Story Chris Niesche
Illustration Neil Webb

How much is goodwill worth? About US$8 trillion, according to data extracted by Capital IQ in February 2020. That was the total value of goodwill shown on the balance books of all listed companies worldwide. It made up about 18% of their total equity and 3% of their total assets.

In Australia, about US$111 billion of goodwill is on listed balance sheets; in New Zealand, it’s US$5.54 billion, reports How Long is the Piece of String?, a study by CA ANZ and the University of Melbourne released last year.

The definition of goodwill in business is straightforward. In a merger or acquisition, it’s the extra amount a buyer pays for a company – over and above its identified assets – for intangible assets such as brand recognition and intellectual property.

The theory is it’s a payment for the future economic benefit those intangibles will deliver to the buyer. You could think of it as a sweet, tempting cherry on top of the sale.

Yet, while accountants agree on what goodwill is, how to value that goodwill after it’s passed onto the buyer’s ledger sparks plenty of argument.

Currently, goodwill is assessed through an annual impairment test, where a company’s accountants review the goodwill every year and write down the asset if it has lost value.

But some accountants and investors question whether that provides enough useful information.

There is a lot of uncertainty about forecasting goodwill’s future benefit for a company – it involves more judgement calls than many accountants are comfortable with. And while goodwill is listed as an asset on the balance sheet, is it really worth its stated value? What if it was a bad buy at an inflated price in the first place?

The problem with goodwill

“One of the reasons why this is an accounting issue at the moment is there’s a bit of a feeling that some post-acquisition performance isn’t assessed very much,” says Keith Kendall, chair of the Australian Accounting Standards Board (AASB).

“Some post-acquisition performance isn’t assessed very much.”  

“There are lots of disclosures at the acquisition time, but there isn’t much specific information coming out about how that has performed, say, two, three years down the track. That’s some of the feedback we’ve been getting from users of financial reports.”

That goodwill debate intensified last year after the International Accounting Standards Board (IASB) released its discussion paper, DP/2020/1 Business Combinations–Disclosures, Goodwill and Impairment, in March 2020. It’s part of an IASB project to reduce the cost and complexity associated with accounting for the impairment of goodwill and other intangible assets.

“Better information would help investors assess the performance of companies that have made acquisitions. Better information would also be expected to help investors more effectively hold a company’s management to account for management’s decisions to acquire those businesses,” the IASB stated.

The IASB’s discussion paper proposed that, at the time of acquisition, a company’s management tell investors their strategic rationale and objectives for the purchase. They would also have to share information about the acquisition’s subsequent performance so investors could see if those initial objectives were being met.

That information to investors would be the same as the company’s management used to monitor and measure the acquisition’s progress.

“Information that is used for decision-making and that is prepared and monitored regularly for management’s use may be scrutinised more closely than information generated solely for external reporting once or twice a year,” the IASB says.

This approach could minimise the cost of providing this information to investors because the information would already be prepared.

In addition, the IASB suggested streamlining the impairment testing of goodwill. Instead of the current annual impairment test, universally seen as time consuming and complex, there would be an annual assessment of impairment indicators. A full impairment test would be completed only if such an indicator is found.

The IASB also proposed presenting total equity, excluding the value of goodwill, on the face of the balance sheet.

Feedback on the discussion paper closed in December 2020, and the IASB will consider that feedback before deciding on the project’s next steps.

Amortisation vs annual impairment tests

Goodwill is assumed to be a diminishing asset, but how should its value be calculated for financial reports? Both amortisation and annual impairment tests have been used, but each method has its shortfalls.

Amortisation, where a set amount is taken off the asset’s value each year, is simple but light on usable information. Annual impairment tests deliver plenty of information, but are complex, involve many judgement calls, and may recognise impairment losses too late to be useful.

In its discussion paper, the IASB stated there was not enough support for the amortisation approach for it to be reintroduced. (However, in a joint submission, CA ANZ and CPA Australia urged the IASB to keep amortisation on the table and conduct further research before ruling this out.)

But accountants aren’t happy with the impairment test, either. The Financial Accounting Standards Board in the US has suggested the high cost of goodwill impairment testing exceeds the benefit to investors and is considering a return to the amortisation model for smaller businesses.

“The major argument against the impairment model is complexity. And whenever you start having complexity in matters, you’re starting to introduce matters of judgement,” says Kendall.

For instance, the accounting standards require the accountant to look at the surrounding economic and commercial circumstances of an entity and test whether these indicate an impairment has occurred.

“As soon as you do something like that, that’s all judgement-based. It raises the prospect of two perfectly well-qualified accountants looking at exactly the same scenario and coming to different conclusions,” says Kendall.

“This is always a concern and it’s something that we prefer not to happen because it undermines another principle that we try to adhere to, which is comparability.”

There is also the issue of when a company doesn’t properly account for an impairment and ends up at loggerheads with the auditors.

“It’s an extended negotiation between the two parties to try and work out the answer,” explains Richard Stewart FCA, corporate value advisory partner at PwC in Sydney.

“Sometimes that finishes easily and sometimes it finishes hard, but it’s always a time-consuming process.”

It’s a problem that could be solved with the reintroduction of amortisation for goodwill, which has been prohibited since the 2004 version of IFRS 3: Business combinations came into force.

The amortisation model has advantages. “It’s simple, it’s clear and everyone knows where they stand and can move on to the next issue,” says Kendall.

But it’s easier to assess the useful life of, say, a tractor, than an intangible asset such as goodwill. The problem with the amortisation model, Kendall adds, is it doesn’t provide much useful information, and that’s the yardstick by which accounting standards should be measured.

When the AASB canvassed the issue with people who use financial statements, investors and analysts told the board they added the amortised goodwill back to the asset and conducted their own analysis.

“That’s a very good argument against adopting amortisation, although it doesn’t settle the matter. That’s the sort of argument that I’m sensitive to in terms of determining where should we jump,” Kendall says.

An impairment test doesn’t predict value

There is also a view that the impairment model is not great as a predictor, or leading indicator, of the future returns of a business, says Jay Shaw CA, a partner at Grant Thornton in New Zealand and a member of the Business Valuation Board of the International Valuation Standards Council.

He’d prefer an impairment test that was more useful as a way of predicting future cash flows and the performance of the acquired business.

Shaw says current impairment testing is better at confirming value than predicting it.

“Reported goodwill impairments currently tend to generally lag behind the true economic impairment, so in other words the actual impairment has already happened and the goodwill impairment is just confirming that,” he explains.

He’s no fan of the amortisation model, either. It relies on the view that goodwill is a wasting asset and Shaw says there is no basis for this.

“It’s really an asset that generally maintains rather than diminishes in value over time,” he says.

“If you look at the functional components of goodwill, including business reputation, knowledge and reputational workforce assets, synergies and assemblage value, I think they suggest that goodwill is really going to maintain value over time as opposed to decline in value.”

“They suggest that goodwill is really going to maintain value over time as opposed to decline in value.”

But is that the case?

In their How Long is the Piece of String? Intangibles and goodwill on balance sheets study, the University of Melbourne’s Professor Matt Pinnuck and CA ANZ’s Amir Ghandar FCA present longitudinal evidence that goodwill does, on average, decline over time. The frequency and size of impairments effectively saw a complete write-down of goodwill to zero over a period of 15 years.

The AASB response

The AASB is unenthusiastic after the IASB’s proposed changes for several reasons.

In its feedback to the discussion paper, it states: “The AASB does not consider that implementing the package would meet the project’s objective to provide investors with more useful information about the acquisitions that companies make at a reasonable cost.”

It argues that sharing information about an acquisition’s performance could be better dealt with as a requirement of management disclosure. It also notes that the proposed performance disclosure requirements wouldn’t apply to internally developed intangible assets.

In addition, relying on the metrics preferred by a company’s management could make them difficult to audit; they could be changed by management over time, with a loss of period-to-period consistency.

Nor does the AASB support removing the annual quantitative impairment test. It says stakeholders are concerned about the loss of information in the financial statements. There is also limited evidence of cost savings.

“Large preparers have indicated that they would continue to perform an annual impairment test regardless of a requirement to do so, as they have well-designed systems and processes in place to perform the annual testing,” the AASB writes in its submission.

It points out that for small-to-medium enterprises to make use of the IASB’s proposal, an auditor would likely need additional audit evidence to confirm that the goodwill is not materially misstated. That could offset any cost savings from the removal of the annual test.

What do CAs think?

Among accountants, though, there is appetite for change: 87% of the 752 CA ANZ members surveyed in the 2020 Chartered Accountants IFRS Survey believe it is important to simplify requirements about goodwill reporting, given how complex impairment testing has become.

Only a small majority, 52%, prefer keeping mandatory annual impairment testing over the impairment indicator approach. But 69% supported the impairment model over amortisation in terms of providing information for users.

“Ultimately, any changes to the goodwill accounting model should be driven by the demands of users,” says Shaw. “Rather than a complete change, ideas to address some of the limitations of the current model might instead be more closely looked at.”

Is goodwill overvalued?

The University of Melbourne’s Professor Matt Pinnuck and Amir Ghandar FCA, CA ANZ’s reporting and assurance leader, analysed more than 15 years of company financials worldwide for their landmark study released in December 2020, How Long is the Piece of String? Intangibles and goodwill on balance sheets.

They found that a significant percentage of listed firms recognised some intangible assets on their balance sheets: 78% worldwide, 81% in New Zealand, but just 41% in Australia. (That lower level in Australia has to do with the number of smaller mining companies listed on the ASX, which tend not to recognise intangible assets.)

A significant percentage of firms recognise goodwill in their assets: 46% worldwide, 52% in New Zealand and 27% in Australia. About 20% of firms impair goodwill every year, with the average impairment write-down being 30%.

Pinnuck and Ghandar saw no evidence of goodwill being overvalued in large companies, but found some indicators it was happening in small companies.

Typically, in a median firm, goodwill is equal to 3% of total assets. But in Australia, 10% of small firms have recognised goodwill equal to or 53% or more of total assets.

In addition, in small companies, there was a lag between periods of poor performance and it being recognised as an impairment.

 Graph: Percent of Firms Impairing Goodwill Across Time. Click image to enlarge.

Impairment recognition is consistently flagged as a key issue in regulatory financial reporting and auditing oversight programs. Asset valuation also has been a mainstay of the regulators’ ‘focus areas’. For example, the Australian Securities and Investments Commission (ASIC) frequently highlights impairment charges – ranging up to the hundreds of millions – that, in its view, have arisen only because of its inquiries.

“While impairment has frequently been a regulatory discussion, focused on the performance of preparers or auditors, it is just as important to address issues with the model itself,” says Ghandar.

“This is no easy feat but accountants and standard setters will have to strike a balance respecting not only conceptual purity, but also practical reality and workability in order to meet the information needs of investors and other users into the future.”

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