FRS 10, Goodwill and intangible assets

Accounting for goodwill has been a problem for accountants for a hundred years or more. FRS 10, Goodwill and Intangible Assets, is the latest but probably not the last attempt to establish acceptable rules for its treatment.

FRS 10 leaves several important issues in a vague state, as we shall see. Before looking at its detail, here is a brief summary of the FRS 10 requirements as regards goodwill.

The FRS 10 requirements regarding goodwill summarised

Purchased goodwill should be capitalised and amortised, usually over a period not exceeding 20 years. Provision is made for the useful life to be extended beyond 20 years when circumstances justify this, and even for the useful life to be taken to be indefinite, so that there is no amortisation at all. (The Companies Act 1985 requires all assets with a finite life to be depreciated, so this last treatment can only be adopted if the ‘true and fair’ override of ss226 and 227 of the Act is invoked).

Whether the goodwill is amortised or not, there must be impairment reviews to confirm that the current value of the goodwill is at least equal to its carrying value. If it is not, the goodwill has to be written down to the lower value determined in the impairment review. FRS 10 does not specify exactly how impairment reviews should be carried out, because this is dealt with in FRS 11, Impairment of Fixed Assets and Goodwill, issued in July 1998. An article on FRED 15, the Exposure Draft preceding FRS 11, appeared in the December 1997 Students’ Newsletter, in the Current Accounting and Auditing Issues series.

We now turn to the detailed requirements of FRS 10.

Objective
The objective of FRS 10 is to ensure that:

(a) capitalised goodwill and intangible as sets are charged in the profit and loss account in the periods in which they are depleted; and
(b) sufficient information is disclosed in the financial statements to enable users to determine the impact of goodwill and intangible assets on the financial position and performance of the reporting entity.

Definitions
FRS 10 includes the following definitions:

(a) Class of intangible assets:
A category of intangible assets having a similar nature, function or use in the business of the entity:
Licences, quotas, patents, copyrights, franchises and trade marks are examples of categories that may be treated as separate classes of intangible assets. Further subdivision may be appropriate, for example, where different types of licence have different functions within the business. Intangible assets that are used within different business segments may be treated as separate classes of intangible assets.

(b) Identifiable assets and liabilities:
The assets and liabilities of an entity that are capable of being disposed of or settled separately, without disposing of a business of the entity.

(c) Impairment:
A reduction in the recoverable amount of a fixed asset or goodwill below its carrying value.

(d) Intangible assets:
Non-financial fixed assets that do not have physical substance but are identifiable and are controlled by the entity through custody or legal rights.

(e) Net realisable value:
The amount at which an asset could be disposed of, less any direct selling costs.

(f) Purchased goodwill:
The difference between the cost of an acquired entity and the aggregate of the fair values of that entity’s identifiable assets and liabilities. Positive goodwill arises when the acquisition cost exceeds the aggregate fair values of the identifiable assets and liabilities. Negative goodwill arises when the aggregate fair values of the identifiable assets and liabilities of the entity exceed the acquisition cost.

(g) Readily ascertainable market value:
The value of an intangible asset that is established by reference to a market where:
(i) the asset belongs to a homogeneous population of assets that are equivalent in all material respects; and (ii) an active market, evidenced by frequent transactions, exists for that population of assets:

Intangible assets that meet those conditions might include certain operating licences, franchises and quotas. Other intangible assets are by their nature unique: although there may be similar assets, they are not equivalent in all material respects and so do not have readily ascertainable market values. Examples of such assets include brands, publishing titles, patented drugs and engineering design patents.

(h) Recoverable amount:
The higher of net realisable value and value in use.

(i) Residual value:
The net realisable value of an asset at the end of its useful economic life. Residual values are based on prices prevailing at the date of acquisition (or revaluation) of the asset and do not take account of expected future price changes.

(j) Useful economic life:
The useful economic life of an intangible asset is the period over which the entity expects to derive economic benefit from that asset. The useful economic life of purchased goodwill is the period over which the value of the underlying business acquired is expected to exceed the values of its identifiable net assets.

If purchased goodwill includes intangible assets that have not been recognised separately because they cannot be measured reliably, the useful economic lives of those intangible assets will have a bearing on that of the goodwill as a whole.

(k) Value in use:
The present value of the future cash flows obtainable as a result of an asset’s continued use, including those resulting from its ultimate disposal.

Scope of FRS 10

There is an important limitation on the scope of FRS 10. It does not apply to small entities following the Financial Reporting Standard for Smaller Entities (FRSSE) unless they prepare consolidated financial statements.

FRS 10 thus applies to all financial statements intended to give a true and fair view of the affairs of entities not meeting the ‘small company’ criteria of the Companies Act 1985, and to the consolidated financial statements of those which do meet the small company criteria.

A company is ‘small’ under the provisions of the Companies Act 1985 if it meets two of the following three criteria:

• turnover (sales) not exceeding £2.8m;
• balance sheet total not exceeding £1.4m;
• average number of employees not over 50.

For these small entities the treatment of goodwill may for the time being follow the requirements of SSAP 22, Accounting for Goodwill, which allows either immediate write-off against reserves or amortisation.

Recognition of positive goodwill and intangible assets

Goodwill
Positive purchased goodwill should be capitalised and classified as an asset on the balance sheet. Internally generated goodwill should not be capitalised.

Intangible assets
An intangible asset purchased separately from a business should be capitalised at its cost. An intangible asset acquired as part of the acquisition of a business should be capitalised separately from goodwill if its value can be measured reliably on initial recognition. It should initially be recorded at its fair value, subject to the constraint that, unless the asset has a readily ascertainable market value, the fair value should be limited to an amount that does not create or increase any negative goodwill arising on the acquisition.

Amortisation of positive goodwill and intangible assets

Where goodwill and intangible assets are regarded as having limited useful economic lives, they should be amortised on a systematic basis over those lives.

Where goodwill and intangible assets are regarded as having indefinite useful economic lives, they should not be amortised.

A life of more than 20 years, or an indefinite life, may only be taken if:

• the durability of the acquired business or intangible asset can be demonstrated and justifies estimating the useful economic life to exceed 20 years;
• the goodwill or intangible asset is capable of continued measurement (so that annual impairment reviews will be feasible).

Residual value

In amortising an intangible asset, a residual value may be assigned to that asset only if such residual value can be measured reliably. No residual value may be assigned to goodwill.

Method of amortisation

The method of amortisation should be chosen to reflect the expected pattern of depletion of the goodwill or intangible asset. A straightline method should be chosen unless another method can be demonstrated to be more appropriate.

The useful economic lives of goodwill and intangible assets should be reviewed at the end of each reporting period and revised if necessary. If a useful economic life is revised, the carrying value of the goodwill or intangible asset at the date of revision should be amortised over the revised remaining useful economic life.

Impairment reviews for positive goodwill and intangible assets

FRS 10 sets up two different rules for impairment reviews. The life taken for the goodwill etc., determines which set of rules applies.

(a) Amortisation over a period of up to 20 years
There should be a review at the end of the first full financial year, and subsequently only if events or changes in circumstances indicate that the carrying value may not be recoverable. The first year review may be performed in two stages:
(i) initially identifying any possible impairment by comparing post-acquisition performance in the first year with pre-acquisition forecasts used to support the purchase price; and
(ii) performing a full impairment review in accordance with the requirements of the FRS on impairment of fixed assets and goodwill only if the initial review indicates that the post-acquisition performance has failed to meet preacquisition expectations or if any other previously unforeseen events or changes in circumstances indicate that the carrying values may not be recoverable.

(b) Amortisation over a period exceeding 20 years, or no amortisation
There should be an impairment review at the end of each reporting period.

FRS 10 does not give detailed guidance as to how the impairment review should be carried out. Guidance on this point is given in FRS 11, Impairment of Fixed Assets and Goodwill. The method proposed there is to compare the ‘value in use’ (or net realisable value if higher) with the carrying value. The value in use is calculated by taking the present value of the future cash flows estimated to be generated by the asset. Such an approach obviously requires a lot of subjective judgement in forecasting future cash flows and choosing a suitable discounting rate. Any drop in value must be taken through the profit and loss account.

There are more details of FRED 15, the Exposure Draft which preceded FRS 11, in an article beginning on page 32 of the December 1997 Students’Newsletter[or view the article on our web site].
Revaluation and restoration of past losses

Where an intangible asset has a readily ascertainable market value, the asset may be revalued to its market value. If one intangible asset is revalued, all other capitalised intangible assets of the same class should be revalued. Once an intangible asset has been revalued, further revaluations should be performed sufficiently often to ensure that the carrying value does not differ materially from the market value at the balance sheet date.

Where an external event caused the recognition of an impairment loss in previous periods, and subsequent external events clearly and demonstrably reverse the effects of that event in a way that was not foreseen in the original impairment calculations, any resulting reversal of the impairment loss that increases the recoverable amount of the goodwill or intangible asset above its current carrying value should be recognised in the current period.

Negative goodwill

Negative goodwill arises when the fair value of acquired assets exceeds the consideration given. Such a situation can arise, for example, when a company which is making heavy losses is taken over.

If an acquisition appears to give rise to negative goodwill, the fair values of the acquired assets should be tested for impairment and the fair values of the acquired liabilities checked carefully to ensure that none has been omitted or understated. Negative goodwill remaining after the fair values of the assets and liabilities have been checked should be recognised and separately disclosed on the face of the balance sheet, immediately below the goodwill heading and followed by a subtotal showing the net amount of the positive and negative goodwill.

Negative goodwill up to the fair values of the non-monetary assets acquired should be recognised in the profit and loss account in the periods in which the non-monetary assets are recovered, whether through depreciation or sale.

Any negative goodwill in excess of the fair values of the non-monetary assets acquired should be recognised in the profit and loss account in the periods expected to be benefited.

Transitional arrangements

FRS 10 makes some important provisions as to goodwill that has already been eliminated against reserves.

Ideally, all goodwill that had previously been eliminated against reserves but would not have been fully written down under the requirements of FRS 10 would be reinstated by means of prior year adjustment on implementation of FRS 10. However, the ASB recognises that this will not be practicable in all circumstances, and therefore does not require reinstatement.

FRS 10 includes a useful chart which summarises the possibilities (see below).

Disclosures

(a) Recognition and measurement
The financial statements should describe the method used to value intangible assets. The following information should be disclosed separately for positive goodwill, negative goodwill and each class of intangible asset capitalised on the balance sheet:
(i) the cost or revalued amount at the beginning of the financial period and at the balance sheet date;
(ii) the cumulative amount of provisions for amortisation or impairment at the beginning of the financial period and at the balance sheet date;
(iii) a reconciliation of the movements, separately disclosing additions, disposals, revaluations, transfers, amortisation, impairment losses, reversals of past impairment losses and amounts of negative goodwill written back in the financial period; and
(iv) the net carrying amount at the balance sheet date. The financial statements should disclose the profit or loss on each material disposal of a previously acquired business or business segment.

(b) Amortisation
The financial statements should disclose the methods and periods of amortisation of goodwill and intangible assets and the reasons for choosing those periods.

Where an amortisation period is shortened or extended following a review of the remaining useful economic lives of goodwill and intangible assets, the reason and the effect, if material, should be disclosed in the year of change.

Where there has been a change in the amortisation method used, the reason and the effect, if material, should be disclosed in the year of change.

Where goodwill or an intangible asset is amortised over a period that exceeds 20 years from the date of acquisition or is not amortised, the grounds for rebutting the 20-year presumption should be given. This should be a reasoned explanation based on the specific factors contributing to the durability of the acquired business or intangible asset.

In addition, where goodwill in the financial statements of companies is not amortised, the financial statements should state that they depart from the specific requirement of companies legislation to amortise goodwill over a finite period for the overriding purpose of giving a true and fair view. Particulars of the departure, the reasons for it and its effect should be given in sufficient detail to convey to the reader of the financial statements the circumstances justifying the use of the true and fair override. The reasons for the departure should incorporate the explanation of the specific factors contributing to the durability of the acquired business or intangible asset.

(c) Revaluation
Where a class of assets has been revalued, the financial statements should disclose: the year in which the assets were valued, the values and the bases of valuation; and the original cost (or original fair value) of the assets and the amount of any provision for amortisation that would have been recognised if the assets had been valued at their original cost or fair value. Where any asset has been revalued during the year, the name and qualifications of the person who valued it should be disclosed.

(d) Negative goodwill
The financial statements should disclose the period(s) in which negative goodwill is being written back in the profit and loss account.

Where negative goodwill exceeds the fair values of the non-monetary assets, the amount and source of the ‘excess’ negative goodwill and the period(s) in which it is being written back should be explained.

Comment on FRS 10

FRS 10 may be criticised on several grounds:
(a) It allows goodwill to be carried permanently at cost on the grounds that its life is indefinite. This is possible under the Companies Act 1985 only with the use of the ‘true and fair’ override, and is not allowed by International Accounting Standard (IAS) 22, Business Combinations, (as amended in September 1998)

Goodwill can, of course, be maintained or increased in value, but the particular combination of factors constituting the goodwill at the time of purchase surely loses effectiveness and is replaced with new internally-generated goodwill as time passes.

(b) The impairment process as explained in FRS 10 and FRS 11 is highly subjective. It seems likely that the ASB hopes that impairment reviews will overcome problems like (a) above, but the subjective nature of the impairment procedure means that this will by no means always be the case.

(c) The treatment of negative goodwill is strange. It is to be credited to the profit and loss account over the periods in which the non-monetary assets acquired at the same time are depreciated or recovered through sale. If the italicised reference was to non-current assets it would be more logical, but the use of the term ‘non-monetary’ includes stock, which would normally be recovered through sale within the year following the acquisition. As FRS 10 gives no guidance as to how negative goodwill should be apportioned among the non-monetary assets, it would appear possible to allocate it to stock and thus take credit for it, in many cases, in the year following acquisition.

IAS 22, Business Combinations (as amended in September 1998) adopts a similar approach to negative goodwill.

The positioning of negative goodwill as a credit ‘immediately below the goodwill heading’, with a subtotal showing the net amount of the positive and negative goodwill. This does not break the letter of the Companies Act requirement that assets and liabilities may not be offset, but it could be argued to break the spirit of it. Also, there is no provision in the Companies Act formats for credit balances to appear among the assets in the balance sheet.

(d) By allowing goodwill to have an indefinite life it does not comply with the Companies Act 1985 (barring the use of the true and fair override), and does not agree with the requirements of International Accounting Standards. The US standard stipulates a maximum of 40 years, but even 20 years should be enough for most people.

Conclusion

Commentators have already drawn attention to the shortcomings of FRS 10. It remains to be seen whether its practical application will prove that the problems indicated above are minor.