Business combinations and impairment tests

Readers will remember that the IASB published a Discussion Paper entitled Business Combinations – Disclosures, Goodwill and Impairment on 19 March 2020.

Keywords: Mazars, Thailand, IFRS, Business combinations, Impairment testing, Goodwill, IASB, IAS, FASB, US GAAP

22 November 2021

The key points of the proposals were as follows:

  • no plans to change the current impairment model or to return to amortisation of goodwill;
  • additional disclosures would be required on the performance of the acquired business after the acquisition date, and how this compares with management’s objectives;
  • the information disclosed should be the same as that used by the chief operating decision maker (as defined in IFRS 8 – Operating Segments), as the IASB has chosen to focus on ensuring the relevance of the information (rather than comparability of metrics between different companies);
  • the disclosures currently required under IFRS 3 – Business Combinations would be slightly altered, with additional disclosures required on cash flows from operating activities, and clarification on the issue of profit (henceforth, entities should disclose operating profit before deducting acquisition-related costs and integration costs);
  • the requirement for regular annual impairment testing would be removed (an impairment test would only be carried out when there is an indication that an asset may be impaired);
  • some practical expedients were proposed:
    • permitting entities to use a post-tax discount rate;
    • removing the requirement to adjust business plans where they include items relating to future restructurings or asset enhancements.

Disclosures in the notes

Regarding disclosures, the most significant sticking points were as follows:

The location of disclosures

In particular, some respondents felt that disclosures on the performance of an acquisition should be presented in the management commentary.

They felt that this type of information was by its very nature best located in the management commentary (rather than in the financial statements); that this would help to address issues around the auditability of these disclosures (particularly as regards the objectives set for an acquisition); that this would also help to limit the risk of litigation (safe harbour protections); and finally, that it would avoid repetition of information.

In contrast, other respondents felt that the disclosures should be located in the financial statements, as the IASB has no way of requiring IFRS entities to disclose this information in the management commentary (plus, it is more user-friendly if all disclosures are presented in a single document).

The particularly sensitive nature of some information

Some respondents felt that disclosing quantified objectives set by management could provide third parties with detailed information on an entity’s cost structure, how it determines its selling price or potential future restructuring plans.

However, others felt that it should be possible to provide the necessary information without any negative impact on the entity. They pointed out that press releases often contain information on strategic rationale and objectives.

A third group of respondents felt that it all depended on the level of detail of the disclosures, and that supposed concerns about commercial sensitivity were often put forward as a reason for not disclosing certain information.

The forward-looking nature of the information

Some respondents were concerned that the forward-looking nature of some information could open entities up to litigation.

However, many enforcers and standard-setters agreed with the Board that the information is historical, not forward-looking (such as the assumptions used by management at the date of the business combination).

One solution could be for the Board to require entities to either disclose the information, or else explain why the information is considered to be sensitive (an approach that is already used in IAS 37 for situations where disclosing the information would seriously prejudice the entity in the context of a dispute). Another solution could be to permit entities to present purely qualitative information.

Costs involved, practicability and relevance

In addition, most preparers felt that the potential benefits are outweighed by the costs involved in providing these new disclosures (costs of gathering and auditing the information, and costs relating to the commercially sensitive nature of the information and potential litigation arising from its forward-looking nature).

As regards integration costs, it may be difficult or even impossible to quantify these, particularly in situations where the acquired business is quickly integrated into the entity’s existing activities. Moreover, it could be misleading to present information on the acquired business separately, as this would not necessarily reflect the objectives of the acquisition.

Regarding the format of the disclosures, a very large majority of respondents agreed with the IASB’s preliminary decision not to specify an indicator, but instead to require entities to disclose the information that is regularly monitored by their management. Then, there were more diverse reactions on the proposal to focus on the information received by the Chief Operating Decision Maker, perhaps due to differing perceptions of the level of detail provided to this individual or body.

Disclosures on synergies were felt to be costly to prepare, commercially sensitive, and sometimes difficult to produce at all.

However, there was little objection to the proposed requirement to present disclosures on the amount of pension liabilities and financial debts acquired as part of the business.

Finally, as regards the quantified information (revenue and profit or loss) required by IFRS 3, most respondents felt that the disclosures on cash flows from operating activities would be costly to produce and not particularly useful. There was no particular objection to the proposal to define the ‘profit or loss’ as an ‘operating profit before acquisition-related costs and integration costs’.

Amortisation of goodwill

Opinions diverged significantly on this point and, in particular, there were differences by geographical region. Among users, those in Europe, Japan and Canada tended to be in favour of reintroducing amortisation, while those in the United States, the United Kingdom and Australia would prefer to retain the current system. In contrast, most preparers were in favour of reintroducing amortisation.

The comments received did not put forward any significant new conceptual arguments (or evidence), other than the fact that impairment testing is not considered to be sufficiently effective.

It should also be noted that the US accounting standard-setter, the Financial Accounting Standards Board (FASB), tentatively decided in December 2020 that it would reintroduce amortisation of goodwill on a straight-line basis over a ten-year period (unless an entity opted for a different period, in which case it would need to justify this decision, and the period would be subject to a cap that has yet to be determined). Moreover, entities would not be required to reassess the amortisation period subsequently.

The FASB justified the decision to reintroduce amortisation of goodwill on both conceptual and practical grounds.

This change of direction has led to concerns, particularly in Europe, that entities would be at a disadvantage relative to entities preparing their financial statements under US GAAP.

Goodwill impairment testing

The very large majority of respondents agreed with the IASB that it would not be possible to significantly improve the effectiveness of impairment testing without incurring undue costs.

However, various suggestions for improvements were put forward:

  • regarding the risk of management over-optimism, some respondents suggested that the Board should provide guidance on consistency of assumptions (both consistency between different internal assumptions and consistency between internal assumptions and external evidence), while others suggested that a comparison between forecasts used in previous impairment testing and actual cash flows should be presented in the notes;
  • regarding the risk of the shielding effect, some respondents wanted the Board to clarify what is meant by “monitoring goodwill” (which could be replaced by monitoring the acquisition), or amend the reference to operating segments under IFRS 8 (to make it clearer that this is the highest level at which goodwill may be allocated), or provide guidance on allocating goodwill to cash generating units (CGUs). In the event of a change in the reporting structure, the Board could stipulate that an entity may only change the level at which impairment testing is carried out if it can demonstrate that cash flows have in fact changed. Otherwise, the test would need to be carried out as previously, in accordance with the former reporting structure;
  • other notable suggestions included permitting entities to reverse impairment losses on goodwill, and improving the list of indicators of impairment (by adding indicators that are specific to goodwill, or indicators necessary to demonstrate that goodwill has not become impaired, etc.)

A majority of respondents supported the IASB’s proposals for simplifying the impairment test. They felt that the Board should permit entities to use post-tax cash flows and post-tax discount rates and that it would be useful to remove the current restrictions on how to estimate value in use (future restructurings and asset enhancements).

In contrast, most respondents disagreed with the proposal to remove the requirement for an annual impairment test, feeling that the cost savings would not compensate for the reduction in the effectiveness and robustness of the test. However, this response was based on the IASB’s current tentative decision, and could thus change if the Board ultimately decided to reintroduce amortisation of goodwill.

Other issues

Most respondents agreed that the Board should not amend the criteria for recognising intangible assets acquired in a business combination.

On this subject, it should be noted that the FASB decided in April 2021 to carry out additional research to determine whether some intangible assets should be recognised separately from goodwill (notably non-compete agreements and certain customer-related intangible assets).

Some respondents felt that, if amortisation of goodwill were to be reintroduced, the Board should review the distinction between intangible assets and goodwill (for cost/benefit reasons, as both types of assets would be amortised).

There were also some respondents (including some users) who felt that separate recognition of intangible assets does not provide useful information. Conversely, others felt that the Board should launch a wider-scope project to permit entities to recognise more intangible assets, including those generated internally (to increase comparability between entities expanding through acquisition and those focusing on internal growth).

As regards the Board’s proposal that equity excluding goodwill should be presented in the statement of financial position, most respondents felt that this information was not useful (as it is easy to calculate oneself) and could potentially be misleading (as it would suggest that goodwill was not an asset).

Finally, while most respondents felt that convergence with US GAAP was desirable, there were some differences of opinion. Some respondents felt that convergence was more important than the specific outcome (i.e. whether or not amortisation was reintroduced). Others felt that convergence was desirable, but should not take precedence over the quality of IFRS financial statements.

Where are we following the recent IASB meetings?

Currently, it is extremely difficult to foresee the final outcome of the project. In particular, there is a question over whether the IASB will be influenced by the FASB’s decision to reintroduce amortisation of goodwill, even though no new conceptual arguments in favour of amortisation emerged from this outreach work.

The Board’s deliberations in July 2021 highlighted the fact that none of the approaches are perfect, leading some members to support the “least bad” approach. The joint meeting between the FASB and the IASB, which also took place in July, shortly after the IASB’s meeting, will likely have provided the Board members with more insight into the US standard-setter’s position.

Several members of the IASB said in July that they would like to be able to decide on the whole package of accounting treatment and disclosures required in the notes (while some acknowledged that disclosures in the notes are often addressed at the last minute, at the end of a project).

In practice, the staff planned to approach the subject from different angles: disclosures in the notes, the treatment of goodwill, and other topics.

As regards disclosures in the notes, the staff are to develop illustrative examples, to be tested with preparers, users, regulators and auditors, to determine whether or not the Board’s demands are reasonable. In other words, the objective of these examples is to see whether the concerns expressed by some are due to second-guessing particular aspects of the Board’s requirements.

This should clarify whether it is possible to retain the Board’s preliminary views regarding the disclosures required on subsequent performance and synergies.

As regards the accounting treatment of goodwill, some Board members wanted the staff to work on the useful life of goodwill and the treatment of historical goodwill (and thus the potential transition between two accounting models).

As regards the useful life of goodwill, a feasibility study was proposed, focusing on the costs of determining the useful life of goodwill on a transaction-by-transaction basis; the usefulness of the information obtained; the reliability of estimates; and the merits of the various information bases suggested for calculating amortisation of goodwill.

Regarding transition, it was deemed necessary to estimate the amount of “historical” goodwill (i.e. at the date of transition to a potential new accounting model) and the impact of a change in approach on the financial statements, as well as to investigate the potential effects of the possible approaches (in terms of an entity’s ability to distribute reserves, comply with banking covenants and meet the obligations of a listed company).

At the end of the July meeting, it was expected that the Board would vote in September 2021 on whether or not to reintroduce amortisation of goodwill (and whether the decision should be dependent on other aspects, such as the disclosures required in the notes, the practicalities of amortisation, or the inability to improve the effectiveness of impairment testing).

However, the Board was unable to reach a decision on this key issue in September. The Board has opted to follow the recommendations of the staff and the project will thus focus on the two key areas previously discussed, namely:

  • ensuring the Board has an overview of the whole package of required disclosures (based on the Board’s preliminary views, accompanied by illustrative examples); and
  • carrying out additional analysis on the subsequent accounting treatment of goodwill (i.e. the feasibility of reliably assessing the useful life of goodwill, and the practical implications of a potential change in accounting model).

These new developments raise questions over the ultimate outcome of the project, and particularly the issue of which accounting model will be chosen (impairment-only, or amortisation and impairment).

The practical implications are significant and have only become more so over time, given that impairment losses are now rarely recognised on goodwill related to acquisitions since the IASB moved away from the amortisation model. Many stakeholders will doubtless be keeping a close eye on this project.