Few companies have escaped the ravages of the global financial crisis without having to consider a write-down of goodwill. Total impairments recorded by NZSX companies in the last 3 years have amounted to a heady $1.8 billion, with $330m of that being recorded by 18 companies in 2010 [Source: KPMG research].
Acquisition accounting (NZ IFRS 3 – 2008) requires the acquirer to measure the identifiable assets acquired and the liabilities assumed at their fair values at the date of acquisition. Previously unrecognised items (such as intangible assets and contingent liabilities), as well as most recognised assets and liabilities, are fair valued.
Goodwill arises when the purchase price paid exceeds the aggregate fair value of the assets and liabilities acquired (though there are further complications where there is a non-controlling interest). This residual approach to assessing the value of goodwill relies on a thoughtful, robust process to ensure the level of goodwill makes sense and sits in the right place for future impairment testing.
A number of best practices should be considered to get this right:
1: Make potential acquisition accounting a key part of diligence.
While not a priority during diligence, putting some resources into considering the likely effects of the accounting fair value assessment may unearth potential issues. For example, revenue or cost synergies that may be available to more than one of the potential acquirers of the acquisition target will often get included in the value of the significant intangible assets and may be subject to amortisation. Synergies which are specific to the successful acquirer will typically end up as a component of goodwill.
A preliminary assessment of the fair value and economic lives of likely intangibles will provide insight into the impact of the transaction on future earnings (accretion/dilution analysis). This could impact proposed banking covenants or employee remuneration schemes unless specifically considered or scoped out. When done well, valuation analysis of this type brings greater transparency to investor communications and provides a clearer link between the commercial rationale for the deal and the numbers that end up in the financial statements.
2: The implications in allocating value between intangibles and goodwill.
Mathematics dictates that for a given purchase price, if intangible assets such as brands, customer relationships or technology platforms are ascribed a lower value, the residual goodwill must be higher. As the amortisation of acquired intangible assets acts as a drag on earnings, it may be tempting to lessen this by opting for the low end of the potential value range for a given asset.
Although this may achieve the desired earnings outcome, the resulting increase in the level of goodwill will increase future impairment risk. Indeed amortisation is likely the lesser of two evils here. Many analysts “look through” amortisation and treat it as a non-cash accounting item. An impairment charge is seen as a bigger sin as it is provides evidence that value has been destroyed and, absent macro factors, may call into question past acquisition strategies.
3: Allocate goodwill appropriately between cash generating units (“CGUs”).
Acquired goodwill should be allocated to each of the acquirer’s cash generating units or group of cash generating units that are expected to benefit from the synergies of the acquisition. All too often acquirers will default to a position where synergies are assumed to reside in newly acquired or created CGUs.
This gives rise to these CGUs carrying the full goodwill load. Less focus is given to other parts of the acquiring business and whether they should assume a portion of the goodwill.
Best practice is to utilise cash flow modelling to allocate goodwill according to a relative weighting of the value of the expected synergies. This will reduce the risk of a mismatch between goodwill and the cash flows which support it and lessen the impairment risk in the acquired or newly created CGUs.
4: Tax planning and financial reporting should be aligned.
Cross border acquisitions often give rise to tax planning strategies and transfer of intellectual property between jurisdictions. The resulting transfer pricing regime can directly impact the cash generating expectations of newly acquired businesses (or cash generating units).
Care needs to be exercised to match rather than separate the accounting goodwill from the expected future cash flows of the acquisition in order to avoid unintended financial reporting consequences. Acquisition accounting and tax planning need to be developed in tandem so that goodwill is allocated to the cash generating units that are expected to benefit from the transaction.
5: Prepare for IFRS 13.
IFRS 13 “Fair Value Measurement” was issued on 12 May 2011 and provides guidance on how fair value should be measured for accounting purposes. It will have a direct bearing on acquisition accounting through the fair values assigned to acquired assets and liabilities assumed and consequently the residual level of goodwill.
Although IFRS 13 is not effective until January 2013, early adoption by preparers appears likely. While the new standard is not expected to give rise to significant changes from prior practice, the formalisation of guidance raises the compliance bar.
Concepts such as the assumed “highest and best use” of assets acquired will need to be explicitly considered and documented as part of the fair value exercise. The added guidance could also equip regulators with a framework to review and potentially challenge the approach taken in assessing fair values. Boards need to be fully versed with the requirements of the new standard from both an accounting and valuation standpoint.
In many instances goodwill impairment may be a necessary consequence of changes in economic factors or deterioration in business performance. In other instances, impairment risk can be reduced by better aligning the accounting to the underlying economics of the businesses supporting the goodwill.
The regulatory and accounting framework around financial reporting valuation and impairment testing appears likely to become more challenging. As well as better understanding the downstream accounting implications of deals, robust analysis should also enhance the comfort level of directors when dealing with heightened scrutiny. Best practices today will become a necessity tomorrow.
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Important disclaimer: The views expressed above represent the personal views of the author and do not necessarily represent the views of KPMG.