The treatment of goodwill

March 2022

This month top tutor Tom Clendon explains current accounting treatment for goodwill.

Question

Can you explain why some are against the current accounting treatment for goodwill?

Tom’s answer

Good question. I like questions that have that phrase ‘explain why’ and seek to challenge orthodox thinking. Before we challenge the current regulation, let us first remind ourselves of the accounting treatment of goodwill.

How to account for goodwill

Where a group acquires a subsidiary, and the aggregate of the purchase consideration for the controlling interest and the amount attributed to the non-controlling interest exceeds the fair value of the net assets acquired, then the difference that arises represents a premium paid and is called goodwill.

In other words, purchased goodwill arises when you buy a business, and you pay more for the business than the assets you are getting.

This is not because you are being “ripped off” – rather it reflects the value put on the goodwill of the business because it has a certain reputation, staff are already employed, systems are in place, and there are existing customers! Such goodwill is recognised as an intangible asset in the group accounts because there is a transaction that underpins it.

The inherent goodwill, the self-generated goodwill, that every business has, however, cannot be recognised as an asset. This is because it has not been bought and thus cannot be reliably measured.

All of the above is uncontroversial.

Annual impairment review

The controversy regarding IFRS 3 Business Combinations is that it subsequently requires purchased goodwill to be subject to an annual impairment review.

This treatment has its critics when compared to an alternative treatment of systematically writing off such goodwill over its useful life (which is after all the default treatment for other intangible assets). The arguments against the annual impairment review of goodwill are as follows:

1: Costs to the preparer

The process of conducting an annual impairment review is not without cost. Every year the group will have to ascertain the recoverable amount of the cash generating unit where the goodwill is allocated.
If goodwill were systematically amortised, then these costs would be avoided.

2: Less relevant information for the user

A characteristic of useful information is that it should be relevant. In turn that means it has a predictive value. With the current system of annual impairment reviews, it is harder for users to predict future profits as in many years there will be no impairment loss charged for goodwill – but in years when there is the impairment loss and it is large, profits will fall off a cliff!
If goodwill were systematically amortised, then reported group profits would be smoother and thus easier to predict. Investors don’t like surprises.

3: Overstatement of the purchased goodwill

In reality the purchased goodwill at the date of acquisition does have a limited useful life.
Where year after year the purchased goodwill is impairment-tested and not found to have suffered a loss then what is really happening is that the original goodwill (reputation, staff and customer loyalty) is actually being dissipated and is really being gradually replaced by newly created (inherent) goodwill.

After all, if you measure the amount of water in a pond every year you could conclude that the water level never falls but surely after 10 years the original water there has evaporated and been replaced by new different water!

The original water in the pond is like the original goodwill at acquisition, it does dissipate over time as staff leave or as new customers are attracted.

If goodwill were systematically amortised, then the overstatement of purchased goodwill by allowing inherent goodwill to be recognised as an asset through the back door, would be prevented.

The challenge

Of course, if IFRS 3 Business Combinations were to be revised to require the amortisation of purchased goodwill then companies would have to determine the useful economic life of goodwill. This would be very subjective.

UK GAAP, in the form of FRS 102, takes the pragmatic view by setting a maximum of 10 years.

• Tom Clendon is an ACCA SBR online lecturer and podcaster. See www.tomclendon.co.uk