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The business acquisitions standard, IFRS 3, falls down when it comes to reliably valuing the intangible assets that form the core of so many modern businesses, says Jane Fuller

This article was first published in the June 2014 UK issue of Accounting and Business magazine.

The abandonment of the Omnicom-Publicis ‘merger of equals’ is a reminder that some good has come out of the reforms to acquisition accounting. The reality of most deals is that one company is the acquirer, and therefore the boss.

Modern accounting for business combinations – IFRS 3 and SFAS 141 – reflects takeover reality. The advertising giants’ attempt to pool their businesses and share power was a throwback to a merger ideal that never existed.

But what of other provisions of IFRS 3, which is now undergoing a post-implementation review (PiR) by the International Accounting Standards Board (IASB)? This is more difficult than for IFRS 8, Operating Segments. Analysts use segmental breakdowns in their valuation models: we would like more ‘granularity’ but the principle is a given.

Analysis of acquisitions is different. The heavy lifting is done at the time of the deal, using the wealth of published information about and from acquirer and target.

To judge the chances of the acquirer achieving an acceptable return on investment, an analyst aims first to pin down the full costs of the acquisition, and then to work out whether the additional taxed operating profits will cover the acquirer’s cost of capital. How many of us, months later, pore over a note in the annual report that breaks down the intangible assets acquired into ‘identifiables’ and residual goodwill? Not many, apparently – and the knock-on effect is that the amortisation number in the profit and loss account is disregarded.

IFRS 3 was developed in a more idealistic era, when faith was stronger in efficient market pricing and in the ability of models to replicate market – or fair value – pricing. IFRS 3 was intended to result in more intangible assets being recognised and measured at fair value, so the bar was lower for recognition and measurement reliability than in IAS 38, Intangible Assets.

There is a genuine problem with the balance sheets of companies in sectors that rely on human skill and ingenuity, rather than physical assets, to create value: pharma, media, technology, to name a few.

Ideally, internally generated goodwill would be on the balance sheet too, but IFRS 3 has exposed the practical difficulty of doing this. The exercise of identifying ‘separable’ assets and assuming they can be valued has been pushed too far.

If breaking down goodwill is either too difficult or irrelevant, a logical revision to IFRS 3 would be to leave it all on the balance sheet. This also makes it easier to hold management to account afterwards, with the impairment test as the mechanism for recognising overpayment – rightly more embarrassing than quiet whittling away via amortisation.

But impairment tests have tended to be behind the curve in recognising losses and they, too, rely on valuation models. A positive development is that the new auditors’ reports, commenting on key audit risks, are now publicly focusing on the carrying value of goodwill. More information about valuation assumptions would, of course, be welcome.

Where does this leave amortisation? Applied to intangible assets with a finite life and an acquisition cost that can be measured reliably, it genuinely represents the wasting of the asset and should not be ignored. There is a respectable argument that all intangible assets waste, but many believe that the expenses incurred to maintain indefinite ones – research, marketing, training – cover that.

The tendency to disregard amortisation has, in turn, become part of a more worrying trend towards adjusted profit measures, which can all too easily degenerate into ‘earnings before the bad stuff’. The IASB should be returning to this financial statement presentation issue.

Some reforms to IFRS 3 that bring it more into line with practice in analysing the value created or destroyed by acquisitions would be welcome.

Jane Fuller is former financial editor of the Financial Times and co-director of the Centre for the Study of Financial Innovation think-tank

Last updated: 29 May 2014