FRS 10, Goodwill and intangible assets
| by Neil D Stein
04 Nov 1998
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.
(a) capitalised goodwill and intangible as sets are charged in the profit and loss account in the periods in which they are depleted; and
(a) Class of intangible assets:
(b) Identifiable assets and liabilities:
(d) Intangible assets:
(e) Net realisable value:
(f) Purchased goodwill:
(g) Readily ascertainable market value:
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:
(i) Residual value:
(j) Useful economic life:
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:
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:
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
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:
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
(b) Amortisation over a period exceeding 20 years, or no amortisation
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].
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 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.
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).
(a) Recognition and measurement
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.
(d) Negative goodwill
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:
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.
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.
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