Fundamentally impaired

Consolidation and Equity Method -Potential Voting Rights and Allocation of Ownership Interests

When it comes to goodwill, the IASB' s proposals on business combinations are

seriously flawed. Andy Simmonds and Nigel Sleigh-Johnson

Andy Simmonds is technical partner at Deloitte & Touche and chaired the working party that prepared the ICAEW comments on the IASB proposals. Nigel Sleigh-Johnson is head of financial reporting at the ICAEW. The institute' s submission to the IASB can be found at UB=TB2I_50678 and its submission to the ASB at UB=TB2I_50680.

In December 2002, the International Accounting Standards Board published Exposure Draft 3, Business Combinations, together with related amendments to existing standards

IAS 36, Impairment of Assets, and IAS 38, Intangible Assets. At the same time, the UK Accounting Standards Board published a consultation paper containing the text of the IASB proposals and additional commentary.

The IASB proposals are widerangingand herald a radical shift in UK accounting. UK listed companies are required under EU law to adopt International Financial Reporting Standards from 2005. Further, the ASB is committed to bringing about rapid convergence of UK standards and IFRS, and UK legislation may soon permit or require all companies to follow IFRS. The IASB proposals are therefore of profound importance for UK accounting, and may have wider implications for acquisitive businesses (see panel).

High hurdles

The ICAEW enthusiastically supports the work of IASB as the global standard setter and has been a prime advocate of international harmonisation of accounting standards. However, convergence must not be at any price. The outcome must be high quality accounting solutions. And the initial and ongoing cost to business of implementing new and revised standards must be clearly justified in terms of the enhanced usefulness of the information.

Business combinations Financial Reporting

These are important hurdles for the many changes to current accounting under consideration by the IASB. In this article we focus on the more controversial proposals on business combinations - especially on goodwill - which, in our view, fail to clear them.

On a more positive note, ED 3 proposes the elimination of merger accounting. All business combinations would be accounted for using the acquisition accounting method. True mergers are very rare. Accordingly, the risk of applying acquisition accounting where in reality no acquirer exists is outweighed by the benefits of introducing a more certain and consistent approach around the world. We therefore accept this decision on pragmatic grounds.

Strong disagreement

ED 3 also prohibits amortisation of the goodwill that arises under acquisition accounting. Instead, goodwill would be accounted for after initial recognition at cost less any accumulated impairment losses, with annual impairment testing required. We strongly disagree with an ' impairment only' regime. This approach is appropriate only where: . the life of goodwill is difficult to assess or can be shown not to be finite;

•    and, more significantly, the prescribed impairment test can be shown to be both reliable and justified in terms of costs and benefits.

The IASB notes that the primary challenge in this area was achieving an acceptable level of reliability in the form of ' representational faithfulness' while at the same time striking some balance with what is practicable. The impairment-only approach simply does not achieve this balance. Some of the reasons are summarised in the panel. Any benefit of annual impairment testing to users of the financial statements of most smaller companies - both quoted and unquoted - would be heavily outweighed by the cost and effort involved. The IASB should permit amortisation over a finite life on clearly-defined cost/benefit grounds. This is not an ideal solution. But it is pragmatic: goodwill, by its nature, does not lend itself to a conceptuallypure accounting solution.

A step too far

Should IASB not waver from its preference for non-amortisation, fundamental changes to its proposed impairment testing regime would be essential. A two-step impairment test for goodwill is proposed, involving a screening test (step 1) and a test of the implied value of goodwill (step 2). We consider that mandating a two-step approach is a step too far, and is neither necessary nor justified.

Under the screening test, goodwill allocated to a cash-generating unit (CGU) would be identified as potentially impaired if the carrying amount of the CGU exceeds its recoverable amount. This is consistent with

IAS 36 and ensures that no CGU (including goodwill) is carried at more than its recoverable amount. No further testing is necessary. Where the recoverable amount is lower than the aggregate carrying value, it is reasonable to assume that any impairment firstly relates to goodwill. A one-step test is also consistent with the approach to testing other intangibles for impairment, reducing the scope for accounting arbitrage.

Complex and costly

Step 2 is effectively imported from the equivalent US standard, FAS 142. It involves measuring the impairment loss attributable to potentially-impaired goodwill as the excess of its carrying amount over its ' implied value' , that is, its current value. The IASB notes that this twostep approach is inconsistent with

IAS 36, and is more costly and more complex. We agree. By comparison, the US standard has a simplified step 1 test intended only to indicate whether step 2 is necessary. In retaining the full rigour of IAS 36 at step 1, the IASB is making step 2 into, at best, a costly complexity and, at worst, the cause of misstatement in assets other than goodwill.

ED 3 and the related amendments to

IAS 36 and IAS 38 contain many other significant proposals - many entirely sensible - that cannot be examined here. Separate identification of many intangibles that are at present simply subsumed within goodwill on a business combination would be required. This should enable users to understand better the economics of the transaction and provide a basis for management subsequently to explain their stewardship of those assets. While we have major reservations regarding the practicality of the current proposals on intangibles, they might in the long run be viewed as a watershed in the development of more useful and relevant financial statements.

All at one go

The IASB' s proposals represent only Phase I of its project on business combinations. The ASB has decided to consult on replacing relevant UK standards only once both Phases I and II are complete. We agree with this approach. UK companies should not have to change to a Phase I standard and then - before 2005 - to a potentially different Phase II standard. We have urged the IASB not to proceed to an IFRS based on Phase I before it has published its proposals on Phase II and sought comment on the overall package.

Some possible business impacts

1. No merger accounting - some believe that the need to identify one party to a combination as the acquirer may discourage some high profile combinations, notwithstanding the lack of any impact on cash flows.

2. Enhanced transparency - the separate identification and impairmenttesting of a wide range of intangibles that would otherwise have been subsumed within the goodwill balance would increase greatly the information available to the market. Management might face greater pressure to manage and explain post-acquisition changes in the value of intangibles.

3. Assessment of post-acquisition performance - analysts and other users tend to disregard goodwill amortisation numbers. They may take more note of amortisation charges relating to specific intangibles - such as customer lists, order or production backlogs and customer relationships - recognised as a result of the IASB proposals. Goodwill impairment numbers - more volatile than amortisation charges - may also be of greater interest to the market, possibly driving fluctuations in share price.

Some problems with ' impairment only'

1 . Goodwill and identified intangibles, which are similar in nature, will be subject to different accounting treatments. This diminishes comparability and reliability and creates a serious risk of accounting arbitrage.

2 . In some cases, the life of goodwill is known with a high degree of probability not to be indefinite, for example goodwill arising on the acquisition of new technology businesses.

3 . Impairment tests are complex and subject to a high degree of subjectivity and uncertainty such that they are no less arbitrary than amortisation over a finite life. In practice, the continued identification of acquired goodwill is highly problematic, particularly following the restructuring and combination of existing businesses.

4 . The cost of impairment tests may not be justified, particularly in the case of many unquoted entities where the tests are likely to convey little useful information to users of their financial statements.

5 . Impairment-only, as currently proposed by the IASB, effectively permits capitalisation of internally-generated goodwill. This is prohibited by the IASB Framework and, moreover, results in a lack of comparability between the financial statements of acquisitive companies and those growing without recourse to acquisition.

Financial Reporting Accounting solutions

Associates and FRS 17

Group A has a 40% owned associate, B. The associate, which is 60% owned by a listed group that has early-adopted FRS 17, Retirement Benefits, has itself fully adopted FRS 17. The A group has not yet adopted FRS 17 and continues to give the transitional disclosures required by the standard. How should the associate be accounted for in the group financial statements?

FRS 9, Associates and Joint Ventures, requires that ' the same accounting policies as those of the investor should be applied' (para 31(c)). When equity accounting in A, the results of B should be adjusted to reverse the adoption of FRS 17 and include B' s pension obligations measured under SSAP 24, Accounting for Pension Costs.

In some cases it may not be possible to make the necessary adjustments because the information will not be available.

FRS 9 does not give any guidance in this situation. However, if a group cannot obtain the information, then the only option would be to use the associate' s financial statements containing FRS 17 numbers. This would give a rather unusual result, in that the A group statement of total recognised gains and losses would include an appropriate share of the actuarial gains or losses included in B' s own financial statements, following the requirement of para 29 of FRS 9.

Where such a situation arises, we would expect that the disclosures required by para 41 of

FRS 2, Subsidiary Undertakings, which refer to para 3(2), Sch 4A of the Companies Act, should be given. Where different accounting policies are applied within a group this requires disclosure of the particulars of the departure, the reason for it and the effect.

If the SSAP 24 information cannot be obtained, the A group should reexamine whether or not the investment actually meets the definition of an associate, particularly in respect of significant influence being required.

Retail concessions

Company C is about to purchase a department store, D. It is assessing what the most appropriate accounting policies would be for D. What impact would the recently issued ASB exposure draft on revenue recognition have on stores that operate concessions?

The exposure draft gives guidance on revenue recognition in principal/agent situations. It proposes that for the seller to account as principal, and record revenue on a gross basis, the seller should have exposure to all significant benefits and risks associated with at least one of (a) the selling price, and (b) stock.

In the case of store concessions, C should be examining whether store D is able to set prices of the goods or whether it takes the risk where stock is damaged or does not move.

Further facts are as follows: D pays concession holder E 95% of gross sales and also makes a ' rental' charge to E for the floor space the concession uses; D has the right to say which lines are stocked in its store; E has the right to move stock around its concessions in different stores; at the end of a season E must take back any unsold stock.

Under the principles of the new exposure draft, it is clear that E takes most of the risks and receives most of the benefits associated with the stock in its concession. The answer would therefore be that store D is in substance acting as agent in selling to the customer and that it should not recognise the gross turnover of the concession. Instead it should report the commission receivable as turnover.

The exposure draft does, however, encourage disclosure in the agent' s accounts of the gross value of sales throughput where the seller is acting as agent.

Accounting Solutions is compiled by Peter Holgate, Michael Gaull and Angela Courtney of the PricewaterhouseCoopers Accounting Technical Department. They are contributing authors to PwC' s Manual of Accounting, published by Gee.

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International accounting solutions Financial Reporting

Potential voting rights

Q1: A, B and C own shares that entitle them to 40%, 30% and 30% respectively of the voting rights of X. A also owns options presently exercisable that allow it to acquire from B and C shares that carry 20% of the voting rights in Company X.

How should A account for its investment in X in its consolidated financial statements?

SIC-33 - , requires the impact of potential voting rights that are presently exercisable to be considered when assessing whether control or significant influence exists. All potential voting rights should be considered. A already owns 40% of the voting rights and has the right to acquire shares carrying 20% of the voting rights. This option is presently (ie, currently) exercisable, so A controls X and should consolidate X.

SIC-33 requires that the existence of potential ownership voting rights should be considered when assessing control but not in the allocation of ownership. The share of X' s net assets allocated to the minorities in A' s group accounts is 60%.

Would the answer to Q1 be different if A did not have the funds to exercise the option?

No. The option is currently exercisable and should be considered to determine whether A has control. A' s ability to exercise is not relevant. SIC-33 states that all facts and circumstances that affect potential voting rights should be examined except the intention of management and the financial capability to exercise. The ability to exercise power does not exist when the potential voting rights lack economic substance (eg, the exercise price is deliberately set so high as to have only a remote possibility of exercise). Potential voting rights are considered when, in substance, they provide the ability to exercise power.

Would the answer to Q1 be different if the exercise price was set so that the current value of the option was out of the money (the exercise price is above the current market value of shares)?

No. The current price of the option is not relevant. However, the ability to exercise power does not exist when potential voting rights lack economic substance (eg, the exercise price is deliberately set so high as to have only a remote possibility of exercise). Potential voting rights are considered when, in substance, they provide the ability to exercise power.

Q2: Now assume a different fact pattern. A no longer holds an option to acquire shares from B and C. Instead A holds a bond issued by X that is presently convertible at A' s option into X' s shares that would give an additional 15% of the voting rights in X.

How should A now account for its investment in X?

SIC-33 requires that the impact of all potential voting rights that are presently exercisable be considered when assessing whether control or significant influence exists. A already owns 40% of the voting rights and has the right to convert the bond into shares carrying 15% of the voting rights. The bond is currently convertible, so A controls X and should consolidate X.

Combined financial statements

L operates in 40 countries and has four business segments. L has decided to sell its medical segment to another multinational.

The medical segment in some countries includes a group of subsidiaries, in other countries a single subsidiary or just a division of a larger legal entity. Different holding companies hold L' s investment in the medical segment. The medical segment is a separate economic entity. The relevant listing authority requires financial statements for the medical segment to be included in the document sent to L' s shareholders in connection with the transaction.

Would combined financial statements, prepared on the basis of an aggregation of the operating units that make up the medical segment, comply with IAS?

IAS does not provide specific guidance on combined financial statements. The objectives of financial statements, described in the International Accounting Standards Board' s are to provide information to users about an entity. The entity does not have to be a group. The medical segment is a separate economic entity. Combined financial statements drawn up to reflect the results and financial position of the medical segment will comply with IAS so long as the medical segment has a history of management as a separate economic entity within A and has been under the control of A throughout the period covered by the combined financial statements.

However, combined financial statements drawn up on this basis cannot be described as consolidated financial statements. Consolidated financial statements are defined in

IAS 27, Consolidated Financial Statements and Accounting for Investments in Subsidiaries, as the financial statements of a group. These accounts should be described as combined financial statements and should contain a comprehensive note explaining the basis of preparation.

International Accounting Solutions is compiled by Robert Dove, a director in PricewaterhouseCoopers' Global Corporate Reporting Group.

Publications PwC has published Making the Change to IFRS which can be downloaded from PwC' s website at

Financial Reporting ASB update

Recent standards

Amendment to

FRS 17 ' Retirement Benefits' and Financial Reporting December 2002 - Standard for Smaller Entities (effective June 2002) November 2002 (Accountancy, February 2003)

Recent UITF abstracts

36: Contracts for Sales of Capacity March 2003 Accounting periods ending on or after

(Accountancy, May 2003) 22 June 2003

Other statements

Operating and Financial Review January 2003 - (Accountancy, February 2003)

Current proposals


Statement of Principles for Financial Reporting: May 2003 1 August 2003 Proposed Interpretation for Public Benefit Entities (discussion paper)

Treasury Shares (draft UITF abstract) May 2003 19 June 2003

Accounting for ESOP Trusts (draft revised UITF Abstract 13) May 2003 19 June 2003

Emission Rights May 2003 14 July 2003

Current proposals


FRED 23: Financial Instruments: Hedge Accounting May 2002 Comments being analysed

(Accountancy, July 2002)

FRED 24: The Effects of Changes in Foreign Exchange Rates. May 2002 ASB has sent comments to IASB Financial Reporting in Hyperinflationary Economies (Accountancy, July 2002)

FRED 25: Related Party Disclosures May 2002 ASB has sent comments to IASB

(Accountancy, July 2002)

FRED 26: Earnings per Share May 2002 ASB has sent comments to IASB

(Accountancy, July 2002)

FRED 27: Events After the Balance Sheet Date May 2002 ASB has sent comments to IASB

(Accountancy, July 2002)

FRED 28: Inventories. May 2002 ASB has sent comments to IASB Construction and Service Contracts (Accountancy, August 2002)

FRED 29: Property, Plant and Equipment. May 2002 ASB has sent comments to IASB Borrowing Costs (Accountancy, August 2002)

IASB Proposals to Amend Certain International Accounting May 2002 ASB has sent comments to IASB Standards (consultation paper)

FRED 30: Financial Instruments: Disclosure and Presentation June 2002 ASB has sent comments to IASB & Recognition and Measurement (Accountancy, September2002)

IASB Proposals for First-time Application of International July 2002 ASB has sent comments to IASB Financial Reporting Standards (consultation paper)

FRED 31: Share-based Payment November 2002 Comments being analysed

(Accountancy, January 2003)

IASB Proposals on Business Combinations, December 2002 Comments being analysed Impairment and Intangible Assets (consultation paper)

Amendment to

FRS 5 ' Reporting the Substance of Transactions' : February 2003 Comments being analysed Revenue Recognition (exposure draft) (Accountancy, April 2003)

IASB update Financial Reporting

Recent standards

IAS 41: Agriculture February 2001 Accounting periods beginning on or after 1 January 2003

IAS 19: Employment Benefits. Limited Amendment in Relation to May 2002 Annual financial statements covering Asset Ceiling periods ending on or after 31 May 2002

Other recent documents

Changes in the IASC Foundation Constitution Related to the International Financial Reporting Interpretations Committee March 2002 5 March 2002

Preface to International Financial Reporting Standards May 2002 Effective on issue

Current projects

Amendments to

IAS 39, Financial Instruments: Recognition and Measurement, and IAS 32, Financial Instruments: Disclosure and Presentation Board redeliberations underway

Business Combinations (Phase 1) (including amendments to

IAS 36 and IAS 38) Comments being analysed

Business Combinations (Phase 2) Exposure draft expected third quarter 2003

Convergence - Short-term Projects Exposure draft expected third quarter 2003

Deposit-taking, Lending and Securities Activities: Exposure draft expected third quarter 2003 Disclosure and Presentation

First-time Adoption of IFRSs IFRS to be published this month

Improvements to International Accounting Standards Board redeliberations underway

Insurance Contracts (Phase 1) Exposure draft expected third quarter 2003

Reporting Performance Exposure draft expected fourth quarter 2003

Share-based Payment Board redeliberations underway


(comment period expired)

G4+1: Joint Ventures November 1999 Awaiting agenda decision

G4+1: Leases: Implementation of a New Approach March 2000 Research work being undertaken

Extractive Industries (issues paper) November 2000 Research work being undertaken

Financial Instruments and Similar Items (Financial Instruments JWG) December 2000 Awaiting agenda decision

June 2003


Financial Reporting APB update

Scope and authority of pronouncements

The Auditing Practices Board (APB) has published a revised statement entitled: .

The statement, which was published as an exposure draft for consultation in November 2002, provides an overview of the types of document issued by APB; explains the level of authority associated with each type of document; and sets out the regulatory regime supporting APB pronouncements derived from legislation and the rules of the accountancy bodies.

This statement reflects the position of the APB at the date of issue. In January 2003, the Department of Trade and Industry announced changes to the structure of audit regulation in the United Kingdom which will impact the APB and some of the arrangements referred to in the statement.

In particular, it is intended that the Financial Reporting Council will take on the functions of the Accountancy Foundation, and that the APB will assume responsibility for issuing ethical standards concerning the integrity, objectivity and independence of auditors. The APB therefore recognises that this statement will need to be updated when these proposed changes to audit regulation become effective.

Jon Grant APB executive director

Recent standards

SAS 610 (Revised): Communication of June 2001 Financial statements for

Audit Matters to Those Charged with (Accountancy, periods beginning on or

Governance August 2001) after 23 December 2001

Recent bulletins

2002/1: The duty of the auditors in the July 2002 July 2002

Republic of Ireland to report to the

director of corporate enforcement

2002/2: The United Kingdom Directors' October 2002 October 2002

Remuneration Report Regulations

2002/3: Guidance for reporting November 2002 November 2002

accountants of stakeholder pension

schemes in the UK

Other recent documents

PN 19 (I): Banks in the Republic of Ireland February 2002 -

PN 23: Auditing Derivative Financial April 2002 -


PN 11 (Revised): The Audit of Charities May 2002 -

in the United Kingdom

PN20 (I): The Audit of Insurers in the August 2002 -

Republic of Ireland

PN24: The Audit of Friendly Societies in the September 2002 -

United Kingdom

Effective communication between audit September 2002 -

committees and external auditors

The Scope and Authority of Pronouncements April 2003 -

Documents issued for comment

PN14 (Revised): The Audit of Registered

Social Landlords in the United Kingdom February 2003 12 May 2003


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