Business combinations and goodwill–a new model under debate
In June the US Financial Accounting Standards Board adopted two new accounting standards: FAS 141 'Business Combinations' and FAS 142 'Goodwill and Other Intangibles'. Applicable for business combinations from 1 July 2001, these introduce major changes in US accounting, notably:
- a ban on pooling (ie merger accounting); all business combinations are to be treated as purchases (ie acquisitions)
- no amortisation of goodwill
- in most cases, annual testing for goodwill impairment
- impairment testing rather than amortisation, for acquired intangible assets with indefinite lives.
The Canadian standard-setter was a partner with the FASB in the development of FAS 141 and FAS 142 and has issued similar standards. In Australia, merger accounting is already outlawed. International Accounting Standards (IASs) at present recognise both merger accounting and acquisition accounting. The guidance for differentiating the circumstances in which either is applied is, however, not robust; it is substantially less developed than the material in the UK's FRS 6 'Acquisitions and Mergers'. IASs also mandate the amortisation of goodwill, in contrast to the UK standard under which goodwill may be either amortised or systematically tested for impairment.
Given this variety of accounting treatments across the world (and a few more variations in other jurisdictions), business combinations and related questions of accounting for goodwill and acquired intangible assets were seen as urgent priorities for the international agenda when standard-setters met earlier this year. There was concern that diversity in accounting for business combinations was creating competitive advantages in terms of deal-making.
The IASB has already started its work on these questions. Perhaps not surprisingly, it is focusing on the recent work by the FASB. It will, however, also be considering various aspects of accounting associated with business combinations where UK standards have moved 'ahead' of international thinking. Acquisition provisions are perhaps the most important example, where, compared with UK standards, IAS 22 allows some flexibility in charging costs to the acquisition balance sheet. An international exposure draft is expected in the early part of next year.
The banning of merger accountingInitial signs from the IASB are that it is minded to follow Australia and the USA in banning merger accounting (ie combining the assets and liabilities of both entities at their book values). In every business combination, an acquirer would have to be identified for the purpose of accounting, with the assets and liabilities of the target being fair valued and a balance calculated for goodwill.
Identifying the acquirer may not be easy, though, when a business combination is equally balanced, or when a new entity is formed to issue shares to shareholders of both parties. To identify an acquirer, the new US literature calls for consideration of all facts and circumstances, including: relative voting rights; the existence of a large voting minority interest; the composition of the governing body of the combined entity; the composition of the senior management; and the terms of exchange of equity securities.
UK readers will find this list familiar; it is similar to considerations required under FRS 6 for identifying mergers. Concern has already been expressed that the effect of banning merger accounting would be to swap a situation where, in some cases, there is a 'fine line' between merger and acquisition accounting, for a situation where there is a 'fine line' in choosing one party or the other as the acquirer for accounting purposes.
Meanwhile, UK commentators in meetings with the IASB have continued to explain the view that there are some, albeit relatively few, business combinations which are true mergers. Accounting standards should not deny this. It may be, though, that our merger accounting methodology does not adequately reflect the nature of a merger as the creation of a new economic entity. 'Fresh start accounting'—fair valuing at least the tangible and financial assets and liabilities of the two combining entities—may be the way forward for accounting for mergers, as equally it may be for accounting for the creation of joint ventures.
Goodwill—amortisation or impairment testing?The UK might rightfully claim to have led the world's thinking on accounting for goodwill. In particular, in the development stages of FRS 10 'Goodwill and Intangible Assets', the ASB recognised that goodwill was in many cases not a wasting asset and that, where goodwill has an indefinite life, amortisation does not measure any economic reality. In FRS 10 the ASB in effect left companies the choice of amortisation or systematic testing for impairment. In practice, relatively few companies seem to have taken the latter option.
The USA, in FAS 142, has banned the amortisation of goodwill. Instead, goodwill is to be tested for impairment in an annual comparison of the fair value of a reporting unit with its carrying amount. The exceptions to annual review are where an event occurs which seems likely to have caused impairment (in which case immediate review is required) and where recent tests have shown a substantial excess of fair value over carrying amount with no significant change in the assets and liabilities of the entity (in which case the review is deferred).
Indications are that the IASB will favour the US route, ban goodwill amortisation and mandate impairment testing. An issue for the IASB will be whether to follow the FASB in applying impairment tests at a fairly high 'reporting unit' level or to use the existing standard, IAS 36, which requires testing at the generally lower level of cash-generating units. If the IASB maintains the use of IAS 36, then it may also want to consider inclusion of a test involving the subsequent monitoring of cash flows, as required in the UK's FRS 11 'Impairment of Fixed Assets and Goodwill'.
All the information in this article is of course 'indications' at this stage, rather than decisions; there are some months to go before a new international exposure draft on business combinations is concluded.
Jenny Carter would be pleased to receive comments on any aspects of business combination accounting. Her email address is j.carter@asb.org.uk
