acquired goodwill is that “a decrease in

market value of the asset is significantly” and “not only a short-term decrease”.

This leads in to the company’s different calculation methods, what does the

word short- term means in the car-business toward the meaning in a ventures

capital company. The venture capital company speculates in business

acquisition, with lots of selling and buying companies. The car-company should

be more long ranged in their investments, and the both companies definition of

“short-term” would certainly distinguish from each other. So the word “short-

term” may mean 5 years for some, and 1 year for some. If we take an example,

company (A) acquires another company (B) in a economic boom with a large

goodwill-post within. The cash-flows is looking very good until the market

reaches a recession within 3 years with significant decreased cash-flow of the

new investment (B). When they do the impairment-test they see that it would

be a necessary to do a impairment, but because of the market situation they

know it’s only a short term decrease, and therefore no impairment is going to

be made. They return to a new economic boom and the cash-flow is again

good. This scenario case is for the car-company with a long “short-term” view.

The venture capital company on the other hand, maybe would have made

impairments.

This question whether you should do an impairment just because the market is

in a recession is very tricky. Suppose you acquire a company in the end of a

recession, the cash flows maybe look very good, but the same investment that

be acquired in a decrease in the market, may not look as good. Therefore I

believe that it’s good that the framework doesn’t set a specific time over how

long you should wait before doing a impairment, because the market may be

misleading. My personal opinion is that you have to see a investment at least

over a whole business cycle before you can judge if it’s good or bad.

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3.3 Subjectivity

To continue on the “future cash flow problems” there is another angle to

analyze it, the amount of subjectivity the framework gives the company and

how that can affect the accounting. The previous rules about goodwill

accounting gave corporations options in how long time goodwill should be

amortized. Today another subjective look can revel trough IAS 36, it’s about

the company`s assumptions.

Many people think they have the ability to see to the future. Stock-market

analysts always predict the future concerning in what direction the market is

going. Sometimes they find the right answers but very much of the time they

come wrong. It is not a big conclusion that’s hard if not impossible to predict

the future, but you can do assumptions. When calculating the “value in use”

you have financial forecast of the next five years to your help. The value of

goodwill is depending on what the company believes about the future cash

flows, it pretty much forced to do assumptions. In theory you can say that if the

companies consider the future to be good in form of flourishing cash flows,

then it would never be necessary with a impairment. Of course this is a bit

exaggerating picture because users of the economic information would react

sooner or later and say that it is reasonable to say that the result year after year

is going to be in a certain manner if they are way wrong every year.

An example that can show that the new impairment tests rules can fail is that

current economic situation. For a couple of years ago, people may have think

that the results was going to continue grow (no impairments), they had wrong

and the market sink like a stone. But now many think that the bottom is

reached and from now it’s going to get better, the results and cash flows are on

their way up again, so the forecasts is still optimistic. But nobody knows if the

bottom is reached, and you can’t blame the company to be optimistic either, its

impossible to know exactly when a recession is occur. And if there is

framework like IAS 36 that build on the company`s faith to the future, it’s for

me, fully logical that there believes are positive about the future, from a

economic stand of view.

3.4 Agent theory

The financial information is often said to be created for the users sake.

Analysts, owners and banks should get a summary over the companies

situations. Due to this, companies will have to present their financials and

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future believes in a way that will make the users satisfied. If you had a annual

report in front of you and saw that there is going to be massive impairments in

goodwill due to a significant downs in the upcoming five years, you might be

very careful before you invest any money in that company and of course that

thought is in the back of the mind in the management. They know that if they

do impairment in acquired goodwill it will show that some acquisition didn’t go

quite the way they expected which can affect the investors and analytics trust to

the company and management in the future. Besides the trust problem, the

impairments going to lead to less dividend to their present owners who strive to

get as much dividend as possible. The question that comes up will be how

much influence do the users have on the amount of impairments that the

company presents?

Users of the economic information shouldn’t affect the company that much

that a necessary impairment doesn’t take place because of fear of the reaction

from the owners. I believe there must be fear from companies to execute

impairments, there most important users are their owners that`s counting on

getting as high dividend as possible. When a impairment takes place it will

affect the income statement negatively and in the long run the distributable

funds to the owners will decrease and may not meet the expectations the

owners expect, this can affect the entities action in doing necessary impairments

on acquired goodwill.

There is another side of companies’ argument to not doing necessary

impairment, if an entity executes big impairments on acquired goodwill, this will

show that they have failed in their investments with a decreased growth. The

company`s vision of the future is negative. If the entity doesn’t dare to convey

that an investments has gone bad or not showing expected results to the

owners it’s going to be a very twisted picture of the reality.

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4. Reflections by the author

In my report about the framework of IAS 36 my work has been fully oriented

to criticize and raise the negative parts of IAS 36 and IFRS 3. Because I have

drawn my conclusions by my own it doesn’t lie no scientific value in the paper,

it is more of a philosophic thinking that the reader itself have to judge whether

he or she believe in the drawn analysis and conclusions. The paper`s purpose is

to get people to think about the framework and what the global accounting

framework-setters is moving towards.

My personal opinion is that rules that regulate how companies should present

their economic information never should get any significant impact on the

economy and its cyclical process. IAS 36 impairment rules on goodwill could be

one of the contributors to the increased volatility in the stock-market the last

years. As said before the impairment has big impact on the dividend that will be

given to the owners and that of course is affected the market. And the

impairment should logically fall in to the system when the market is in a

recession, which may create an even lower down in the market. The other

reason why I don’t envy the IAS 36 framework is the big part of subjectivity

that is involved when deciding whether impairment should be made or not. The

management could almost completely steer the value of goodwill by their own

used assumptions. If they “believe” the future looking bright, no impairments

have to be done. With this phenomenon they can decide whenever a

impairment is best for the company, which add to the earlier discussion when a

new management is applied.

The old amortizing rules didn’t give the same impact during a recession; you

always had the same amount of value decrease on goodwill every year. With this

the fair image of the company may have been misleading, but that disadvantage

is better to live with than today’s subjective frameworks.

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