Steve Collings looks at the fundamental principles in accounting for goodwill and intangible assets and also looks at some fundamental differences between current UK GAAP, IFRS and the proposed IFRS for SMEs.

As accountants we are all aware that an intangible asset does not have any physical form and accounting for such assets has always been a major issue for the accounting profession for many years.  Goodwill particularly has always posed problems.

Goodwill can primarily take two forms: purchased goodwill and internally-generated goodwill.  Goodwill is accounted for under the provisions in FRS 10 'Goodwill and Intangible Assets' and IFRS 3 'Business Combinations'. 

Under IFRS 3 and FRS 10, internally-generated goodwill cannot be capitalised.  This also applies to internally-generated brands such as mastheads, publishing titles, customer lists etc in substance.  They should, instead, be treated as either research or development costs in accordance with the principles in IAS 38 'Intangible Assets.

FRS 10 allows internally-generated intangible assets to be capitalised only if there is a readily ascertainable market value and specifically prohibits the capitalisation of internally-generated goodwill.  Where readily ascertainable values are not available then costs incurred should be written off to the profit and loss account as incurred. 

FRS 10 requires purchased intangible assets to be capitalised at cost and amortised over its estimated useful life.  FRS 10 defines the useful economic life of an intangible asset as:

'the period over which the entity expects to derive economic benefits from that asset'. 

In some respects, goodwill and other capitalised intangible assets may be deemed to have an indefinite useful economic life or a useful economic life of more than 20 years.  A useful economic life of more than 20 years can only be chosen if two criteria are met:

·         The lifespan of the intangible asset(s) can be demonstrated to be longer than 20 years; and

·         The intangible asset is capable of continued measurement in order that annual impairment reviews can be undertaken.

For all intangible assets that have been deemed to have either an indefinite life or a lifespan of more than 20 years, annual impairment reviews must be undertaken in accordance with IAS 36 'Impairment of Assets' or FRS 11 'Impairment of Fixed Assets and Goodwill'.  If the impairment test reveals an impairment, then the asset should be written down to its recoverable amount.

Assets carried in the balance sheet (statement of financial position) should never be carried at anymore than their recoverable amount.  IAS 36 'Impairment of Assets' and FRS 11 'Impairment of Fixed Assets and Goodwill' are similar in their determination of recoverable amount.

Under both standards, recoverable amount is the HIGHER of:

·         Fair value less costs to sell; and

·         Value in use.

Fair value less costs to sell is the amount obtainable from the sale of an asset or cash-generating unit in an arm's length transaction between knowledgeable, willing parties, less the costs involved in the disposal.

Value in use is the present value of the future cash flows expected to be derived from an asset or cash-generating unit.

A cash-generating unit is the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets.

FRS 10 prohibits the revaluation of intangible assets after their initial recognition at cost or fair value on acquisition.  Only in rare situations can intangible assets be revalued and such situations are where there are readily ascertainable market values.  Where such readily ascertainable market values are available, then all intangible assets within the same class of intangible assets must be revalued. 

The following are required to be disclosed in an entity's financial statements in relation to intangible assets:

·         Valuation method.

·         For each class of intangible asset:

o   The cost or revalued amount at the start of the accounting period.

o   The cumulative provisions for amortisation or impairment at the beginning and end of the period.

o   A reconciliation of the movements, showing additions, disposals, revaluations, transfers, amortisation, impairment losses and reversals of past impairment losses.

o   Carrying amount at the reporting date.

·         The method of amortisation together with the reasons for choosing the method of amortisation.

·         The reasons for, and the effect of, changing useful economic lives.

·         The reasons for, and the effect of, changing amortisation methods.

·         Where an intangible asset is amortised over more than 20 years, or has an indefinite life and is therefore not amortised, the reasons for rebutting the 20 year presumption. 

Where intangible assets have been revalued:

·         The year in which the revaluation took place and the basis of valuation.

·         The original cost or fair value and the amount of any amortisation provisions that would have been recognised if the intangible asset had not been subject to revaluation.

·         The name and qualifications of the person who valued the intangible asset.

Under the provisions in IFRS 3 'Business Combinations' goodwill amortisation is prohibited, whereas FRS 10 permits goodwill amortisation if the useful economic life of the purchased goodwill is less than 20 years.  IFRS 3 requires annual impairment tests, whereas FRS 10 requires annual impairment tests on goodwill if the useful economic life of the goodwill is more than 20 years.

The proposed IFRS for SMEs allows amortisation of goodwill if the expected useful life of goodwill is less than 10 years.   If it is more than 10 years, then annual impairment tests are required.  In contrast, FRS 10 refers to an expected useful economic life of more than 20 years.

On 11 May 2010, the International Accounting Standards Board (IASB) published for comment their proposed changes to the way financial liabilities are to be accounted for.  These changes were as a result of investor feedback and the IASBs work on financial assets and their issuance of IFRS 9: Financial Instruments which was issued in November 2009 but applies only to financial assets.

The IASB's 'project objective' is to:

The closing date for comments to be received by the IASB is 16 July 2010.

The IASBs project objective refers to the concept of 'own credit'.  This refers to the accounting effect of changes in the credit risk of a financial liability.  It works on the concept that changes in a financial liability's credit risk will affect the fair value of that financial liability.  Therefore, in today's economic climate, when an entity's credit worthiness deteriorates (as we have seen quite a lot over the last few months') then the fair value of its issued debt will also decrease and vice versa.

Where an entity uses fair value as a means of valuing their financial liabilities, such fluctuations in an entity's credit worthiness will cause a gain or (loss) to be recognised in the income statement (profit and loss).  Because many investors find the accounting treatment of financial liabilities valued at fair value through profit or loss confusing, this prompted a discussion paper which was published in June 2009: Credit Risk in Liability Measurement. 

The IASB have asked for responses from investors concerning financial liabilities and received over 90 responses.  In general, the responses confirmed that:

·         Profit and loss volatility caused by own credit does not provide useful information (with the exception for derivatives and liabilities held-for-trading).

·         Investors did not want the IASB to develop a new measurement method, but information on the effects of own credit can still be useful.

The IASB have considered the responses they have received and are proposing a limited change which will address the issue of own credit for financial liabilities.  They are proposing a two-step approach.

The 'two-step' approach would address the issue of P&L volatility as follows:

·         The fair value change of liabilities under the fair value option would be recognised in P&L.

·         The portion of the fair value change due to own credit would be reversed out of P&L and recognised in 'other comprehensive income', therefore bypassing the P&L.

Entity A Inc has a financial liability which it values under the fair value option.  In the year to 31 December 2009 the total change in this fair value amounts to £250. 

The whole of this fluctuation would be recognised in the P&L.

Facts as above, but under the 'two-step' approach we would firstly ascertain the change in fair value, which is still £250.  However, we would go a step further and also determine the change in fair value from 'own credit'.  For the purpose of this illustration, let us assume that the change in fair value from own credit amounts to £30.

Step 1 : (£250 - £30) = £220 would be recognised in P&L.

Step 2 : The £30 which is a change in fair value from own credit would be recognised in 'other comprehensive income' and not P&L.

The IASB are not proposing any other change for financial liabilities.

The overall effect of this proposal would be to eradicate the volatility in the P&L caused by changes in own credit, though information about own credit will still be available for investors.  The IASBs proposals would only apply to those financial liabilities an entity 'chooses' to measure at fair value and therefore financial liabilities which are 'required' to be measured at fair value (such as derivatives and liabilities held-for-trading) would fall outside the scope of this proposal.  The proposals will largely affect large financial institutions.

Some financial liabilities often contain the requirement to split certain debt instruments into those instruments which are measured at amortised cost for example splitting a 'vanilla' instrument and a derivative component which is measured at fair value (this is sometimes referred to as 'bifurcation').  The IASB do not propose any changes in this respect.

The concept of going concern has been in the profession's headlines recently due to the current economic climate and it seems to be an area where practitioners and clients alike encounter difficulty in applying the concept.

The concept of going concern is a fundamental accounting principle and financial statements are prepared on a going concern basis when it is assumed that the company will continue in operation for the foreseeable future and there is neither the intention, nor the need, to either liquidate it or to cease trading.  Directors of small companies are not relieved of their duty to assess going concern because all company accounts are required, by law, to give a true and fair view.  Some directors consider a going concern review should only be undertaken by those companies who fall within the scope of statutory audit : this is not the case, and directors of small companies should consider taking advice to ensure that disclosures and accounting treatment of items within the financial statements conform to the Financial Reporting Standard for Smaller Entities (FRSSE).

In October 2009, the Financial Reporting Council issued guidance 'Going Concern and Liquidity Risk: Guidance for Directors of UK Companies 2009'.  This guidance applies to accounting periods ending on or after 31 December 2009, however, the guidance covers existing requirements set out in Financial Reporting Standards and FRSSE and as a consequence, earlier accounting periods will be expected to comply with the guidance.

Principle 1 in the guidance states:

Smaller companies undoubtedly will undertake lesser work in assessing going concern, whereas larger, more complex companies, will undertake more detailed assessment of going concern.

Directors should assess going concern at least annually and it should be considered at an early stage.  In assessing going concern, directors should take into consideration key factors such as over-dependence on one customer, the extent of borrowing facilities and the likelihood of these being renewed if they are nearing maturity.

Some entities may prepare forecasts and budgets, and the guidance recognises that these are long-established techniques in business management, and undoubtedly medium and large companies will often have this information to hand.  Budgets and forecasts can only be as reliable as the underlying information used in their preparation and so realistic presumptions need to be made by the directors in preparing such budgets and forecasts.  In situations where the critical assumptions underlying the forecasts and budgets may be challenged, the forecasts and budgets should be revised so they predict the most likely outcome.

The guidance issued by the FRC suggests an entity, particularly a medium and large entity, prepare a sensitivity analysis in order to understand any critical assumptions on which any budgets and forecasts are prepared.  'Stress testing' is a concept which involves assessing the extent to which budgets and forecasts react to changes in variables such as changes in interest rates and exchange rates.

The lack of finance available to companies, particularly smaller companies, has been well-publicised of late.  Indeed, some entities are finding it increasingly more difficult to obtain finance or even renew existing borrowing facilities as banks and other financial institutions 'tighten their belt'. 

The renewal of borrowing facilities or the application for borrowing can be indicative of an company's ability to continue as a going concern and the guidance issued by the FRC does make the point that in the absence of confirmation from the lenders this does not, in itself, cast significant doubt upon the company having the ability to continue as a going concern.

Directors should assess the entity's exposure to contingent liabilities.  Where companies have frequent disputes with suppliers, the scope for contingent liabilities, which may result in legal proceedings giving rise to large outflows of cash in the future, is much higher than a company who does not have many disputes.

It is crucially important that directors obtain information about major aspects of their organisation from which they operate, in particular looking at what competitors are doing, how technically up-to-date their products or services as well as looking at other factors such as economic and political factors.

In assessing going concern, directors should take account of the timing of cash flows.  For example, if the company has a large outflow of cash due to take place in the year, directors should assess how this outflow of cash can be matched with inflows of cash.  This is particularly important if the company has a large tax liability to be settled or if loan repayments are falling due.

Principle 2 states:

This is where some directors often mis-interpret this principle.  The review period should be twelve months from the date of approval of the financial statements : not twelve months from the balance sheet date.

The guidance recognises that FRSSE, UK GAAP and IFRS each provide for a minimum period that directors should review when assessing going concern.  The guidance also recognises that the extent of the review period is a matter of judgement which is to be based on facts and circumstances which may mean that obtaining information for longer periods may be required.

Where an entity is audited, the directors' review of going concern is less than twelve months from the date of approval of the financial statements, and the directors' have failed to make such disclosure in the financial statements, the auditor's report must make reference to the fact that the review period is less than twelve months from the date of approval in their report.

Principle 3 states:

There are 3 conclusions which all companies can reach in assessing going concern:

·         The use of the going concern basis of accounting is appropriate because there are no material uncertainties related to events or conditions that may cast significant doubt about the ability of the company to continue as a going concern.

·         The use of the going concern basis is appropriate but there are material uncertainties related to events or conditions that may cast significant doubt about the ability of the company to continue as a going concern.

·         The going concern basis of accounting is not appropriate.

In situations where there are no material uncertainties, the accounts should be prepared under the going concern basis.  Relevant disclosures should be made in the financial statements including disclosures concerning the principal risks and uncertainties facing the company (the Business Review).  Listed companies are required to make further disclosure concerning:

·         The main trends and factors which are likely to affect the future development, performance or position of the company's business; and

·         Information about persons with whom the company has contractual or other arrangements that are essential to the business of the company.

The accounts should be prepared using the going concern basis but disclosure should be made in the financial statements concerning the material uncertainties that give rise to significant doubts about the going concern principle.

Where the directors conclude that the going concern basis of accounting is not appropriate in the circumstances, disclosure should be made on the accounting basis adopted (for example, break-up basis).