BE130 – Lecture 6 – Critical Perspectives on Goodwill and other Intangible Assets PDF

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Summary

BE130 – Current IssuesLecture 6 – Critical Perspectives on Goodwill and other IntangibleAssetsIntangible Asset  an identifiable non-monetary asset without physical substance (IAS 38)  Identifiable  separable & arises from contractual rights  Non-monetary  excludes cash &...

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BE130 – Current Issues Lecture 6 – Critical Perspectives on Goodwill and other Intangible Assets Intangible Asset  an identifiable non-monetary asset without physical substance (IAS 38)  Identifiable  separable & arises from contractual rights  Non-monetary  excludes cash & other monetary items  Asset  resource, control, past event & future economic benefit  Lack of physical substance  claims to economic benefits from non-physical sources Asset  a resource controlled by an entity as a result of past event, from which future economic benefits are expected to flow to the entity (IAS 38)  Controlled  the entity has the power to obtain and to restrict other access to the economic benefits  Future economic benefits are probable  these may include revenue, cash flows, reduced cost or liabilities  Arises from past transaction or event  R&D, purchase Identifiability & lack of physical form An asset is identifiable, if it either:  Is separable  Capable of being separated and divided from the entity to sell, transfer, licence, exchange and so on  Or arises from contractual or other legal rights  Contracts or other legal rights facilitate the sale, exchange or transfer processes Lack of physical substance characteristics distinguishes IA from tangible assets because tangible assets are also identifiable. 

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To be recognised, an IA should also meet other recognition criterion  measurability:  Cost of the asset should be measured reliably using a monetary value (cash payments or FV of consideration) An IA should initially be recognised at cost Some internally generated IA are not recognised because their cost cannot be measured reliably.

Examples of IA include: brands, publishing titles, software, trademarks, patents, copyrights, films, licenses, franchises, and customer and supplier relationships. If an intangible item does not meet either the definition or the recognition criteria, then expenditure on this should be considered as an expense when it is incurred and should be written-off. Subsequent Measurement Methods

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Cost Model Revaluation Model

Cost Model  An IA shall be carried at its cost less  Any accumulated amortisation and  Any accumulated impairment losses  So, need to identify IA’s useful life which could be  Finite period  (e.g. based on contract or patent grant time)  Indefinite  if there is no foreseeable limit to the period over which the asset is expected to generate net CF o Not amortised, but annual impairment tests Revaluation Model  IA regularly re-valued to FV  Less any subsequent amortisation charges and impairment losses  Only permitted if there is an active market with:  Identical / similar items  Willing buyers and sellers  Publicly available prices (rare) Goodwill An asset representing future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognized (IFRS 3). Although goodwill is not separately identifiable, it is an IA. However, it is defined and accounted for differently. Regulations for goodwill accounting are different because, in contrast to other IA, goodwill cannot be individually identified & separately recognised.  It is inherent in a business together with other assets & generates cash in combination with them Only purchased goodwill can be recognised as an asset.  Indefinite life, so no depreciation/amortisation  Subject to annual impairment tests Internally generated (inherent) goodwill  Due to ‘going concern’ capabilities of an organisation, a company’s market value is higher than the FV of its net assets  This means that goodwill is always in existence whether there is an acquisition transaction or not  However, regulations do not allow capitalisation of internally generated goodwill because its costs can not be measured reliably and its value would be an estimate  In contrast, acquired goodwill has a measurable cost

Types of IAs and relevant standards

Business Combinations  Goodwill arises during a business combination:  Mergers, acquisitions (M&A), takeovers  A business combination occurs when an entity obtains control of one or more businesses  Controlling an entity means the power to govern its financial and operational policies to obtain benefits  Control can be obtained by acquiring assets and associated liabilities or equity interests Business Combination Process

Steps of Goodwill Recognition

Step 1: Identify the acquirer  The acquirer is the entity that obtains control of the business  Sometimes it is not so clear  e.g. when two companies merge into one  Additional elements to be considered:  Relative voting rights in combined entity  Composition of governing body and senior management of combined entity  Terms of exchange of equity instruments  Relative size of entities  Existence of large minority voting interest in combined entity Step 2: Determine the acquisition date  The acquisition date is the date on which the acquirer obtains control of the acquire  It is generally the same as the closing date: the date on which the acquirer legally transfers the consideration (the payment for the investment), acquires the assets and assumes the liabilities of the acquiree  However, it can be earlier of later than the closing date depending on the contractual arrangements in the written agreement  On the acquisition date the followings to be measured at their FVs:  Considerations paid, including contingent considerations  Any previously held equity stakes,  Any NCI, measured either at FV or proportionate share of net asset  Acquired assets,  Assumed liabilities Step 3: Determine FV of consideration  Acquisition consideration may be in the form of:  Assets transferred  usually paid by cash  Liabilities assumed  may take over long-term debts  New equity issues  acquired firm shareholders may be given some shares of the acquiring firms

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Contingent consideration  obligation of acquirer to transfer additional assets / equity interest to former owners as part of exchange for control if specified future events occur / conditions are met

Step 4: Identify and measure assets, liabilities and NCI at their FVs  Assets and liability recognition:  Must meet definition of asset / liability at acquisition date  Must be exchanged as part of acquisition measured at fair value at acquisition date Full v Partial Acquisition Control can be achieved through:  Full  acquisition of the target’s all (100%) shares  Partial  acquisition of majority shares (50% < x < 100%) When control is achieved through partial acquisition:  Any remaining (not acquired) equity interests is called as a Non-Controlling Interest (NCI)  The NCI and corresponding goodwill should be shown on the parent’s consolidated balance sheet  The subsidiary profit and loss should be allocated proportionately between the parent and the NCI How to evaluate the NCI? IFRS 3 provides two options for measuring NCI: 1. At its FV, on the basis market prices / valuation  This is known as FV approach, which determines full goodwill attributable to both parent and NCI; 2. As a proportionate share of the net amount of the identifiable acquired assets /assumed liabilities  This is known as the NCI’s net asset proportionate share approach, which determines only a partial goodwill that is attributable to the parent Step 5: Recognize the measure goodwill The acquirer should recognize goodwill at the acquisition date. According to IFRS 3: Goodwill = (FV of the consideration transferred + value of previously held equity + NCI) - FV of net assets acquired One-off versus step acquisitions Business combination may be undertaken:  As a one-off transaction  where acquirer will not have any prior equity interests in the acquired firm  Or as a step acquisition in several stages  where the acquirer will have an investment in the acquiree (non-controlling interest) before obtaining control

Measuring goodwill: Full acquisition When control is achieved through full acquisition, goodwill is the difference between the paid consideration & the net amount of assets acquired. Measuring goodwill: Partial acquisition When control is achieved through partial acquisition the amount of goodwill depends on how the parent determines the NCI in its financial statements. Goodwill calculation methods when partial acquisition Two methods for goodwill calculation:  When the NCI is measured at its FV, goodwill is calculated using the full goodwill method  When the NCI is measured as its proportionate share of the acquired net assets & liabilities, goodwill is calculated using the partial goodwill method Selection of a method depends on the intention:  If intends to buy the NCI, then use the FV method  Goodwill varies depending on the selected method Partial Goodwill Method When NCI is measured as the proportionate share of the net identifiable assets of the acquiree  Does not include any goodwill related to the NCI.  Only partial goodwill to be recognised by the parent, because, in this case, goodwill is calculated solely by reference to the acquirer’s acquired interest Example:  P acquires 80% shares of S and pays £800. The net amount of S’s all identifiable assets & liabilities is £600  NCI’s share in the net assets of S is £120 (20%x£600)  Should be measured as the NCI’s proportionate share in the net amount of acquired asset & liabilities What is the amount of goodwill in this case? Goodwill = FV of the consideration transferred + value of previously held equity + NCI’s proportionate share of the net assets of the acquiree - FV of net assets acquired

Full Goodwill Method  If NCI is measured at FV, the parent recognises full goodwill, which is goodwill attributable to both the parent & the NCI  For this purpose, need to determine FV of both NCI and the net amount of identifiable assets of the acquiree (using market price /valuation method) Example:  P acquires 80% shares of S and pays £800. The net amount of S’s all identifiable assets & liabilities is £600.  P determines the FV of NCI to be £185  FV of 20% NCI in S will not necessarily be proportional to the price paid by P for its 80%  Primarily due to control premium and discount rate What is the amount of goodwill in this case? Goodwill = FV of the consideration transferred + value of previously held equity + FV of NCI - FV of net assets acquired

Difference between full and partial methods

Goodwill  

Full Goodwill Method 385

Partial Goodwill Method 320

Difference 65

The difference is the goodwill attributable at the non-controlling interest, as partial goodwill records only the goodwill attributable to the parent company Comparison of full and partial goodwill shows that goodwill attributable to NCI is £65

Additional Example

Parent acquires 80% shares of Subsidiary for consideration of £500. The FV of the net assets of Subsidiary at the date of acquisition is £400. The FV of the NCI at that date (i.e. FV of not acquired shares) is £100. Required: What are the amounts of goodwill to be recognised under the Full goodwill and Partial goodwill methods?

Summary of Goodwill calculation methods

Measurement subsequent to initial recognition Current regulations (IFRS 3, IAS 27, IAS 36, IAS 38):

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Prohibit amortization of goodwill Require goodwill have an indefinite life Require goodwill be subject to impairment test annually or more often when required Require goodwill impairment losses not to be reversed

Possible alternative accounting treatments/alternative approaches to goodwill  Separating goodwill into different components and applying different treatments thereto;  Direct write-off  Recognition of goodwill as an asset with subsequent amortisation  Recognition of goodwill as an asset and test it for impairment Johnson & Petrone (1998) discuss the following possible component parts of goodwill: 1. Excess of the FV over BV of acquired net assets 2. FV of other net assets not recognised by acquiree 3. FV of the ‘going concern’ element of the business 4. FV of synergies from the business combination 5. Overvaluation of the consideration paid 6. Overpayment by the acquirer Does goodwill meet the asset definition? Goodwill meets the definition of an asset under the relevant definitions in the existing Conceptual Framework, because:  It is a resource controlled by the entity.  It is the results from a past event (the business combination)  Future economic benefits are expected to flow to the entity in combination with other assets and they will contribute indirectly to future cash flows Goodwill should not be recognized as an asset as it is not specifically identifiable (Gore and Zimmmerman, 2010). Johnson & Petrone (1998) conclude that meeting the asset definition is a necessary condition, but not sufficient condition to recognise the goodwill as an assets. There is the need to meet other three criteria:  Measurability, relevance, reliability. Is goodwill an overpayment? Churyk’s (2005) empirical results show that goodwill is not an overvaluation payment at initial recognition. However, subsequently goodwill may become impaired, as indicated by identifiable conditions:  Decline in stock prices  Book value is greater than the market value So impairment tests may be appropriate  reporting goodwill as an asset and subsequent impairment tests provide relevant information....