A reform of goodwill accounting should make the prospects and performance of M&A deals transparent – good governance and strict enforcement are essential for this.
People have always been skeptical about the asset nature of goodwill. Yet this “asset of a special kind” (Eugen Schmalenbach) is economically significant. The goodwill of E.ON, the German energy giant, for example, at €17.8 billion, exceeded equity by almost double in 2020. Since the impairment-only approach replaced amortization in 2003, goodwill has been on the rise on IFRS balance sheets. Even in the ‘corona year’ of 2020, goodwill impairments among the largest 30 German firms accounted for only about 2% of the initial carrying amounts of EUR 316.6bn.
Consequently, goodwill has long been an ongoing issue for the FREP, the German financial reporting enforcement agency. In 2014, Vice-President Thormann feared that preparers could reduce the impairment-only model to absurdity through questionable exercise of discretion and lack of transparency, thus endangering it in principle. However, preparers and users of IFRS financial statements have apparently come to an arrangement. For example, analysts often net goodwill against equity on a lump-sum basis, and many companies highlight “before special items” figures that are adjusted for goodwill impairments. So has IFRS goodwill accounting become irrelevant?
Far from it! IFRS is about mapping M&A deals into financial statements in a way that is useful for decision-making. These transactions are often fundamental turning points for the buying companies; the Monsanto deal, for example, dramatically changed the balance sheet of the Bayer Group, the German pharma and agribusiness firm. So it’s good that goodwill accounting is currently back on the agenda. The FASB wants to go back to amortization. That would be a mistake, because the useful life of goodwill cannot be reasonably estimated. In contrast, the IASB, under its chairman Andreas Barckow, is relying on information about acquisition targets and subsequent deal performance. Such information would be highly relevant.
Nevertheless, the IASB’s proposals fall short. Goodwill is just an asset-side residual. From an accounting point of view, this debit item, which IFRS 3 assumes is an asset, could also be an expense or a reduction in equity. Therefore, one must first settle the recognition issue: What is the economic substance of this item? In order to be eligible for capitalization, a resource would have to exist that is sufficiently likely to generate future benefits – and does not represent an overpayment by the acquirer.
Since this economic substance varies from case to case, it is not possible to make a blanket statement as to whether “goodwill”, per se, is an asset. Each deal is shaped by its own industrial logic and other factors. The users of financial statements rightly expect to have the expected future economic benefits explained to them on a case-by-case basis. Therefore, an asset called “goodwill” would have to be limited to the amount that can be comprehensibly justified on the basis of future growth and restructuring plans, synergies or real options. (This idea already characterises the capitalisation of development expenditure under IAS 38).
For subsequent measurement, the expected inflows of benefits need to be tracked. If these are realized as planned, goodwill would have to be amortized in subsequent periods on a “consumption-oriented” basis. If they fail to materialize, an additional write-off must be taken; this also applies if the cost of capital increases. Only truly “eternal” future potential justifies the permanent retention of goodwill.
It would be naïve to assume that companies would always report the prospects and performance of their M&A deals free of self-interest and strategic discretion. Nevertheless, there would be two advantages over the status quo. First, goodwill would require justification at initial recognition. To date, its economic substance – unlike that of other intangible assets – is not questioned at all. This accountability to the supervisory board as well as the auditors and users of the financial statements is likely to have a disciplining effect on management. Secondly, the potential planned at the outset would later have to be benchmarked against reality. Those who have to be measured against their forecasts in the future will draw up more realistic plans and make more of an effort to keep to them.
In practice, however, it is often argued (and understandably so) that expected benefits can hardly be tracked over the long term; as a result of integration and restructuring, acquired goodwill is inextricably mixed with other value drivers. Apparently, many companies are no longer able to say, even after only a short time period, whether a deal has actually generated the expected value. This would be a massive problem for the governance of M&A processes and should alarm capital providers. For subsequent valuation, this would mean a total write-off, because if the expected benefits cannot be tracked ex post, the recognition criteria for goodwill are no longer met. (This applies analogously to the capitalization of development costs, which presupposes functioning R&D controlling.) Such a solution could motivate companies to use synergy controlling to make their M&A activities more transparent, internally and externally.
The holistic reform of goodwill accounting outlined here would be useful for decision-making, as it would make the objectives and performance of acquisitions visible in the financial statements and justify them comprehensibly. However, as many accounting scandals have shown, it presupposes managers with integrity, vigilant supervisory boards and strict accounting controls by auditors and enforcement. Unfortunately, the FASB and IASB have long since decided to rethink only the subsequent measurement of goodwill. A return by the FASB to an amortization approach would raise the tricky question of how to treat extant goodwills. It would also be an admission of rejecting the goal of decision usefulness as unrealistic and settling for simplicity and objectifiability. The IASB could follow for convergence reasons – or go it alone to develop a superior solution; a dilemma. IASB chairman Barckow is not to be envied for this never-ending story that is goodwill accounting.
Thorsten Sellhorn teaches and conducts research on financial and sustainability reporting at the Ludwig-Maximilians-Universiät in Munich. He is a member of the EFRAG Academic Panel and the IFRS Advisory Council. He was President of the European Accounting Association from 2019-2021.