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Contents
1. Introduction
2. Goodwill is a big number
3. Examples of qualitative descriptions
4. Examples of non-compliance
5. Conclusion

1. Introduction
The recent issue of revised accounting standards for business combinations under USGAAP (SFAS14R) and IFRS (IFRS3R) has been a significant step down the road to convergence.  One of the most interesting changes has been the adoption by the Financial Accounting Standards Board, in the US, of the IFRS requirement for acquiring companies to disclose and explain the nature of the goodwill arising from the purchase price allocation. SFAS141R will require acquirers to disclose “a qualitative description of the factors that make up the goodwill recognized..”. It goes on to suggest that these might include expected synergies and intangible assets that do not qualify for separate recognition. 

 

The new USGAAP requirement remains noticeably weaker than the IFRS3 equivalent which is for “a description of the factors that contributed to a cost that results in the recognition of goodwill –a description of each intangible asset that was not recognized separately from goodwill and an explanation of why the intangible asset’s fair value could not be measured reliably –or a description of the nature of the excess recognised in profit or loss”.

 

Given that goodwill is usually a significant part of the total purchase price and often the largest component, it is right that stakeholders should be told what it represents but two doubts remain as to whether IFRS3 and SFAS141R go far enough. Is a qualitative description, along the lines required in the revised standards, adequate for stakeholders’ needs? And secondly, what happens if companies fail even to comply with this simple disclosure requirement?

 

2. Goodwill is a big number
Over the first five years of application of the original SFAS141 standard on business combinations from 2002, the S&P100 companies in the US racked up acquisitions costing in excess of one trillion dollars, of which $490 billion (47%) was allocated to goodwill. Proctor & Gamble spent $53 billion on Gillette, of which $35 billion was goodwill. When Bank of America bought MBNA, $20 billion of the total price of $35 billion went to goodwill. It seems self-evident that stakeholders should be adequately informed about these major investments of company funds. Goodwill in the UK too, accounts for a significant portion of acquisitions. In the first year under IFRS3, goodwill accounted for 53% of acquisition value, or £21bn.

 

3. Examples of qualitative descriptions
On the face of it a regurgitation of the words in either standard would suffice to comply with the letter of the standards. “Goodwill represents expected synergies from the merger of operations and intangible assets that do not qualify for separate recognition”.  Here you have a standard paragraph that can be inserted into any acquiring company’s annual report or 10-K that will both comply with the letter of the accounting standards and, in all probability, be true.  However, such disclosure does not comply with the spirit of the standards. Already in European companies and others preparing financial statements under IFRS, we see disclosures of this level of superficiality. 

 

Mittal Steel
For example, in its 2006 annual report Mittal Steel Company discloses details of the acquisitioVn of Arcelor for €29 billion, of which €6 billion was allocated to goodwill. In addition Mittal completed two earlier acquisitions in 2005 for a total of €8 billion, including €1 billion of goodwill. One note covers all three acquisitions and states that “Goodwill recorded in connection with the above acquisitions is primarily attributable to the assembled workforces of the acquired businesses and the synergies expected to arise after the Company’s acquisition of those businesses. Granted these acquired businesses are similar, as they are all steel producers, but is a generic disclosure that does little more than repeat the wording in IFRS3 really adequate to explain to stakeholders what €7 billion was spent on? 

 

Vodafone
In May 2006 Vodafone acquired Telsim Mobil in Turkey for £2.6 billion and the note in the 2007 Annual Report explains that the goodwill of £1.6 billion “is attributable to the expected profitability of the acquired business and the synergies expected to arise…”.. The first part of this explanation is entirely meaningless because the, presumably intangible, assets that drive the profitability are not identified even qualitatively. Might the profitability drivers have something to do with Telsim’s customers and/or its brand? £2.6 billion is small change to Vodafone but they do, as the saying goes, “have form” when it comes to goodwill. The goodwill impairment write-offs following the Mannesmann acquisition in 2000 totalled £34.6 billion at the last count. 

 

eBay
When eBay bought Skype in 2005 they allocated $2.4 billion of the total purchase price of $2.6 billion to goodwill. If SFAS141R had been in force at that time, we would doubtless have seen some bland disclosure about the synergies and workforce. But such a disclosure would have done nothing to warn stakeholders that the goodwill on the Skype acquisition would be impaired to the tune of $1.4 billion by the third quarter of 2007. The underlying reason for the impairment appears to be that eBay management had no strategy to exploit Skype’s undoubted popularity and drive revenues. Skype was, and remains, a largely free service for most of its users and, unlike Google or Yahoo, has not been able to generate revenues through paid advertisments. 

 

It may be too much to hope that an arcane accounting disclosure requirement might protect stakeholders from poor company management but stronger disclosure requirements and a requirement to quantify, at least in broad terms, and have audited, the components of goodwill would bring improvements. Quantification brings a discipline to the acquisition process and management, knowing that their estimates would be subject to audit scrutiny, might be dissuaded from repeating some of the excesses of the past. Such a process could be effective even if the quantification of the components of goodwill did not have to be disclosed.

 

4. Examples of non-compliance
It is depressing how many large companies decide that the present, decidedly unchallenging, requirements of IFRS3 for disclosure of the components of goodwill are all too much, and who choose to remain silent, with the acquiescence of their auditors. For example, the acquisition of Allied Domecq by Pernod Ricard in July 2005 cost around €15 billion of which €3 billion was allocated to goodwill. 

 

The relevant note in the annual report starts encouragingly, apparently with a calculation of the goodwill. In fact it is nothing of the kind. The calculation is of the difference between the fair values of the net assets acquired and the total purchase consideration. This may seem like a matter of semantics but company management need to be able to calculate the fair value of the goodwill in order to arrive at an acceptable purchase price.  Starting with the price necessary to achieve the deal, and then calculating the goodwill as the balancing figure may lead to overpayment. Not only did they not calculate the value of goodwill, they failed to mention what the goodwill comprises at all.

 

In fact, Pernod did probably not overpay. The synergies available to them through combining of production facilities and additional distribution and market power from the combined brand portfolios would be very valuable. They could even have told stakeholders how clever they were, getting the deal at a bargain price because the goodwill elements were worth more than they had to pay for them.

 

There are numerous other examples of a complete disregard of the requirement to disclose the components of goodwill. Alcatel allocated €8 billion to goodwill on the acquisition of Lucent in April 2006. In the year to September 2007, Siemens completed two major acquisitions at a combined cost of €7 billion, of which close to €5 billion was allocated to goodwill. In neither case, did the acquirer make any effort to explain what the goodwill represented.  In 2006, Nestlé were equally dismissive of the requirement to describe CHF2.6 billion of acquired goodwill, but by 2007 they had at least identified synergies, complimentary market share and competitive position as elements of acquisition goodwill of €6.9 billion in that year.

 

5. Conclusion
IFRS3 disclosure requirement on the components of goodwill is just about adequate for stakeholders’ needs. USGAAP is still some way short of even this level of disclosure and, most disturbingly, compliance frequently consists of “going through the motions” and sometimes doesn’t happen at all. 

 

Auditors seem unwilling to make an issue of this, and perhaps this is because compliance still results in such woolly, ‘motherhood and apple pie’ type statements. The attitude seems to be that if disclosure requirements are considered to be bland and uninformative, it doesn’t matter if they are overlooked altogether. The absence of any effective monitoring of compliance with IFRS by reporting companies and their auditors, along the lines of the SEC in the United States, means that the quality of disclosure is likely to remain poor.

 

There is a strong case for quantification of the components of goodwill, audited on a ‘broad brush’ basis to demonstrate that the numbers do at least add up in principle on the acquisition, based on a set of well though out, reasonable, assumptions about the future of the combined entities. Even if the quantification was not required to be disclosed, the fact that the calculations had been made and reviewed by auditors would increase confidence and give company managers pause for thought when negotiating deals.