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October 17, 2021 09:35 PM

Goodwill accounting: The perennial quest

A reform of goodwill accounting should make the prospects and performance of M&A deals transparent - good governance and strict enforcement are essential for this.

It has always been doubted that derivative goodwill is an asset. Yet this "asset of a special kind" (Schmalenbach) is economically significant; at German energy firm E.ON, for example, goodwill exceeded equity by almost double in 2020, at €17.8 billion. Since the impairment-only approach replaced amortization in 2003, goodwill has been on the rise in IFRS balance sheets. Even in the corona year of 2020, goodwill impairments in the DAX 30 only accounted for just above 2% of the initial carrying amounts of EUR 316.6bn.

Consequently, goodwill has long been an ongoing issue for the FREP, Germany’s enforcer. In 2014, Vice-President Thormann feared that preparers could reduce the impairment-only model to absurdity through questionable exercise of discretion and lack of transparency and thus endanger it in principle. In the process, preparers and users of IFRS financial statements have apparently come to an arrangement. For example, analysts often net goodwill against equity on a lump-sum basis, and many companies highlight "before special items" figures that are adjusted for goodwill impairments. So is IFRS goodwill accounting irrelevant?

Far from it! IFRS are supposed to depict M&A deals in a decision-useful way. These transactions are often fundamental turning points for acquirers; the Monsanto deal, for example, dramatically changed the balance sheet of the Bayer Group. So it's good that goodwill is currently back on the agenda. The FASB wants to go back to scheduled amortization. That would be a mistake, because the useful life of goodwill cannot be reasonably estimated. In contrast, the IASB, under its chairman Andreas Barckow, is considering new disclosures about acquisition objectives and their subsequent achievement. Such information would be highly relevant.

Nevertheless, the proposals fall short. Goodwill is - see Schmalenbach above - initially only a debit-side residual. From an accounting point of view, this item, which IFRS 3 presumes to be an asset, could just as well be an expense or a reduction in equity. Therefore, the recognition question must first be clarified: What is the economic substance behind this item? In order to be eligible for capitalization, a resource would have to exist that is sufficiently likely to generate future benefits - and does not represent an overpayment, for example, made in a bidding war.

Since this economic substance varies from case to case, it is not possible to make a blanket statement as to whether "goodwill" is an asset. Each deal is shaped by its own industrial logic and other factors. The users of financial statements rightly expect to have the expected future economic benefits explained to them on a case-by-case basis. Therefore, a "goodwill" asset would have to be limited to the amount that can be comprehensibly justified on the basis of future growth and restructuring plans, synergies, or real options (cf. Sellhorn, DB 2000, 885 ff). (This idea already characterises the capitalisation of development expenditure under IAS 38).

For subsequent measurement, the expected inflows of benefits need to be tracked. If these occur as planned, the goodwill would have to be amortized in subsequent periods on a "consumption-oriented" basis. If they are missed, an additional (unscheduled) write-down must be made; this also applies if the cost of capital increases. Only truly "eternal" future benefits would justify the permanent retention of goodwill.

It would be naïve to assume that companies would always report the prospects and performance of their M&A deals free of self-interest and strategic discretion. Nevertheless, there would be two advantages over the status quo. First, goodwill would require justification at initial recognition; to date, its economic substance - unlike other intangible assets - is not at all questioned. This accountability to the supervisory board as well as the auditors and users of the financial statements is likely to have a disciplinary effect. Secondly, the potentials planned at the outset would later have to be confronted with reality. Those who will be measured against their forecasts in the future will draw up more realistic plans and make more of an effort to keep to them.

In practice, however, it is often argued (and understandably so) that expected benefits can hardly be tracked over the long term; as a result of integration and restructuring, the acquired goodwill is mixed with other values. Apparently, many companies after even a short time are no longer able to say whether a deal has actually generated the expected value. This would be a massive problem for the governance of M&A processes and should alarm capital providers. For the subsequent valuation, this would mean a total write-off, because if the expected benefits cannot be tracked ex post, the recognition criteria for goodwill would no longer apply. This is already true for the capitalization of development costs, which requires functioning R&D controlling. Such a solution could motivate companies to use synergy controlling to make their M&A activities more transparent – internally and externally.

The holistic reform of goodwill accounting outlined here would be decision useful, as it would make the objectives and performance of acquisitions visible in the financial statements and justify them in a comprehensible manner. However, as many accounting scandals have shown, it presupposes managers with integrity, vigilant supervisory boards and strict accounting controls by auditors and enforcers. Unfortunately, the FASB and IASB have long since decided to rethink only the subsequent measurement of goodwill. A return by the FASB to scheduled amortization would raise the tricky question of how to treat legacy goodwill balances. It would also be an admission of rejecting the goal of decision usefulness as unrealistic, and settling for simplicity and objectifiability. The IASB could follow for convergence reasons, or go it alone to develop a superior solution - a dilemma. Even the capable IASB head Barckow is not to be envied for this permanent bone of contention that is goodwill accounting.

Thorsten Sellhorn

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About Thorsten Sellhorn

Ludwig-Maximilian University Of Munich
Professor of Accounting

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