FRS 10, Goodwill and intangible assets

This month's article deals with FRS10, Goodwill and Intangible Assets. Accounting for goodwill has been one of the most controversial aspects of financial reporting in recent years. In 1984 the ASC issued SSAP 22 to deal with the subject. SSAP 22 allowed companies a choice of treatment of purchased goodwill:

• immediate write-off to reserves — the preferred treatment;
• amortisation over useful economic life.

SSAP 22 was criticised for a number of reasons:

• it permitted a choice of accounting treatment. The preferred treatment led to a large depletion of shareholders funds and an overstatement of subsequent investment returns. It also led to businesses that wished to minimise the effect of the equity depletions to separately value brands and other intangible fixed assets which are allegedly very similar in nature to goodwill and should therefore be subsumed under the same heading. (The issue of accounting for brands will be addressed in more detail later in the article).
• since SSAP 22 did not specify which reserve the goodwill should be eliminated against, a diversity of practice has been apparent in this respect. The majority of companies wrote the goodwill off to the profit and loss reserve but others created a separate goodwill write off reserve. Such a reserve, of course, would usually have had a debit balance on it.
• SSAP 22’s preferred treatment was not one that is accepted internationally.

These criticisms led the ASB to reconsider the issue and publish FR S10.

The nature of goodwill

FRS 10 defines purchased goodwill as “The difference between the cost of an acquired entity and the aggregate of the fair values of its accountable and identifiable net assets”. In order to have some insight into the nature of goodwill it is useful to consider why a business might have goodwill attaching to it. Another way of asking the same question is to ask why a business would be worth more than the sum of the fair values of the accountable and identifiable net assets of that business. The reasons are due to factors such as:

The expertise of the workforce — current accounting practices do not normally recognise the value of human resources as an asset on the balance sheet.

The reputation of the product(s) of the business — if the product has a well known name attached to it then sales and profits will be boosted on the basis of reputation alone.

The general economic environment — levels of interest rates and exchange rates and levels of investor confidence generally will clearly have a major influence on the value of businesses and hence on the amount of goodwill attaching to a business.

The factors which lead to the existence of goodwill are such that goodwill is difficult to value objectively at any time other than where the business is bought and sold (clearly a value for the business must be available under these circumstances!). Even where goodwill can be valued objectively, its value is likely to fluctuate unpredictably and irregularly due to the factors that lead to its existence (particularly the ‘general economic environment’).

The matters we have discussed in this section seem to lead us to the conclusion that any attempt to put a value on goodwill in any situation other than the purchase or sale of a business would be unwise. It is for this reason that the Companies Act contains a provision that goodwill may only be recognised as an intangible fixed asset if it was acquired ‘for valuable consideration’, in other words, as part of the purchase or sale of a business or business segment.

Internally generated versus purchased goodwill

It is important to stress that goodwill is likely to be present in any business, whether that business has been purchased or developed. Goodwill that arises on the purchase of a business is called, for obvious reasons, purchased goodwill. All other goodwill is referred to as internally generated goodwill (or alternatively inherent, or non-purchased goodwill — these terms all mean the same thing). It is a well-established accounting principle that internally generated goodwill should not be recognised in financial statements. This is of course equivalent to saying (as the Companies Act does) that goodwill may only be recognised as an intangible fixed asset if it is acquired ‘for valuable consideration’.

Goodwill — the key issues

We have already said that we can effectively confine ourselves to considering goodwill that has been purchased. To put it in very simple terms, cash has been credited with the purchase price, what should be debited? If the debit is to go to intangible fixed assets rather than the profit and loss account, then two issues need to be addressed:

Is goodwill an asset?

The accounting requirements of FRS 10 are based on the view that purchased goodwill is neither an asset like other assets or an immediate loss in value. Rather, it forms a bridge between the cost of the investment shown as an asset in the acquirer’s own financial statements and the values attributed to the acquired assets and liabilities in the consolidated financial statements. (Although goodwill can arise in an individual company on acquisition of an unincorporated business by far the most common instance of purchased goodwill is goodwill arising on consolidation.) Although the purchased goodwill is not itself an asset, its inclusion amongst the assets of the reporting entity rather than as a deduction from shareholders’ equity, recognises that goodwill is part of a larger assets the investment in the acquired business, for which management remains accountable. As a postscript to this paragraph, it is worth stressing that although goodwill may display some of the characteristics of an asset, it is unique in the sense that it is incapable of being realised (i.e., sold) without selling the whole business.

Does goodwill have a finite useful life?

SSAP 22 argued that purchased goodwill disappears over time because it is gradually replaced by internally generated goodwill that is not accounted for. This occurs because the factors that influence the level of goodwill attaching to a business (see earlier in the article) will change over a period of time as the workforce and the products etc change. Whilst this is still a helpful argument for us to some degree the issue is not so clear cut following the issue of FRS 10. We will see later that goodwill can theoretically be retained in the balance sheet indefinitely if it is capable of continued measurement.

A summary of the basic requirements of FRS 10

The FRS outlaws the previous preferred treatment of writing goodwill off to reserves. FRS 10 makes the refutable presumption that the useful economic life of purchased goodwill (and also certain other intangible fixed assets — see later in this chapter for more details) is limited and does not exceed 20 years. Assuming this presumption to be valid, FRS 10 requires that purchased goodwill be capitalised as an intangible fixed asset and amortised over the useful economic life of the goodwill. In such circumstances the goodwill should be reviewed for impairment:

• at the end of the first financial year following the acquisition;
• in other periods if events or changes in circumstances indicate that the carrying amount may not be recoverable.

The procedures for performing the impairment review are as laid down in FRS 11 and were covered in an earlier article in this series. As we have already seen the presumption discussed in the previous paragraph may be rebutted 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.

The FRS allows for circumstances in which the useful economic life of purchased goodwill can be taken to be infinite. In such cases, subject to the results of annual impairment reviews (see above) no amortisation would be required. We have already stated that one of the issues that needs to be considered in this regard is the durability of the acquired business. Durability depends on a number of factors such as:

• the nature of the business;
• the stability of the industry in which the acquired business operates;
• typical life-spans of the products to which the goodwill attaches;
• the extent to which the acquisition overcomes market entry barriers that will continue to exist;
• the expected future impact of competition on the business.

The useful economic lives of goodwill and intangible assets will usually be uncertain. This uncertainty does not in itself form grounds for treating a useful economic life as indefinite or for adopting a 20-year period by default.

We have already stated that the 1985 Companies Act requires that, where goodwill is capitalised as an intangible fixed asset, it should be amortised over an appropriate period. Therefore non-amortisation appears to go against this requirement of the Companies Act. Such a departure is only permitted in circumstances where it is necessary so in order to show a true and fair view, given the special circumstances of the business. The Companies Act requires that disclosure of the circumstances behind such departures should be given but is not specific as to the form these disclosures should take. Therefore the Urgent Issues Task Force has issued a pronouncement (Abstract 7) which lays down best practice in this area. The following disclosures are required:

1. a statement of the treatment normally adopted by the Act and a statement of the treatment actually adopted;
2. the reasons for using the different treatment;
3. a quantification of the effect of the departure.;

The information in (a) to (c) above should be provided in every set of financial statements in which the ‘special circumstance departure’ occurs, not just the first time.

Whenever goodwill or intangible assets are regarded as having a useful economic life of more than 20 years (whether or not this is infinite) should be reviewed for impairment at the end of each reporting period.

FRS 10 — an evaluation of the basic proposals

FRS 10 represents a radical shift in the method of accounting for purchased goodwill on future acquisitions. The standard does not have mandatory retrospective effect, so any purchased goodwill already written off to reserves in respect of previously acquired businesses does not have to be reinstated and amortised over its useful economic life. (There is an option for companies to reinstate previously written off goodwill as a prior year adjustment). The standard makes the surely accurate statement that purchased goodwill must have a useful economic life — albeit difficult to determine in many cases. The draft standard therefore takes a pragmatic approach that where the useful economic life of goodwill is not determinable within reasonable limits of accuracy it should be assumed that the maximum period over which amortisation is appropriate should be 20 years. The standard therefore makes some attempt to ensure that the costs of purchasing a business are matched with the income which that business generates for the purchasers — albeit a necessarily ‘broad brush’ attempt.

The possibility for the economic life of goodwill to be infinite is, in the opinion of this writer, questionable on technical grounds. We have identified as a basic principle that over the course of time purchased goodwill gradually gets replaced by internally generated goodwill. Therefore ascribing an infinite useful economic life to purchased goodwill seems akin to recognising internally generated goodwill in financial statements. However given the comments contained in FRS 10 regarding goodwill being retained if it is capable of continued measurement then indefinite retention is certainly a possibility. However the requirement for annual impairment reviews in these circumstances may well deter companies from choosing write-off periods that exceed 20 years.

Subject to the reservation we have just mentioned, the FRS seems to represent a sensible step on the path to finding a solution to the long-standing problem of accounting for goodwill.

Accounting for negative goodwill

Negative goodwill arises when the amount paid for a business is less than the sum of the fair values of the accountable and identifiable net assets. At first sight, if a company came to the conclusion that the amount they had ascribed to purchased goodwill in respect of a business they had purchased was negative they might well question the valuation they had placed on the accountable and identifiable net assets of the acquired business!

Negative goodwill can arise in practice however and could be due to either one of the following factors:

• The acquired business is expecting to make losses in the future — in such circumstances it is expected that the value of the net assets of the business will fall as the losses are made and this may well depress the purchase price accordingly.
• The purchaser has acquired a bargain — maybe the selling company wants to sell very quickly, perhaps due to a need for immediate cash. In such circumstances the purchasing company is clearly in a strong position to negotiate a very attractive purchase price. Alternatively the value to the purchasing company of the acquired business may be greater than the value to the selling company. This may arise if the acquired business fits particularly neatly into the operations of the purchasing company.

The position that FRS 10 adopts is that the primary reason for negative goodwill must be caused by a valuation difference relating to non-monetary assets. This position is justified on the grounds that generally the fair value of monetary net assets is incontrovertible. Therefore FRS 10 requires that negative goodwill should be released to the profit and loss account over the periods in which the non-monetary assets are recovered, whether through depreciation or sale. As far as the balance sheet is concerned, unrecovered negative goodwill (which should arise only rarely) should be shown in the balance sheet alongside positive goodwill.

Example

A business whose net assets have a fair value of £25 million is purchased for £23 million. This means that there is negative goodwill of £2 million. The non-monetary assets of the business at the date of purchase have a fair value at the date of purchase that totals £20 million (stocks £5 million and tangible fixed assets £15 million). In the year following acquisition all the stocks were sold and £3 million depreciation was charged on the tangible fixed assets of the business at the date of acquisition. Therefore non-monetary assets of £20 million at the date of purchase, £8 million was written off in the year following purchase so negative goodwill of:

8/20 x £2 million = £800,000 would be written back to PL.

Intangible fixed assets other than goodwill

Earlier in the article we stated that one of the effects of the previously preferred method of treating purchased goodwill (immediate write off to reserves) was to deplete the amount of equity (or shareholders funds) of the relevant business. We noted that businesses that wished to minimise the effect of the equity depletions to separately value brands and other intangible fixed assets that are allegedly very similar in nature to goodwill and should therefore be subsumed under the same heading. It is therefore necessary to consider whether or not the practice of separate recognition of brands (and other intangible fixed assets as well, although in practice much of the debate has concentrated around the separate recognition of brands) is in keeping with the principles we have been discussing.

• It is certainly true that a brand name can represent an asset that increases the price an acquisitive company is prepared to pay in order to acquire the shares of a target company. It could be argued that a balance sheet that does not reflect the value of brand names in some way is weak or deficient.

The problem of accounting for brand names has been thrown into sharp relief in recent years following the desire of several well known companies (Grand Metropolitan, Rank Hovis McDougall, and Tate & Lyle, for example) to capitalise them. Reasons why enterprises might wish to reflect the cost or value of brands in their balance sheets might include:

• The improvement of the ‘strength’ of the balance sheet — by increasing equity and reversing to some extent the ‘equity depletion’ which occurs when goodwill is written off to reserves.
• The reduction of gearing — by increasing equity whilst leaving borrowings unchanged
.
• The beneficial effect on share price— in that a balance sheet does not include valuable brands which may lead to a company being undervalued by investment analysts.

Many of the characteristics that we have already discussed as being characteristics of goodwill also apply to brand names. However the one feature which distinguishes brand names from goodwill is that brand names are often capable of being separately realised. As a result, recent practice has been to treat such brands as separate intangibles which are not subject to the provisions of accounting standards on goodwill and in particular are frequently not eliminated from the financial statements in the manner prescribed.

It would seem that, provided they are capable of separate realisation, such brand names are not ‘goodwill’ in the true FRS 10 sense. FRS 12 deals with goodwill and other intangible fixed assets (other than development costs, which are dealt with by SSAP 13). The FRS states that:

1. Intangible fixed assets that are purchased separately should be capitalised at cost.
2. Intangible fixed assets that are acquired as part of the acquisition of a business should be recognised separately from goodwill only if their value can be measured reliably on initial recognition.
3. Internally developed intangible fixed assets (for example, a brand name in respect of a product that is developed in house, rather than being added to the product range as part of an acquisition) should only be recognised if they have a readily ascertainable market value.

Once any intangible fixed assets are capitalised, FRS 10 requires that they be dealt with in exactly the same way as goodwill (amortisation over useful economic life, which is presumed to be 20 years or less). In this context, however, it is worth noting that FRS 10 allows for the possibility that the useful economic life of an intangible fixed asset could be infinite. It is easier to see this being possible with a separately identifiable brand than with ‘pure’ goodwill.

As a postscript to this article, it is worth noting that FRS 10 allows for the possibility of brands and other intangible fixed assets to be periodically revalued and carried at market value. Where revaluations take place, the accounting principles to be applied would be the same as those discussed in a previous article in this series dealing with FRS 15. Revaluation of goodwill is not permitted.