9.3 Goodwill and intangible assets in M&A

Goodwill and intangible assets play a crucial role in mergers and acquisitions. These elements often represent a significant portion of a company's value, arising when the purchase price exceeds the fair value of identifiable net assets acquired.

Accounting for goodwill and intangibles involves complex valuation techniques and ongoing impairment testing. Proper recognition and measurement of these assets are essential for accurate financial reporting and providing stakeholders with a clear picture of a company's financial position post-acquisition.

Identifying goodwill in M&A

• Goodwill arises in business combinations when the purchase price exceeds the fair value of the acquired company's identifiable net assets
• Represents the value of intangible elements like brand reputation, customer base, employee skills that are not separately recognized
• Goodwill is a key consideration in M&A accounting as it often represents a significant portion of the purchase price

Goodwill definition and recognition

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• Goodwill defined as an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognized
• Recognized as an intangible asset on the balance sheet of the acquirer
• Not recognized internally generated goodwill only goodwill acquired in a business combination
• Goodwill has an indefinite useful life and is not amortized but instead tested annually for impairment

Calculating goodwill amount

• Goodwill calculated as the excess of the purchase price over the fair value of the acquired company's identifiable net assets
• Formula: Goodwill = Purchase Price - Fair Value of Net Assets Acquired
• Example: If Company A acquires Company B for $100 million and the fair value of Company B's net assets is$80 million, goodwill would be recognized for $20 million ($100m - $80m)
• Negative goodwill arises if the purchase price is less than the fair value of net assets acquired

Negative goodwill considerations

• Negative goodwill indicates the acquirer made a bargain purchase
• Acquirer must reassess the identification and measurement of the acquired assets, liabilities, and contingent liabilities to ensure accuracy
• If negative goodwill still exists after reassessment, it is recognized as a gain in the acquirer's income statement
• Example: If purchase price is $80m and fair value of net assets is$100m, negative goodwill of $20m would be recognized as a gain

Accounting for goodwill

• Goodwill is initially recognized on the balance sheet of the acquirer at cost
• Not amortized but subject to annual impairment tests to ensure carrying amount is recoverable
• Impairment losses are recognized in the income statement and cannot be reversed

Initial recognition of goodwill

• Goodwill recorded as an asset on the acquirer's balance sheet at the acquisition date
• Measured at cost, which is the excess of the purchase price over the fair value of net assets acquired
• Becomes part of a cash-generating unit (CGU) or group of CGUs for impairment testing purposes
• CGUs are the smallest identifiable group of assets that generate independent cash inflows

Subsequent measurement of goodwill

• Goodwill is not amortized as it has an indefinite useful life
• Carried at cost less any accumulated impairment losses
• Tested annually for impairment or more frequently if events or changes in circumstances indicate potential impairment
• If carrying amount exceeds recoverable amount, an impairment loss is recognized

Goodwill impairment testing

• Performed at the CGU level or group of CGUs to which goodwill has been allocated
• Recoverable amount is the higher of fair value less costs of disposal and value in use
• Value in use is the present value of future cash flows expected to be derived from the CGU
• If recoverable amount is less than carrying amount, an impairment loss is recognized first against goodwill and then pro-rata against other assets in the CGU
• Impairment losses cannot be reversed in subsequent periods

Intangible assets in M&A

• Intangible assets are identifiable non-monetary assets without physical substance
• Often represent a significant portion of the value in M&A transactions
• Must be separately recognized from goodwill if they meet certain criteria

Identifying intangible assets

• Intangible assets must be identifiable, controlled by the entity, and expected to generate future economic benefits
• Examples include patents, trademarks, customer relationships, technology, and in-process research and development (IPR&D)
• Acquirer must recognize identifiable intangible assets separately from goodwill
• Some intangibles may not meet the criteria for separate recognition (e.g. assembled workforce) and are subsumed into goodwill

Valuation of intangible assets

• Intangible assets acquired in a business combination are initially measured at fair value
• Various valuation techniques used, such as the multi-period excess earnings method (MPEEM) for customer relationships and the relief-from-royalty method for trademarks
• Key assumptions include estimated future cash flows, discount rates, royalty rates, and attrition rates
• Valuation often involves significant judgment and may require the use of valuation specialists

Useful life of intangible assets

• Intangible assets are classified as having either a finite or indefinite useful life
• Finite useful life intangibles are amortized over their estimated useful lives (e.g. patents, customer relationships)
• Indefinite useful life intangibles are not amortized but tested annually for impairment (e.g. trademarks, certain licenses)
• Useful life is determined based on factors such as legal, regulatory, or contractual provisions, expected use, and effects of obsolescence

Accounting for intangible assets

• Intangible assets recognized separately from goodwill in a business combination
• Initially measured at fair value and subsequently accounted for based on their useful life
• Subject to amortization (finite useful life) or annual impairment testing (indefinite useful life)

Capitalizing vs expensing

• Intangible assets acquired in a business combination are capitalized on the balance sheet
• Internally developed intangibles are expensed as incurred unless they meet certain criteria for capitalization
• Research costs are expensed, while development costs are capitalized if technical and economic feasibility can be demonstrated
• Capitalized development costs are amortized over their estimated useful lives once the related asset is available for use

Amortization of intangible assets

• Intangible assets with finite useful lives are amortized on a systematic basis over their estimated useful lives
• Amortization method should reflect the pattern of economic benefits consumption (e.g. straight-line, units of production)
• Amortization expense is recognized in the income statement
• Useful life and amortization method are reviewed at least annually and adjusted if necessary

Impairment of intangible assets

• Intangible assets with indefinite useful lives and capitalized development costs not yet available for use are tested annually for impairment
• Finite useful life intangibles are tested for impairment when indicators of impairment are present
• If carrying amount exceeds recoverable amount (higher of fair value less costs of disposal and value in use), an impairment loss is recognized
• Impairment losses cannot be reversed for goodwill but may be reversed for other intangible assets if conditions improve

Disclosure requirements

• Entities must provide detailed disclosures about goodwill, intangible assets, and business combinations in their financial statements
• Disclosures provide transparency to users and enable assessment of the effects of these items on financial position and performance

Goodwill disclosures in financial statements

• Reconciliation of carrying amount at beginning and end of period, showing additions, disposals, impairment losses, and other changes
• Allocation of goodwill to CGUs or groups of CGUs
• Key assumptions used in determining recoverable amounts for impairment testing
• Sensitivity analysis for reasonably possible changes in key assumptions

Intangible asset disclosures

• Classes of intangible assets, distinguishing between internally generated and acquired
• Useful lives or amortization rates
• Amortization methods
• Gross carrying amount and accumulated amortization at beginning and end of period
• Reconciliation of carrying amount, showing additions, disposals, impairments, and other changes
• Research and development expenditure recognized as an expense

Business combination disclosures

• Name and description of the acquiree
• Acquisition date and percentage of voting equity interests acquired
• Primary reasons for the acquisition and description of factors that make up goodwill
• Acquisition-date fair values of consideration transferred, assets acquired, and liabilities assumed
• Amount of goodwill expected to be deductible for tax purposes
• Amounts recognized for transactions separately from the acquisition

International accounting standards

• Goodwill and intangible assets are addressed by both IFRS and US GAAP
• While there are similarities between the two frameworks, some key differences exist
• Convergence efforts have aimed to reduce differences, but some remain

IFRS vs US GAAP for goodwill

• Both require annual impairment testing of goodwill
• IFRS prohibits amortization of goodwill, while US GAAP allows private companies to amortize goodwill over up to 10 years
• IFRS requires impairment testing at the CGU or group of CGUs level, while US GAAP requires testing at the reporting unit level
• IFRS uses a one-step impairment test, while US GAAP uses a two-step test (though recently simplified to a one-step test)

IFRS vs US GAAP for intangibles

• Both require separate recognition of intangible assets in a business combination if certain criteria are met
• IFRS allows revaluation of intangible assets to fair value in certain circumstances, while US GAAP prohibits revaluation
• IFRS requires capitalization of development costs meeting certain criteria, while US GAAP generally requires expensing of all research and development costs
• Differences in the types of intangible assets that may be recognized (e.g. IFRS allows recognition of certain internally generated brands)

Recent changes to standards

• IFRS: IASB issued amendments to IAS 36 (Impairment of Assets) to clarify disclosures and align with US GAAP
• US GAAP: FASB issued ASU 2017-04, simplifying the goodwill impairment test by eliminating Step 2
• US GAAP: FASB issued ASU 2014-02, allowing private companies to amortize goodwill and simplify impairment testing
• Ongoing convergence efforts aim to further reduce differences between IFRS and US GAAP in this area