Filling the goodwill GAAP

In recent times, many large corporations in India and abroad have recorded significant charges on account of goodwill impairment. This brings to centre stage the initial accounting of goodwill and its subsequent measurement, requiring closer evaluation by management, accountants and investors. This assumes importance because mergers and acquisitions have increased in size, number and span across industries and jurisdictions, with incorporations recording large goodwill balances in financial statements.

Simply put, goodwill is the excess amount paid by an acquiring entity above the acquired net assets (such as receivables and fixed assets). The goodwill gets recorded as an asset in the buyer’s financial statements. The excess payment may be attributable to reputation, business connections, synergies, intangible benefits such as assembled workforce, and so on. It must be noted that the purchase price paid for acquisitions in the past few years has been based on high multiples and premiums, which in turn has resulted in bloated goodwill balances.

Under Indian generally accepted accounting principles (IGAAP), this goodwill balance could significantly differ between entities, depending on the form and structure of the acquisition/ investment. Namely, whether the acquisition is to be accounted under AS–10 “Accounting for Fixed Assets”; or an amalgamation in the nature of purchase to be accounted under AS-14 “Accounting for Amalgamations”; or goodwill arising on consolidation of a subsidiary in the parent’s consolidated financial statements, to be accounted under AS-21 “Consolidated Financial Statements”.

These differences may arise because AS-10 and AS-14 allow the acquired net assets to be recorded at fair value, including allocation to previously unrecognised intangibles, whereas AS-21 requires recording at the historical carrying value appearing in the books of the acquired subsidiary.

This is also one of the major differences between IGAAP and international financial reporting standards (IFRS)/ US GAAP, which require recording the acquired net assets at fair value, including allocation to amortisable intangibles such as customer relationships, trademarks, and technology.

Generally it is observed that due to fair value accounting, a lower amount of goodwill offset by fair value of intangibles is recorded under IFRS/ US GAAP, whereas under IGAAP a higher balance of goodwill is recorded because it subsumes the value of intangibles.

The subsequent accounting treatment and measurement of goodwill depends on the type of goodwill. On review of the accounting policies of various listed Indian companies, it appears that though goodwill is tested for impairment there is widespread diversity on its amortisation. This arises from the different accounting treatments prescribed under IGAAP. For example, AS-10 prescribes that goodwill on acquisition should be written off over a period based on financial prudence. However, it also highlights that many enterprises do not write it off, and instead retain as an asset.

Further, AS-14 is more prescriptive in saying that goodwill arising on amalgamation should be amortised over a period not exceeding five years unless a somewhat longer period can be justified. Finally, as AS-21 is silent on amortisation of goodwill arising on consolidation, there is a mixed practice.

Again, this is a significant area of difference between IGAAP and IFRS/ US GAAP, which prohibits amortisation of goodwill but requires mandatory annual impairment evaluation.

A few pointers for management, accountants and investors deciphering financial statements, especially those with large goodwill balances:

Goodwill being the balancing figure, both sides of the equation should be evaluated in detail at the time of initial accounting — that is, the acquisition price paid to the sellers and the amount allocated to the net assets acquired. For example, the buyer could have been deceived and consequently paid more for a business/ subsidiary based on improprieties or misrepresentations of revenue/ cash flow projections and net assets. Accordingly, it may not be appropriate to capitalise as goodwill the value of assets that the buyer wrongly thought existed.

Rapid changes in the economic, technological, political and competitive environment, including significant decline in market capitalisation, may require a more robust and possibly frequent goodwill impairment analysis. Also, timely and transparent disclosures on fair value estimates in financial reports and sensitivity analysis of significant assumptions will prove useful to investors.

Finally, impairment of goodwill, though commonly described as a non-cash charge, represents lost capital — which if put to alternative use may have improved the company’s return on assets and, consequently, shareholder value. Stakeholders should carefully review the quality of the goodwill asset, particularly given the current external environment and diversity in accounting practices.

(The author is Partner and Head, US GAAP and SEC services, KPMG in India)

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