Goodwill and intangible assets under IFRS

Goodwill and intangible assets: the short answer

An intangible asset is an identifiable non-monetary asset without physical substance, such as software, a patent, a brand or a customer list. Goodwill is the unidentifiable residue a buyer pays in a business combination above the fair value of the net assets it can identify. The distinction matters because intangibles are usually amortised, while goodwill is never amortised under IFRS and is tested for impairment every year.

Three standards govern the area. IAS 38 Intangible Assets sets the definition, the recognition tests and the rules for amortisation. IFRS 3 Business Combinations decides how intangibles and goodwill are measured when one business acquires another. IAS 36 Impairment of Assets decides when their carrying amounts must be written down. This guide follows an acquisition through all three, then looks at intangibles a company builds itself.

When is something an intangible asset under IAS 38?

IAS 38 sets three tests for the definition: the item must be identifiable, the entity must control it, and it must be expected to bring future economic benefits. Identifiable means either separable, so it could be sold, licensed or rented on its own, or arising from contractual or other legal rights (IAS 38 para 12). Staff skills and market share usually fail the control test, because the entity cannot stop employees leaving or customers switching.

An item that meets the definition is recognised only if the future benefits are probable and its cost can be measured reliably (IAS 38 para 21). Purchased intangibles pass these tests easily because the price paid is evidence of both. Internally generated intangibles are harder, and IAS 38 adds specific rules for them, covered later in this guide.

• Typically recognised: purchased software and licences, patents, trademarks, customer contracts and relationships acquired in a business combination, franchise rights, broadcasting and landing rights, capitalised development costs.
• Never recognised as assets: internally generated goodwill, internally generated brands, mastheads, publishing titles and customer lists, research costs, start-up costs, training, advertising and relocation costs.

How to calculate goodwill: a worked example

IFRS 3 para 32 measures goodwill as the consideration transferred, plus the non-controlling interest, plus the fair value of any previously held interest, minus the net of the identifiable assets acquired and liabilities assumed at their acquisition-date fair values. The key word is identifiable: every intangible that meets the IAS 38 definition must be separated out of goodwill, even if the target never recorded it.

Example. Parent pays EUR 5,000,000 cash for 80% of Target. Target's book net assets are EUR 3,000,000. The purchase price allocation identifies a brand worth EUR 600,000, customer relationships worth EUR 400,000 and a EUR 200,000 uplift on property, so identifiable net assets at fair value are EUR 4,200,000. For clarity the example ignores deferred tax; in practice IAS 12 requires deferred tax on the fair value uplifts, which increases goodwill.

IFRS 3 para 19 lets the acquirer measure the non-controlling interest either at its proportionate share of identifiable net assets or at fair value, deal by deal. The choice changes the goodwill figure, as the calculation shows.

• Proportionate method: non-controlling interest = 20% x 4,200,000 = 840,000.
• Goodwill = 5,000,000 + 840,000 - 4,200,000 = 1,640,000 (the parent's share only).
• Fair value method: non-controlling interest measured at its fair value of 1,150,000.
• Goodwill = 5,000,000 + 1,150,000 - 4,200,000 = 1,950,000 (full goodwill, including the minority's share).
• Consolidation entry (proportionate): Dr Identifiable net assets 4,200,000 / Dr Goodwill 1,640,000 / Cr Cash 5,000,000 / Cr Non-controlling interest 840,000.

Bargain purchases and provisional amounts

Occasionally the identifiable net assets are worth more than the consideration plus the non-controlling interest, which produces negative goodwill. IFRS 3 treats this with suspicion: the acquirer must first reassess whether it has identified and measured every asset and liability correctly. Only if a gain remains after that review is it recognised immediately in profit or loss as a bargain purchase gain, typically where a seller was forced to sell.

Purchase price allocations are rarely final at the first reporting date. IFRS 3 allows provisional amounts and a measurement period of up to one year from the acquisition date, during which adjustments that reflect facts existing at the acquisition date are made retrospectively against goodwill. After the measurement period, the business combination accounting is revised only to correct an error under IAS 8; information about events after the acquisition date, such as a later change in the fair value of contingent consideration classified as a liability, goes to profit or loss, not goodwill.

Internally generated intangibles: research versus development

For a project a company runs itself, IAS 38 splits costs into a research phase and a development phase. Research costs are always expensed (IAS 38 para 54), because at that stage the entity cannot show that an asset will result. Development costs are capitalised only from the date the entity can demonstrate all six criteria in IAS 38 para 57, and costs expensed before that date cannot be reinstated later.

Example. A software company spends EUR 900,000 on a new product in the year. EUR 250,000 relates to research and is expensed. Of the development spend, EUR 150,000 was incurred before the six criteria were met and is also expensed. The remaining EUR 500,000 is capitalised: Dr Development costs (intangible asset) 500,000 / Cr Bank or payables 500,000. Total 250,000 + 150,000 + 500,000 = 900,000. When the product is available for use, the EUR 500,000 is amortised over its expected useful life, say five years, at EUR 100,000 a year.

• Technical feasibility of completing the asset so it will be available for use or sale.
• The intention to complete the asset and use or sell it.
• The ability to use or sell it.
• How it will generate probable future economic benefits, such as a market for its output.
• Adequate technical, financial and other resources to complete it.
• The ability to measure the development expenditure reliably.

Amortisation: finite and indefinite useful lives

An intangible with a finite useful life is amortised on a systematic basis over that life, using a pattern that reflects how the benefits are consumed; if the pattern cannot be determined reliably, the straight-line method is used. The residual value is normally assumed to be zero. The useful life and method are reviewed at least at each financial year end, and changes are accounted for prospectively as a change in estimate.

An intangible with an indefinite useful life, meaning there is no foreseeable limit to the period over which it generates cash, is not amortised. It is tested for impairment annually and whenever there is an indication of impairment, and the indefinite-life assessment is reviewed every period. Indefinite is not the same as infinite: a trademark that can be renewed at little cost and supports a product with no expected end of life may qualify, while a licence with a fixed expiry date does not.

Continuing the acquisition example: the customer relationships of EUR 400,000 have an estimated life of eight years, so amortisation is EUR 50,000 a year: Dr Amortisation expense 50,000 / Cr Accumulated amortisation 50,000. The brand of EUR 600,000 is judged to have an indefinite life and is not amortised, but it joins goodwill in the annual impairment test.

Goodwill impairment testing under IAS 36

Goodwill cannot generate cash on its own, so IAS 36 allocates it to the cash-generating units, or groups of units, expected to benefit from the combination, and tests those units at least annually. A unit is impaired when its carrying amount, including goodwill, exceeds its recoverable amount, which is the higher of fair value less costs of disposal and value in use. The loss is allocated first to goodwill and then to the other assets of the unit pro rata.

Example. The unit containing Target carries identifiable net assets of EUR 4,000,000 and recognised goodwill of EUR 1,640,000. Because goodwill was measured using the proportionate method, it reflects only the parent's 80% share, so IAS 36 requires it to be notionally grossed up for the non-controlling interest before the comparison: 1,640,000 / 80% = EUR 2,050,000, giving a notional carrying amount of 4,000,000 + 2,050,000 = EUR 6,050,000. The recoverable amount is EUR 5,000,000, so the notional impairment is EUR 1,050,000, all absorbed by goodwill. Only the parent's share is recognised, because the rest relates to goodwill that was never recorded: 80% x 1,050,000 = EUR 840,000. Dr Impairment loss 840,000 / Cr Goodwill (accumulated impairment) 840,000, leaving goodwill of EUR 800,000. Had the non-controlling interest been measured at fair value, no gross-up would be needed and the loss would be shared between the owners of the parent and the non-controlling interest.

An impairment of goodwill is never reversed, even if the unit recovers later. Impairments of other intangibles and of tangible assets can be reversed, up to the carrying amount that would have existed without the impairment.

Cost model versus revaluation model

After recognition, IAS 38 allows the cost model or the revaluation model for each class of intangibles. The revaluation model is available only where fair value can be measured by reference to an active market, meaning homogeneous items, willing buyers and sellers at any time, and public prices. Few intangibles meet that test; examples are some transferable taxi licences, fishing quotas or production quotas. Brands, patents, software and customer lists almost never have an active market, so in practice nearly every company uses the cost model.

Under the cost model the asset is carried at cost less accumulated amortisation and accumulated impairment losses. Any increase in value, however well evidenced by a valuation report, is not recognised. This is one reason balance sheets understate the value of knowledge-heavy businesses and why market capitalisation often far exceeds book equity.

Goodwill under other frameworks

Not every framework follows the impairment-only model. The IFRS for SMEs Accounting Standard requires goodwill to be amortised over its useful life, and where that life cannot be estimated reliably it is set by management's best estimate but not exceeding ten years. UK FRS 102, which is derived from the IFRS for SMEs, takes the same approach. US GAAP tests goodwill for impairment without amortisation for public companies, but private companies may elect to amortise it over ten years or less.

For a group that reports under more than one framework, for example a Canadian subsidiary using ASPE for its own statements inside an IFRS group, goodwill and intangible balances often differ between the local books and the group reporting pack. Keeping a reconciliation of those differences avoids surprises at consolidation.

Common mistakes with goodwill and intangibles

Most errors come from either stuffing too much into goodwill or capitalising costs that IAS 38 says must be expensed. Auditors look first at the purchase price allocation and at the capitalisation policy for development costs.

• Leaving customer relationships, brands and order backlogs inside goodwill instead of identifying them separately.
• Amortising goodwill under full IFRS, or failing to test it annually.
• Capitalising research costs, or development costs incurred before all six IAS 38 criteria were met.
• Recognising an internally generated brand or customer list because a valuation shows it is worth something.
• Treating a licence with a fixed expiry date as having an indefinite life.
• Reversing a goodwill impairment when trading improves.
• Forgetting deferred tax on fair value uplifts in the purchase price allocation, which misstates goodwill.

Recording goodwill and intangibles in Skyline Nexus ERP

In Skyline Nexus ERP the structure for these balances is set in the chart of accounts. Each account type carries a classification, a normal balance and a Balance Sheet Liquidity setting of Current or Non-Current, so goodwill, capitalised development costs and their accumulated amortisation and impairment accounts can be set up as non-current asset accounts that land in the right place on the balance sheet. Purchase price allocation and goodwill entries are recorded as manual journals, which must balance, can be routed for approval above a configurable threshold, and are corrected by reversal rather than deletion once posted.

Goodwill itself is not amortised, so it stays as a ledger balance until an impairment journal is posted. For assets tracked in the Asset Management register, lifecycle screens cover depreciation, revaluation, impairment and disposal. The depreciation screen offers straight line, declining balance, sum of years digits and units of production, and impairment and impairment reversals have their own posting listeners. For groups, the Consolidation area records business groups with each member's ownership percentage and consolidation method and produces consolidated reports; every journal change is visible in the accounting Audit Trail with old and new values.