The Hindu Business Line : Dealing with goodwill impairment post-deals

The difference between cost of acquisition and fair value of all assets and liabilities is determined as the goodwill or negative goodwill, as the case may be.

MS C. G. SRIVIDYA, PARTNER (VALUATION SERVICES), GRANT THORNTON

Did you know that the Jaguar-Land Rover mega deal struck by Tata Motors for a princely sum of $2.3 billion could be valued much less come 2009? Occurrences such as these are a possibility, says Ms C. G. Srividya, Partner (Valuation Services), Grant Thornton. “It is necessary to assess and account for the acquired entity, its assets and liabilities acquired not only at the time of acquisition, but also subsequently every year to ensure that the value originally accounted for has not deteriorated,” notes Ms Srividya in an exclusive e-mail interaction with Business Line.

Just like how inflation slowly eats away our purchasing power, impairment in the value could occur when the current and projected performance of the acquired entity is below what was estimated at the time of acquisition, she adds. How? Loss of customers, loss of contracts, loss of key management, failure of technology, overall market or economic slowdown, litigation, etc., may lead to this diminishing of value. Read on to find out how acquisitions may in reality turn out to be worth much less than previously stated.

Excerpts from the interview:

First, how are acquisitions booked?

A company, which maintains its books of accounts under IFRS (International Financial Reporting Standards) or US GAAP (Generally Accepted Accounting Principles), needs to account for its business combinations including mergers and acquisitions as per IFRS 3 and SFAS (Statements of Financial Accounting Standards) 141 and 142 respectively.

And what do these standards spell out?

As per these standards, the purchase price needs to be allocated to various tangible and intangible assets and liabilities. The difference between the purchase price and the above assets (net of liabilities) is the goodwill.

The consolidated balance sheet of the company will reflect the fair values of the tangible assets and liabilities, intangible assets, and goodwill of the acquired business.

Goodwill. That’s like something constant, right?

No. The goodwill is tested for impairment periodically, typically once a year, at the financial year end to assess if the amount will continue to be carried at the original value or need to be written down. The treatment is the same irrespective of whether the acquired entity is Indian or foreign.

Is it mandatory?

There are several Indian companies which maintain the books of accounts under the US GAAP or IFRS and they need to follow the purchase price allocation (PPA) and goodwill impairment testing guidelines. Indian companies that account only under the Indian GAAP also, based on requirement, carryout a fair valuation exercise of their investments (full or part acquisitions) to assess, if there is any impairment to the investment amount carried in their books.

You mentioned this term, purchase price allocation. What’s that?

The purchase price (cost of acquisition) is determined based on the purchase consideration and the direct cost of the transaction. Purchase consideration refers to the fair value of assets, liabilities assumed and equity issued by the acquirer in exchange for control of the acquired entity.

Aren’t acquisitions already done at fair value?

Here, fair value refers to the amount at which that asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties. Fair values of all balance sheet items of the acquired entity — fixed assets, investments, current assets, current liabilities and other liabilities (including contingent liability) — need to be determined. Intangible assets also need to be identified and fair values for these needs to be determined, naturally.

The difference between the cost of acquisition and fair value of all assets and liabilities is determined as the goodwill or negative goodwill, as the case may be.

Going back to PPA, why is it so important?

The assets and liabilities pertaining to the acquired entity are shown at the fair values in the consolidated balance sheet.

The intangible assets with finite life are amortised over the estimated useful life of the asset. However, intangible assets with indefinite life are not amortised but tested for impairment annually.

What happens to goodwill then? Is it amortised too?

The goodwill is not amortised, but tested for impairment annually and stated net of impairment loss, as I indicated earlier.

What are the assets that fall in the ‘intangibles’ category?

Intangible assets could be order backlog, customer relationship, customer list, vendor contracts, vendor relationship, non-compete agreement, beneficial lease arrangement, franchise arrangement, brand, patents, copyrights, trademarks, technical knowhow, process knowhow, software products, other intellectual property rights, distribution network, service network, etc.

Intangible assets are valued only when their fair values can be determined reliably.

The process starts with detailed discussion with management of the acquiring and acquired entities to identify possible intangible assets. Identification of intangible assets is done based on whether these intangibles fulfil a contractual/legal or separability criteria.

Is workforce part of the intangibles?

Assembled workforce is not recognised as a separate intangible, but is considered as part of goodwill.

Right. So, how can the fair value of intangibles be estimated?

The fair values of intangibles can be determined based on market, income or cost approaches. While a market-based approach, based on comparable market transaction of similar assets, is a preferred approach, it is rarely used due to non-availability of information on such comparable transactions.

The income approach is commonly used and internally accepted for most assets. The value can be estimated through the income approach by using different methods such as multi-period excess earnings, relief from royalty, saving in cost method, etc.

The focus of this approach is to determine a benefit stream that is reasonably reflective of the asset’s most likely future benefits and then is discounted to present value with an appropriate risk-adjusted discount rate.

Isn’t there a third approach to test fair value of intangibles?

Yes. The cost approach establishes value based on cost of reproducing or replacing the asset. But this method is used only when the other methods cannot be used.

How is goodwill tested for impairment?

The goodwill that is determined and carried in the books after the PPA exercise is tested for impairment every year or sometimes before the end of the financial year, when there is any indication that the value could be impaired.

Are there signals to indicate impairment?

The fair value of the reporting unit is estimated as on the impairment testing date and this value is compared to the carrying value of the net tangible assets, intangible assets and goodwill. If the fair value is greater than the carrying value, then there is no impairment, else there is impairment.

D. MURALI

KUMAR SHANKAR ROY

http://InterviewsInsights.blogspot.com

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