goodwill hunting

Amortising goodwill and its effect on cash flow and value has been an obsession since the 1960s says Wayne Lonergan*

Corporate Australia is delighted at the prospect of no longer having to annually amortise acquired goodwill.  Indeed, goodwill amortisation has been an obsession with corporate Australia since at least the 1960s.
Exactly why this should be so is a mystery as amortising goodwill doesn’t affect cash flow, and therefore can’t, as a matter of logic, effect value.
The lack of impact of goodwill amortisation on share values is not just a matter of valuation theory.  Some 93 percent of investment institutions add back goodwill when assessing value. The other 7 percent of investment institutions are, admittedly, a bit of a worry (sorry, their names and addresses won’t be forwarded to readers who send in a S.A.E).
Historically, there were situations where goodwill amortisation charges may have restricted the ability of some companies to pay dividends.  However, modern capital management techniques, share buy-backs etc have largely overcome such constraints.

The impact of AIFRS

Accounting decisions on transition to AIFRS will have significant implications for post-AIFRS reporting, particularly so in terms of exposure to post AIFRS impairment losses.
AASB 1 allows three alternative treatments of past business acquisitions:
• apply AASB 3 retrospectively to all past business combinations
• apply AASB 3 retrospectively to some past business combinations but exempt others (however, all business combinations post the earliest date of acquisition chosen to apply AASB 3 must be restated); and
• apply the AASB 3 exemptions to all past business combinations.
Future write-downs will exacerbate losses
Corporate Australia will be a lot less delighted about the new goodwill standard in the next economic downturn, or period of high interest rate, which usually precipitate downturns, because profit declines, or trading losses, will be exacerbated by the necessity to make impairment write-downs of the value of acquired goodwill.
AASB 136 also has the unintended effect of introducing “hit the wall” accounting for goodwill because goodwill is now tested at the cash generating unit (CGU) level.
In simple terms, and putting aside the inevitable arguments with the auditors about what comprises a CGU eg. branch, state, country, product, it is the relevant business unit that the group reports at.
The way the AIFRS standard works is that the value of acquired goodwill, internally generated goodwill, synergistic benefits and unrecognised increments in the value of identifiable intangible assets (brands, mastheads, patents, etc.) will be combined at the CGU reference point for testing the value of acquired goodwill for impairment. Simply put, the reference point for goodwill testing is no longer the value of the goodwill of the entity acquired.
Rather, it is the total goodwill pre and post the date of acquisition plus the whole of any increase in the value of identifiable intangible assets in the CGU of which the acquired entity is now part.
The net effect is that the initial decline in value of acquired entity goodwill will be sheltered by the value of other unrecognised intangible asset values in the larger CGU which the acquired entity is now part of.
This process of sheltering will initially avoid the accounting recognition of the reduction in the value of acquired goodwill but only up to a point. Once this point is reached, the whole of the fall in value of acquired goodwill will have to be recognised.

Obvious impacts

The impact on share prices of goodwill write-downs coinciding with the announcement of profit downturns or losses, and the associated further loss of investor confidence, is obvious.
There are a number of reasons why the occasional goodwill write-downs will be a much greater issue under AIFRS than was the annual straight line amortisation under the previous Australian Accounting standards.
Firstly, goodwill is no longer amortised in 20 equal annual instalments, which (informed) investors simply add back to profits.  Instead there will be occasional, and much larger write-downs, coinciding with major deteriorations in profitability and/or high interest rates.
Secondly, goodwill impairment write-downs will start from a higher pre-amortisation base because acquisition goodwill will be valued at cost rather than cost less an annual amortisation charge.
Thirdly, goodwill write-downs under AIFRS are asymmetric. The value of acquired goodwill is written down if its value falls but it is prohibited from being written up when interest rates rise or business conditions improve and the value is recouped.
Fourthly, revaluations of identifiable intangible assets are effectively prohibited under AIFRS. This applies to both pre-existing revaluations and future revaluations.
Fifthly, because impairment testing is now at the CGU level, rather than at the legal entity level, early warnings of value decline will be sheltered initially by the unrecognised value of internally generated goodwill and the unrecognised value of other intangible assets within the CGU the revaluation of which is now prohibited under AIFRS.
The elimination of the requirement to amortise goodwill each year is really a non-event, as amortisation doesn’t affect cash flows. However:
• in future, higher values will be attributed to the carrying value of acquired goodwill;
• these higher values will be carried forward until a significant increase in interest rates or a serious economic downturn occurs;
• at probably the worst point in the interest rate cycle or downturn reported results will be further depressed by goodwill write-offs;
• because of the (effective) prohibition on revaluing intangible assets future write-offs will be charged against profits rather than revaluation reserves;
• when the value of goodwill recovers it won’t be allowed to be written back up; and
• some acquirers will be forced to report lower post acquisition profits due to the AIFRS requirement to recognise and amortise the value of acquired identifiable intangible assets.
Companies who have any doubts about the sustainability of their carrying value of goodwill in the next interest rate rise or economic downturn are strongly advised to take advantage of the first time adoption provisions of the new standard.

 *Wayne Lonergan is managing director of the specialist valuation practice Lonergan Edwards & Associates Limited