Faculty of Economic Sciences, Communication and IT

Department of Business Administration

Erik Sunnerdahl

IAS 36 – Impairment on goodwill

A critical view of the framework

International Financial Accounting 7,5 HP

Date/Term: 09-10-19
Supervisor: Berndt
Andersson
Examiner: Berndt
Andersson

Karlstads universitet 651 88 Karlstad

Tfn 054-700 10 00 Fax 054-700 14 60
Information@kau.se www.kau.se
1
Abstract

In March 2002 a big step towards total accounting harmonizing around the
world made its present. The IASB and EU decided that all the listed companies
within the union should establish their consolidated reports under the new
IFRS/IAS frameworks. The new rules applied from January 2005.

The purpose of this report is to with a critical view; review the rules of IAS 36
and IFRS 3 that touches the new goodwill valuation. The new framework
pronounce that goodwill shouldn’t be amortized over a specific time of years
like it did before January 2005, it must instead be up for a yearly impairment
test. The test checks if the acquired goodwill-value is reported to high, if that is
the case, impairment is made.

The analysis is build upon my own conclusions about the frameworks. My

concluded opinion is that the new framework of IAS 36 with impairment of
goodwill leaves too much “free-hands” to the companies. They can control the
value of the goodwill just with a positive vision of the future without breaking
any rules.

The IAS 36 impairment framework is building much of the information upon

future cash-flows and market position. This can lead to increased volatility on
the stock-market. In an economic boom you might not have to do any
impairment on goodwill. In a recession on the other hand, large impairment
have to be done because of the switched market conditions which will have a
significant negative effect at the income-statement. If the companies’ forecasts
about the future cash flows are negative there should be made impairments,
and the already attacked income-statement would get a second punch.

My concluded opinion about the new framework is that the theoretic thought is
good, but the implementation and design of IAS 36 have more disadvantages
than benefits. I vote to bring back the old amortizing system on goodwill over a
specified time, because the uncertainties weren’t that big when you always knew
what will come in the next income-statement. That would certainly facilitate the
users of the financial information. And after all, the financial information is
made for the users.

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Table of contents
1. Introduction ........................................................................................................... 4
1.1 Background ..................................................................................................... 4
1.2 Problem definition........................................................................................... 5
2. Theory ................................................................................................................... 6
2.1 IFRS 3 – Business combination ...................................................................... 6
2.2 IAS 36 – impairment on goodwill ................................................................... 6
2.2.1 External sources of information: .............................................................. 8
2.2.2 Internal sources of information: ............................................................... 8
2.3 What do the experts say about the new goodwill framework? ....................... 8
3. Analysis/ Conclusion .......................................................................................... 10
3.1 Volatility ....................................................................................................... 10
3.2 Different view on terms ................................................................................ 12
3.3 Subjectivity ................................................................................................... 13
3.4 Agent theory .................................................................................................. 13
4. Reflections by the author .................................................................................... 15
References ............................................................................................................... 16

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1. Introduction
In the opening chapter, the background research will be described as part of the problem
definition that will be raised later in this chapter.

1.1 Background

World economy today’s is seeking total globalization in accounting. The biggest

step to harmonize the accounting rules made present in march 2002 when the
European union decided that all listed companies within the union would be
required to establish their financial reporting to the accounting frameworks
IASB/IFRS that’s created by IASB (International accounting standard boards).
Since then a number of countries have stated their interest about doing the
same thing, for example China, Japan and Russia (Barker 2003). The new rules
applied from January 2005 (Thorell 2004).

The main reason why IASBs framework was implemented was to enable a
better comparability between the listed companies within the union (Chiapello
et al. 2009).

Skeptics all over Europe meant that the new “global” accounting framework is
very hard to optimize and adopt in all countries, mainly because of the cultural
differences in accounting and business within the EU. These differences reveal
itself in example trough different tax-rates and meaning of specific words in
different countries. For example: the word probability can mean 60 % chance
in Germany but 80 % chance in Sweden. This of course makes the
interpretation of the framework far more complicated (Zeff 2007).

One of the biggest differences in due to the new accounting standards is the
subject regarding acquired goodwill. The new rules of IAS 36 and IFRS 3 imply
that acquired goodwill yearly should be set up for an impairment test, that will
be done to see whether indications on a impairment have occurred. If
indications tells the company that there could be a impairment under the year,
the test should be done more frequently. Preceding principles in goodwill
accounting intended that goodwill is an asset that should be amortized under a
maximum of twenty years, with the possibility to get longer amortization if the
rules of the yearly impairment test were implemented (Thorell 2004).

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The main objective of the new framework in form of IFRS 3 and IAS 36 was to
progress towards international convergence in the accounting rules, especially
with the US accounting rules of US GAAP. As a result of the new standards
IFRS 3 and IAS 36, made it possible to eliminate a number of differences that
had existed between IFRS and US GAAP in accounting for business
combinations before the year 2004. These new frameworks increased the
comparability of financial statements between the countries (Jerman 2008).

In a debate article in the biggest Swedish financial site “Dagens Industri” a

teacher at Handelshögskolan in Stockholm named Peter Malmqvist discuss the
problem with a properly accounting in acquired goodwill. He says that it always
has been a problem with acquired goodwill and it still is, many big companys in
Sweden have big goodwill posts and that they have to describe how the
afflicated companys (that have earned the goodwill) is evolving in the current
reporting, something that is very rare in today`s reporting system (Malmqvist
2009).

1.2 Problem definition

Is the accounting rules trough IAS 36 and IFRS 3 effective or does it relay to
much on the companies honestly, what can affect their decisions and how
precise is it?

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2. Theory
This section deals with the theories that are relevant and of interest to answer the problem
definition given above.

2.1 IFRS 3 – Business combination

IFRS 3 deals with the situation of business combinations. The framework`s

purpose is to increase the comparability, relevance and reliability in the
information that the company reports about business acquisition (FAR 2006).

The framework regulate how a company that acquire another company should
report and value the goodwill that can occur. Goodwill occurs when the
acquiring company pay a price that exceeds the acquired company`s total equity
(FAR 2006).

The definition of goodwill trough IFRS 3 is:

“An asset that represents future economic benefits arising from other assets acquired in
a business combinations that are not individually identified and separately reported.” (IFRS
3 Annex 1 FAR Förlag 2006 p 14)

When the business combination occurs, the acquiring company allocates the
cost to identifiable assets and liabilities, the value that cannot be allocated
become a residual post, in this situation you have to allocate this value
elsewhere, this is the moment when goodwill is formed. In IFRS 3 p 63 it is
said that IAS 36 explains the accounting policies that is used when deciding the
impairment of the goodwill (FAR 2006).

2.2 IAS 36 – impairment on goodwill

To get a better view over the new goodwill impairment rules it will follow a
brief description over when an impairment test occurred and recognizing
goodwill in a company.

IAS 36 primary objective is to show a variation of methods to ensure that no

assets value of is reported to high, if that is the case, it should be written down
trough impairment.

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A consistently principle in goodwill accounting trough IAS 36 is that, acquired
goodwill is an asset and it should never be valued higher than its recoverable
amount in the balance sheet. The recoverable amount defines as the highest
value of the asset in term of cash flow that it could bring in to the company.
This value is either the fair value or the value in use. Fair value is the amount
for which the asset could be sold between knowledgeable and willing parties,
less the cost to sell. Value in use on the other hand is the expected amount of
cash flow the asset will earn, discounted trough a discount factor to a present
value. In other words, what the asset could bring in to the company today
trough future cash flows (McDonnell 2005).

The calculation of fair value less cost to sell has different types of evidences.
The best evidence is to see the price in a binding sale agreement in an arm
length business deal. If no binding sale agreement is available you can look at
the assets market price (less the cost of disposal) in an active market. If neither
of the above information is obtainable the fair value should be calculated it
should be based on the best information available on the balance sheet day
(Dominique Rachez 2009 Lecture).

The value in use is based on future cash flows that the entity thinks they could
derive from the asset. It takes in consider the time value of money trough a
discount factor that the company calculate trough the market risk-free rate of
interest. So if the company happens to be wrong in their future evaluation, it
can certainly affect the goodwill value. The future cash flows that are used
when calculating “value in use” is based on the managements recently updated
budgets and forecasts and can cover a maximum of five years of future cash
flow (if not the circumstances motivates a longer judgment) (Dominique
Rachez 2009 Lecture).

If the recoverable amount (above described) is less that it’s carrying amount in
the balance sheet, the carrying amount shall be reduced to the recoverable
amount. This is an impairment loss. The impairment loss is affecting the
income-statement negatively and turns down the result of the company
(Dominique Rachez 2009 Lecture.

Down below follows a number of external and internal circumstances that

could be indicators of an impairment of a certain asset.

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2.2.1 External sources of information:

• The asset's market value has reduced significantly, for reasons other than
asset's age and normal use.
• Significant changes in the market that the asset is intended to use, for example
effects that are considered negative, in technology, market conditions,
economic or legal environment that have occurred, or are expected to occur.
• Market rates have risen over the period, which can affect the discount rate
used to calculate the asset's value and affect the recoverable amount of the
asset.
• A change in market capitalization, which means that the company's reported
equitycapital is higher than the company's total stock market value (McDonnell
2005).

2.2.2 Internal sources of information:

• Access occurs to be technologically outdated.

• The potential to use the asset for its intended purpose has somehow
changed.
• Asset returns imply of getting worse, or are expected to be lower than
previously assumed (McDonnell 2005).

2.3 What do the experts say about the new goodwill framework?

To get e deeper understanding about the new methods in valuing goodwill, it is

highly interesting of what the expert thoughts and voices about IFRS 3 and IAS
36.

The British company “Intangible Business” is the world`s biggest independent

company with consultancy in intangible asset valuation for balance sheet and
management. The experts meant that the purpose of IFRS 3 is to get a more
reality based picture of the intangible assets value in a company is good in
theory, in practical matters on the other hand, it`s not working in that way. So
what is the factor that causes the new framework to be ineffective?

Intangible business believes that one of the reasons is the lack of specialists in
valuation of the goodwill. They say further that it`s up to the accountancy

8
profession to make sure that the future judgments and reports doesn’t spin out
of control, with poorly judge acquisitions and reports (Forbes 2007).

In another article created by the joint management director of Intangible

Business Thayne Forbes he presented a number of failures with the framework
of IFRS 3. He argues that reporting of business combination is, even if applied
the right way, “inaccurate and misleading for the unwary reader”. He mentions a
number of flaws that the IFRS 3 is responsible for. The first item that he
considers to be wrong is that only acquired goodwill is allowed on the balance
sheet. If you get goodwill internally from building a new machine or building
you cannot put that on the balance sheet. He argue that the reason for not
putting internally generated goodwill on the balance sheet is that you cannot get
a transaction value, and that the accounting profession think it`s to difficult
valuing the goodwill in a objective way, therefore their solution is to ignore it
(Forbes 2008).

IFRS 3 requires goodwill to be identified and explained to the users, however

Forbes argue that this only occurs in a minority of the occasions in practice,
and in those cases goodwill is explained, its poor and minimal. He argue for
that the company must know wherefrom the goodwill comes from and consist
of. “If they can’t explain it, why did they buy it? (Forbes 2008)

The third flaw Forbes point out is the undervaluing of intangible assets. The
standards say that the company must do an impairment when the goodwill
value is lower than its recoverable value in the balance sheet, to avoid doing an
impairment the companies value its goodwill to low so they avoiding the risk of
doing large impairments. Because if the impairment is done, it will affect the
income-statement and the owners and investors will react negatively. If the
value of goodwill increases, this increase will not be recognized in the balance-
sheet and the volatility of the income-statement is more stabilized (Forbes
2008).

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3. Analysis/ Conclusion
This section presents my own analysis and conclusion based on the theory I gathered and the
problem-definition

3.1 Volatility

Throughout the theory chapter we found that goodwill impairment is highly

affected to the entities own assumptions on the future. And if the company
follows the framework of IAS 36 right, the goodwill value should be written
down when they believe that the future cash flows of the certain asset is going
to decrease. With the old framework of amortizing over time on goodwill, you
always had the same amount of cost in the income statement in a fixed period
of time of maximum 20 year. But in the new system of goodwill accounting it
can be that in economic boom years they might not be any impairment at all. In
a recession or economic collapse period like the one we have and are
experience right now, there should be large impairment which will have a
greatly negative affect at the income-statement. If the companies forecasts
about the future cash flows is negative, there should be made impairments,
which will affect the income-statement even more than it’s already done trough
the recession.

My conclusion over this phenomenon is that the new IAS 36 goodwill

accounting frames are contributing to an increased volatility in the market than
if you compare to the old amortizing system. The new system may create even
lower downs in the recession and higher tops when the economy is in a boom
and in that way the volatility is affected. Thus isn’t said that the old system
worked better or showed a better picture of the reality but it didn’t quite give
the entity that much of “free hands”. Companies can fit in large impairments in
recession time, and then successive do new acquisitions when the market is
getting better.

Peter Malmqvist highlights this phenomenon in a debate article in the Swedish

newspaper in 2005, He discuss that the abolished amortizing rules on acquired
goodwill has led to increased results in the income-statement from the
companies, which will lead to overstated results in listed companies, until the
hangover reaches time. The new framework leads to a judgment of the acquired
goodwill value each and every year, the reason to this is that you wouldn’t get a
twisted value that’s too high. Malmqvist argue that in an economic boom, no

10
uncertainties in showing that the value of goodwill is kept the same as the year
before. In a recession you will have no problems, showing the opposite.
Malmqvist continue to tell that a executive director standard lifetime in a
company last for business cycle, and leaves often in a recession. The new
executive director that takes over, will strive to write down the goodwill value
as much as possible to protect against future impairments, and can always
defend himself in blaming the earlier director if the stock-rate will decrease
dramatically. When a new executive director enters the company, the goodwill
impairment will increase significantly with falling stock-rates as result. Then no
more impairments will be done and the goodwill value will stay the same until
he drop off. This may not lead to more total impairment than it did before if
you see the whole period of time, but for sure it will lead to increased volatility
in the stock-market (Malmqvist, 2005).

You see in today’s economy that unexpected events could get monumental
impact on the owner’s future expectations about the company. If the new
system with the Impairment tests rules is adopted right and owners see that the
company does massive impairments in a recession, it should show that its
future economic situation isn’t looking good, and that could get owners into
sell-panic. Of course it will not affect companies that goodwill posts isn’t that
high, but a consistently trend in big entity`s is that the goodwill-post could be
as much as over 50 % over the total assets.

If you see these frames from owners point of view you don’t know exactly how
much of the company`s goodwill-post is going to be worth which can cause
concerns, and disorder. If you have in mind that the market is driven by
expectations it could cause an increased volatility because of the uncertainty. In
the old system you didn’t have these concerns in the same way. Users and
analytics of economic information always knew when and how much the cost
will affect income statement.

If these new rules are adopted the right way, there should be huge impairments
in a recession which will affect the income-statement negative with result
deteriorations and a decreased unrestricted equity due to this, the stock-owners
will be affected with less dividend.

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3.2 Different view on terms

To continue the above explained discussion about the volatility, it seems that
the volatility in the market is going to increase big times. That doesn’t need to
be happening, because another twist on the IAS 36 impairment framework is
that nothing at all happens.

In the IAS 36 framework it is as earlier said in the theory chapter that one of
the external indicators of impairment on acquired goodwill is that “a decrease in
market value of the asset is significantly” and “not only a short-term decrease”.
This leads in to the company’s different calculation methods, what does the
word short- term means in the car-business toward the meaning in a ventures
capital company. The venture capital company speculates in business
acquisition, with lots of selling and buying companies. The car-company should
be more long ranged in their investments, and the both companies definition of
“short-term” would certainly distinguish from each other. So the word “short-
term” may mean 5 years for some, and 1 year for some. If we take an example,
company (A) acquires another company (B) in a economic boom with a large
goodwill-post within. The cash-flows is looking very good until the market
reaches a recession within 3 years with significant decreased cash-flow of the
new investment (B). When they do the impairment-test they see that it would
be a necessary to do a impairment, but because of the market situation they
know it’s only a short term decrease, and therefore no impairment is going to
be made. They return to a new economic boom and the cash-flow is again
good. This scenario case is for the car-company with a long “short-term” view.
The venture capital company on the other hand, maybe would have made
impairments.

This question whether you should do an impairment just because the market is
in a recession is very tricky. Suppose you acquire a company in the end of a
recession, the cash flows maybe look very good, but the same investment that
be acquired in a decrease in the market, may not look as good. Therefore I
believe that it’s good that the framework doesn’t set a specific time over how
long you should wait before doing a impairment, because the market may be
misleading. My personal opinion is that you have to see a investment at least
over a whole business cycle before you can judge if it’s good or bad.

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3.3 Subjectivity

To continue on the “future cash flow problems” there is another angle to

analyze it, the amount of subjectivity the framework gives the company and
how that can affect the accounting. The previous rules about goodwill
accounting gave corporations options in how long time goodwill should be
amortized. Today another subjective look can revel trough IAS 36, it’s about
the company`s assumptions.

Many people think they have the ability to see to the future. Stock-market
analysts always predict the future concerning in what direction the market is
going. Sometimes they find the right answers but very much of the time they
come wrong. It is not a big conclusion that’s hard if not impossible to predict
the future, but you can do assumptions. When calculating the “value in use”
you have financial forecast of the next five years to your help. The value of
goodwill is depending on what the company believes about the future cash
flows, it pretty much forced to do assumptions. In theory you can say that if the
companies consider the future to be good in form of flourishing cash flows,
then it would never be necessary with a impairment. Of course this is a bit
exaggerating picture because users of the economic information would react
sooner or later and say that it is reasonable to say that the result year after year
is going to be in a certain manner if they are way wrong every year.

An example that can show that the new impairment tests rules can fail is that
current economic situation. For a couple of years ago, people may have think
that the results was going to continue grow (no impairments), they had wrong
and the market sink like a stone. But now many think that the bottom is
reached and from now it’s going to get better, the results and cash flows are on
their way up again, so the forecasts is still optimistic. But nobody knows if the
bottom is reached, and you can’t blame the company to be optimistic either, its
impossible to know exactly when a recession is occur. And if there is
framework like IAS 36 that build on the company`s faith to the future, it’s for
me, fully logical that there believes are positive about the future, from a
economic stand of view.

3.4 Agent theory

The financial information is often said to be created for the users sake.
Analysts, owners and banks should get a summary over the companies
situations. Due to this, companies will have to present their financials and

13
future believes in a way that will make the users satisfied. If you had a annual
report in front of you and saw that there is going to be massive impairments in
goodwill due to a significant downs in the upcoming five years, you might be
very careful before you invest any money in that company and of course that
thought is in the back of the mind in the management. They know that if they
do impairment in acquired goodwill it will show that some acquisition didn’t go
quite the way they expected which can affect the investors and analytics trust to
the company and management in the future. Besides the trust problem, the
impairments going to lead to less dividend to their present owners who strive to
get as much dividend as possible. The question that comes up will be how
much influence do the users have on the amount of impairments that the
company presents?

Users of the economic information shouldn’t affect the company that much
that a necessary impairment doesn’t take place because of fear of the reaction
from the owners. I believe there must be fear from companies to execute
impairments, there most important users are their owners that`s counting on
getting as high dividend as possible. When a impairment takes place it will
affect the income statement negatively and in the long run the distributable
funds to the owners will decrease and may not meet the expectations the
owners expect, this can affect the entities action in doing necessary impairments
on acquired goodwill.

There is another side of companies’ argument to not doing necessary

impairment, if an entity executes big impairments on acquired goodwill, this will
show that they have failed in their investments with a decreased growth. The
company`s vision of the future is negative. If the entity doesn’t dare to convey
that an investments has gone bad or not showing expected results to the
owners it’s going to be a very twisted picture of the reality.

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4. Reflections by the author
In my report about the framework of IAS 36 my work has been fully oriented
to criticize and raise the negative parts of IAS 36 and IFRS 3. Because I have
drawn my conclusions by my own it doesn’t lie no scientific value in the paper,
it is more of a philosophic thinking that the reader itself have to judge whether
he or she believe in the drawn analysis and conclusions. The paper`s purpose is
to get people to think about the framework and what the global accounting
framework-setters is moving towards.

My personal opinion is that rules that regulate how companies should present
their economic information never should get any significant impact on the
economy and its cyclical process. IAS 36 impairment rules on goodwill could be
one of the contributors to the increased volatility in the stock-market the last
years. As said before the impairment has big impact on the dividend that will be
given to the owners and that of course is affected the market. And the
impairment should logically fall in to the system when the market is in a
recession, which may create an even lower down in the market. The other
reason why I don’t envy the IAS 36 framework is the big part of subjectivity
that is involved when deciding whether impairment should be made or not. The
management could almost completely steer the value of goodwill by their own
used assumptions. If they “believe” the future looking bright, no impairments
have to be done. With this phenomenon they can decide whenever a
impairment is best for the company, which add to the earlier discussion when a
new management is applied.

The old amortizing rules didn’t give the same impact during a recession; you
always had the same amount of value decrease on goodwill every year. With this
the fair image of the company may have been misleading, but that disadvantage
is better to live with than today’s subjective frameworks.

15
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standard-stetting: The case of European accounting policy. May 2009 [Online] Vol. 20
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Stockholm: FAR FÖRLAG AB.

Forbes, Thayne (2007) IFRS 3: Dark Matter. March 2007 [Online] Corporate
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Forbes, Thayne (2008) Intangibles and IFRS3: seenbutnotheard. February 2008

[Online] Accounting Web. Available: http://www.intangiblebusiness.com/
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Jerman, Mateja. Manzin, Massimo. (2008) Accounting treatment of goodwill in IFRS

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Dagens Industri. Available: http://di.se/Avdelningar/ Artikel.aspx?ArticleID
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December 2005 [Online] Vol.37 NoJ..66 ,17-19.)

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