The International Accounting Standards Board (IASB) is in the opening phase of what it calls a post-implementation review of its acquisition accounting standard, IFRS 3.
It’s tempting to see this as something of rather limited interest to most of us. After all, IFRS 3 wasn’t ground-breaking, the basics of acquisition accounting are long-established, and perhaps it’s just a question of making running improvements: to clarify something here, to fix an unintended consequence there. I don’t think so. I think it points to the need to think about some of the bigger questions about financial reporting.
Just consider this. Companies spend large sums – sometimes stupendous sums – on acquisitions, and there is a question of accountability for that spend. Lots of it ends up in goodwill, which is not amortised but may go through the P&L in fits and starts called impairment.
Theoretically, quite a bit of it ends up in intangibles (eg, benefit of off-market contracts, an order backlog or customer relationships). Different people have different degrees of difficulty in coming to terms with some of these, either the numbers put on them or the idea that they are assets at all. These intangibles are amortised, but most companies strip that back out again in order to arrive at an adjusted, or non-GAAP, profit measure. They are uncomfortable with amortisation of these intangibles as part of a measure of performance. We’re also told that the analysts strip it out too, usually because it doesn’t help them predict future cash flows. So this topic has got everything: accountability, lack of buy-in from stakeholders, performance, the uses of accounts: what more could we want for a debate about the big issues?
Let’s start with accountability. After all, a key purpose of accounts is stewardship. At the very least one could make the case that this requires amortisation of goodwill, to show whether the income from the target company covers the price that was paid for it – a traditional and very simple accounting idea. This isn’t just the concerns of a cautious, old-school auditor. At KPMG we recently conducted an interview-based survey on this topic and found that same concern shared by at least some companies.
If we were to move to amortisation of goodwill that would take some of the heat out of the question of recognising and valuing intangibles: today, the less the spend goes into amortisable intangibles, the more it goes into non-amortisable goodwill. The deeper issue, though, is why people are uncomfortable with some of those intangibles. I suspect that there are two reasons. First, one could be forgiven for finding some of them difficult to see as separate assets. Customer relationships are at the top of that list. What right does that asset represent? How is it controlled? Whilst I can see that there is information value in trying to allocate the spend to as many specific things as possible, leaving as little as possible as a non-specific rump, I can sympathise with those who feel that it’s basically a sub-analysis of the future trading potential – goodwill by another name.
The second discomfort relates to valuation of intangibles that are uncontentiously assets. Take a target that is in the long-term contracting business, say, construction. Its construction contracts are intangible assets. Being required to put them in at fair value (not straightforward itself), acquiring companies often see the accounting as denying them some of the profit from the post-acquisition work under the contract. That’s true, of course. The underlying issue, however, is a need for IASB to act to forge a consensus around its view on post-acquisition performance. That view is that the acquirer is accountable only for the construction work under the contracts (performing them), and should not take credit for the things that are, accordingly, built into the fair value, ie winning them (the selling margin can be significant in long-term construction) or that they are advantageously priced compared with current prices. If a consensus can’t be forged, then a rethink would be in order.
Part of any consensus is, rightly, the users of accounts. So who are they? I’m a strong believer in stewardship and long-term investment – ownership – so I’d like that section of the investment community to be more vocal. The IASB does, of course, have input from analysts. It’s widely believed that they want to back out the profit and loss effect of intangibles. Taken together with companies’ lack of buy-in and the unsettled question of performance, it’s no wonder that accounts are awash with non-GAAP measures.
Let’s move on to those analysts’ use of the accounts. Why does that drive them to unscramble the intangibles adjustments? The classic reason is that it obscures their understanding of the cash flow (though a recent FRC survey suggests another – the avoidance of double charges). This isn’t just about getting to EBITDA, eg disregarding the straightforward, wholly non-future-cash charges such as amortisation of customer relationships. Rather, the adjustment to the construction contract margin, being deeply embedded in the trading result, is getting in the way of understanding the cash run-rate from trading. All of this prompts two questions. First, why isn’t the cash flow statement meeting their needs? It’s a primary statement. It’s all about cash. Yet it seems to get short shrift from users that are interested in cash. Where have we gone wrong? We really do need to get to the bottom of that.
The second question is bigger still: are we right to use the accounting for a purpose for which it isn’t designed and which might be better served in other ways – if we’re bold enough to go there? The accounting is designed to be about being accountable for past spend (albeit not followed through to goodwill amortisation), yet it is also being used to model future cash flow. So the debate needs to embrace the wider world of corporate reporting outside of historical accounts.
What do we need to do to provide information about future cash prospects, and how do we facilitate its being compared with historical cash flow performance? The world, or at least the corporate side of it, probably isn’t ready to publish cash flow forecasts, though some of the impairment disclosures hint at its details. So where does the consensus lie?
These are all big-ticket questions about what accounts, and corporate reporting more widely, are about, for whom, how they portray performance, and how they facilitate accountability. I doubt that these can be properly tackled in a project to make running repairs to IFRS 3; but happily the IASB is also engaged in a project to revise, validate and get buy-in for the fundamental principles of accounting – the conceptual framework project.
This really is an opportunity that the IASB and its stakeholders should not miss.
Mike Metcalf is a partner at KPMG , in the firm’s UK Department of Professional Practice.
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