FRS 10: Goodwill and Intangible Assets

In the next in a series of articles, Steve Collings offers an overview of FRS 10 Goodwill and Intangible Assets as a form of ‘refresher’ of the main contents of the standard.

Overview: goodwill and intangible assets

FRS 10 deals with accounting requirements of goodwill and intangible assets.  The standard itself recognises that goodwill obtained during an acquisition is not an asset, like other assets, nor is it an immediate loss in value.  Instead, the standard recognises that goodwill is essentially the difference between the cost of an investment shown in the acquirer’s financial statements and the values that have been attributed to the various assets and liabilities subjected to the acquisition in the consolidated financial statements and is referred to in the standard as ‘purchased goodwill’.  Purchased goodwill can be positive, whereby the acquisition cost exceeds the aggregate fair values of the identifiable assets and liabilities; whilst negative goodwill arises when the purchase consideration is less than the fair values of the identifiable assets and liabilities.

The objective of FRS 10 is to ensure that goodwill and intangible assets capitalised in an entity’s balance sheet are charged to the profit and loss account over their useful economic lives.  The standard then goes on to say that its objective is also to ensure that users can determine the impact that goodwill and intangible assets has on the financial position and performance of the reporting entity.

Classes of intangible assets

The standard suggests six examples of intangible assets:

• Licences
• Quotas
• Patents
• Copyrights
• Franchises
• Trademarks

The standard recognises that these may be treated as separate types of intangible assets, but also states that further subdivision of these may be appropriate in individual circumstances (for example where different types of licence have different functions within the business).

Recognition and measurement

Purchased goodwill

Paragraph 7 to FRS 10 requires positive, purchased goodwill to be recognised as an asset on the balance sheet.

Negative goodwill

Where the initial calculations suggest negative goodwill has arisen during the acquisition, paragraph 48 requires the fair values of the acquired assets to be tested for impairment and also that the fair values of acquired liabilities have also been checked to ensure completeness (i.e. that none have been missed or understated).  If negative goodwill still arises, then this should be recognised and disclosed separately on the face of the balance sheet, directly underneath the goodwill heading and followed by a subtotal arriving at the net amount of positive and negative goodwill.

Furthermore, negative goodwill up to the fair values of the non-monetary assets acquired (e.g. fixed assets) should be recognised in the profit and loss account in the periods in which the assets are recovered.  The standard recognises at paragraph 49 that such non-monetary assets can be recovered by way of depreciation or through sale.

Internally-generated goodwill

The standard prohibits internally-generated goodwill being recognised in the financial statements (FRS 10.8).  Many practitioners have been criticised by their professional body over recent years for inappropriately recognising internally-generated goodwill on a balance sheet, particularly when a client incorporates.

Intangible assets

When a company purchases an intangible asset separately from a business, paragraph 9 to FRS 10 requires such an asset to be capitalised at cost.  However, if the entity purchases an intangible asset as part of the acquisition of a business, the intangible asset(s) should be capitalised separately from goodwill if the value of the intangible asset can be measured reliably on initial acquisition (FRS 10.10).  In instances where the value of an intangible asset(s) cannot be measured reliably, paragraph 13 to FRS 10 requires the asset to be subsumed within the amount of the purchase price attributed to goodwill.

Useful lives and amortisation

Goodwill and intangible assets that are regarded as having limited useful economic lives are required to be amortised over their useful economic lives.  The standard suggests a rebuttable presumption that the useful economic lives of purchased goodwill and intangible assets are limited to periods of 20 years or less.  However, care must be taken before rebutting this presumption.  Paragraph 19 to FRS 10 says that the presumption can only be rebutted and a useful economic life regarded as longer than 20 years, or indefinite, if:

• the durability of the acquired business or intangible asset can be demonstrated and justifies estimating the useful economic life to exceed 20 years; and
• the goodwill or intangible asset is capable of continued measurement (so that annual impairment reviews will be feasible). (FRS 10.19(a) and (b)).

In terms of the first bullet point, FRS 10 offers some factors to determine durability:

• the nature of the business
• the stability of the industry in which the acquired business operates
• typical lifespans of the products to which the goodwill attaches
• the extent to which the acquisition overcomes market entry barriers that will continue to exist
• the expected future impact of competition on the business

There is an inherent uncertainty factor when it comes to determining the useful economic lives of goodwill and intangible assets which needs careful handling which can be illustrated as follows:

For the purposes of tangible fixed assets, the depreciable value is usually calculated using the formula: cost of asset less expected residual value.  For the purposes of intangible assets, the standard does allow a residual value to be assigned, provided that such residual values can be measured reliably (paragraph 28).  The standard acknowledges two circumstances where an intangible asset can be measured reliably:

• when there is a legal or contractual right to receive a certain sum at the end of the period of use of the intangible asset; or
• there is a readily ascertainable market value for the residual asset.  (FRS 10.29 (a) and (b)).

Methods of amortisation can vary between clients and paragraph 30 requires a method of amortisation to be chosen that reflects the expected pattern of depletion of the goodwill or the intangible asset.  The standard requires amortisation to be calculated using the straight-line method, unless another method can be demonstrated to be more appropriate in the company’s individual circumstances.  Where goodwill is concerned, the standard does recognise that it is unlikely that there will be circumstances when it can be justified (or evidence made available to suggest) a less conservative amortisation method than straight-line.

Impairment issues

Where goodwill and intangible assets are being amortised over a period of less than 20 years, impairment issues cannot simply be ignored.  Paragraph 34 requires an impairment review for such goodwill and intangible assets to be reviewed for impairment:

• at the end of the first full financial year following the acquisition (‘the first year review’); and
• in other periods if events or changes in circumstances indicate that the carrying values may not be recoverable.

In relation to the first bullet point, paragraph 40 says that the first year impairment review can be performed in two stages:

• initially identifying any possible impairment by comparing post-acquisition performance in the first year with pre-acquisition forecasts used to support the purchase price; and
• performing a full impairment review in accordance with the requirements of FRS 11 Impairment of Fixed Assets and Goodwill only if the initial review indicates that the post-acquisition performance has failed to meet pre-acquisition expectations or if any other previously unforeseen events or changes in circumstances indicate that the carrying values may not be recoverable.

The standard also requires that where goodwill and intangible assets are being amortised over a period in excess of 20 years (or where no amortisation is being charged at all), the reporting entity must undertake an impairment review at the end of each reporting period in accordance with FRS 11 Impairment of Fixed Assets and Goodwill.

Conclusion

This article has provided a summary of the main issues which may affect practitioners dealing with goodwill and intangible assets.  It is not a comprehensive overview of FRS 10 and readers are encouraged to consult the mainstream standard if they encounter difficulties concerning goodwill and intangible assets.

Category: Accounting and standards, Audit