Accounting for goodwill under FRS 136: Case of Malaysian. plantation companies

Transcription

1 September 2010, Vol.6, No.9 (Serial No.64) Journal of Modern Accounting and Auditing, ISSN , USA Accounting for goodwill under FRS 136: Case of Malaysian plantation companies Nurul Adillah Yusof, Hashanah Ismail (Faculty of Economics and Management, Universiti Putra Malaysia, Serdang 43400, Selangor, Malaysia) Abstract: The introduction of FRS (financial reporting standards) 136 to Malaysian PLC s (public limited company) in 2006 indirectly formalized accounting for purchased goodwill for the first time. Based on a sample of 2006 annual reports of 10 Main Board companies from plantation sector, the study finds the level of desired disclosure has yet to be met. Whilst the intention of the standard is noble, actual practice for first time reporting entities indicate that Malaysian PLC s and their auditors have far to go before they can meet the expectation set by FRS 136 in particular and International Financial Reporting Standards in general. Key words: goodwill; FRS136; impairment testing; CGU (cash generating units) 1. Introduction The Malaysian financial reporting framework has undergone a number of important key changes since the Financial Reporting Act 1997 gave birth to the Malaysian Accounting Standards Board (MASB). As the sole standard setting body for financial reporting in Malaysia, MASB made a critical decision to converge accounting standards hitherto in use to the International Financial Reporting Standards (IFRS) issued by a world standard setting body, the International Accounting Standards Board (IASB), beginning January 1, In 2006 companies are required under FRS3, business combination, to recognize acquired goodwill in a business combination as an asset and test the goodwill for impairment annually. Any impairment loss is to be recognized as expense immediately as required by FRS 136 (Para 60). Together with this standard, a number of other IFRS was made mandatory for Malaysian companies listed on Bursa (PLC s). The migration to (IFRS) underlines Malaysia s commitment to adopt financial reporting standards benchmarked to a world body requirement, that of the IASB. The underlying theme of IFRs is fair value and FRS 136 imposes the requirement to test for asset impairment during the year under review as part of fair valuing a company s resources. This standard became effective for all plc s beginning January 1, Before FRS 136 became effective, firms with purchased goodwill in their balance sheet would write off the asset on a straight line basis over a period of 20 years. Hence the net book value after amortization was not necessarily the same as its real value as even if a firm was doing well, goodwill was still written off. With FRS 136 this practice of equal write off annually over a definite useful life is now disallowed instead of which firms are to test goodwill for impairment t least annually in order to fair value goodwill. FRS136 not only changed the valuation of purchased goodwill, it also introduced new items of reporting to Nurul Adillah Yusof, tutor, Faculty of Economics and Management, Universiti Putra Malaysia; research fields: financial reporting and auditing. Hashanah Ismail, associate professor, Faculty of Economics and Management, University Putra Malaysia; research fields: financial reporting and auditing. 32

2 be disclosed in the firm s financial statements: how fair value is measured, the need to disclose cash generating units (CGU) over which goodwill is allocated, the valuation of recoverable amount and disclosures of estimates made by management in order to estimate future cash flows attributed to the purchased goodwill. FRS 136 brings in a new way of valuing intangibles and may have implications on valuing a company for past, pending and future mergers. This new standard is considered as a radical departure from previous goodwill standard because it requires use of more rigorous and complex techniques to assess impairment and it also requires greater disclosures. Prior studies have shown that the new standard gave preparers incentives to both over and understate goodwill impairment losses in Canada (Lapointe-Antunes, Comler & Madnan, 2008), firms may adopt or delay impairment at the initial adoption of the standard (Beatty & Weber, 2006) and that goodwill impairment involves a lot of discretion in the timing and measurement of impairment losses (Massoud & Raiborn, 2003). Given that FRS136 is effective from January 1, 2006, and is a therefore a relatively newcomer to the Malaysian shores, how have companies adapted to this new learning environment of fair valuing purchased goodwill? It is the objective of this paper to examine how first time reporting entities among Malaysian PLC s have embraced the new fair value standard on goodwill impairment, the nature and extent of disclosures made by these companies in compliance with the disclosure requirements of FRS 136. Results will indicate problems encountered in migrating to fair value accounting and would be useful to standard setters to consider as they deliberate on the adoption of more fair value standards to be put in place. The rest of the paper is organized as follows: Section 2 reviews some of the literature; a description of the research method is in Section 3; then results and discussion of the results are presented in Section 4 and the paper concludes in Section Literature review FRS 136 sees goodwill valuation impairment as comprising two steps: do goodwill impairment test at a reporting level which is the lowest level (e.g., subsidiaries or division (an operating segment)) called the cash generating unit (CGU) in order to identify potential impairment. Each CGU should not be larger than a segment based on either the entity s primary or secondary reporting format based on FRS 114. The fair value of the CGU including goodwill is then compared to its carrying value. If the fair value is greater than its carrying value, no impairments occur but if it was the reverse then impairment loss must be measured. Fair value is either the quoted market price or earnings multiple based on discounted future cash flows of the CGU s. The test for impairment entails details of disclosure tied to materiality which could result in greater variability as it is company specific. The forecast of future cash flows takes financial reporting away from the realm of historical cost accounting and requires use of financial modeling along the veins of the capital asset pricing model (CAPM). Ball (2006) is of the view that convergence de facto (practice) towards one set financial reporting standards is less certain than convergence de jour (rules). A major feature of IFRS is fair value (aka mark to market). Fair value is acceptable if there are observable market prices and managers cannot influence it and there are accurate estimates of value. However, as evidenced by the studies of Lapointe-Antunes, Comler & Madnan (2008). Canadian firms have incentives to both over and understate goodwill impairment losses in the transitional period. Managerial opportunism, however, is constrained by financially literate and independent audit committee members. The study concludes that goodwill impairment leaves considerable room for management interpretation, judgment and bias and such opportunities could materially affect the quality of financial reporting. The findings of 33

3 the study echoes the study of Massoud & Raiborn (2003) who concluded that there is now discretion in the timing and measurement of impairment losses as well as the number of CGU s over which the impairment is to be allocated. Similarly, Godfrey & Koh (2009) reported that in the early years of impairment testing, managers of US firms use goodwill impairment write off discretion to reflect a firm s underlying investment opportunities. Goodwill impairment reflects a reduction in economic goodwill and therefore it affects investment opportunity set. Managers exercise accounting discretion by writing off less goodwill impairments as firm investment opportunity set increases. Beatty & Weber (2006) found that firms may adopt or delay impairment at time of the impairment standard adoption. Masters-Stout (2008) identified the flexibility regarding the timing of goodwill impairments presents a potential for CEO s to manage earnings. Using escalation theory, the authors posit that CEO tenure relates to incentives to manage lower earnings at the beginning of their terms in order to make advances in company performance more achievable. Hence more earnings management is practiced for new CEO s via timing of impairment of goodwill. Clarke & Dean (2007) were very critical of the move towards fair valuing goodwill and claimed that reforms appear to be directed more at appearances than rectifying malpractices. The authors describe the move to fair value accounting as producing a crisis in financial disclosure of PLC s. Compliance with the new standards does not produce statements that disclose shareholders wealth and financial progress; instead, it has resulted in misleading financial statements, even though compliance is with the best of intentions. 3. Research method Since the standard FRS136 is effective only beginning 2006, the study selects companies with year ending December 31, 2006 as first time reporting entities since companies with other year end dates are more likely to comply in their 2007 annual accounts rather than This study focuses on the plantation sector first because the plantation sector is one of the oldest sectors in the economy with many colonial trading houses listed in this sector. This sector has also seen many times NACRA short listed companies for good reporting awards hence good reporting companies are more likely to embrace the new reporting standards as part of their good reporting practice culture. Focusing on one sector alone also removes the variability associated with many sector studies. A work sheet was drawn up for each company to identify whether they had goodwill in their balance sheet or not as December 31, Only those with balance sheet goodwill were selected and the following information coded: (1) Was impairment test done on goodwill? (2) The carrying amount versus recoverable amount (a critical amount to be estimated). This involves management s judgement requiring assessment as to whether the carrying value of assets can be supported by the net present value of future cash flows derived from such assets using cash flow projections which have been discounted at an appropriate rate. In calculating the net present value of future cash flows, certain assumptions are required to be made in respect of highly uncertain matters such as whether it reflects past experience, whether consistent with external information, if not, how and why different. For value in use, companies must justify if period selected is more than 5 years and need to disclose growth and discount rates. (3) Recoverable amount is higher of an asset s or CGU s fair value less costs to sell or value in use. (4) Description on CGUs. How many CGU s were identified? (5) How was fair value measured: Value in use (VIU) or market value? 34

4 4. Results and discussion There are 31 companies listed in the plantation sector in 2006 of which 2 had no goodwill reported. 10 companies were selected as they had a December 31 year end. The percentage of goodwill over total assets reported ranged from 0.01% to 28.43%. Of the 10 companies only 1 was audited by a non big 4 whilst the remaining 9 were audited by Ernst and Young making the audit firm a specialist in plantation sector audit. None of the companies disclosed the CGU description and majority which is 9 out of the 10 companies did not disclose the number of CGUs over which allocation of goodwill impairment is made. Only 1 company disclosed 19 CGU s based on plantation business. Only 4 out of the 10 companies disclosed the basis of allocation for impairment value where 2 companies used fair value less costs to sell and the other 2 companies used value in use (VIU). The remaining 6 disclosed nothing and was silent over what value was used as comparison to book value to discern impairment. Both companies that used value in use as their recoverable amounts disclosed the rate used to discount cash flows projections. However, there is one company that used only one single tax rate to discount its cash flow projections for 10 years period which is over the maximum period of 5 years. According to FRS 136, paragraph 3 (c), an entity shall estimate cash flows projections that is beyond the period covered by the most recent budgets/ forecasts (maximum of 5 years period) using a steady or declining growth for subsequent years. There is also no justification from management provided by this company for using the same rate to discount its cash flows projections over 10 years period. The other two companies that used fair value less costs to sell as their recoverable amounts did not mention whether they used value in use or market price as their fair values. This absence of mandatory disclosure appears to reflect uncertainty and hesitance on the part of the preparers. Despite being audited by one of the big 4 audit firm, non-compliance with the mandatory disclosure did not warrant a qualified audit report. Even among 10 companies, the rate of compliance differs as evidence of failure to meet even basic disclosure requirements. 5. Conclusions FRS 136 and FRS 3 represent a regime shift in goodwill accounting from one of straight line amortization to that of annual impairment assessment in line with the philosophy of fair value accounting. In migrating to fair value accounting, new challenges are encountered. As a radically new accounting treatment, whilst theoretically beneficial in practice accounting for goodwill impairment is fraught with problems. The use of judgment and unverifiable estimates could result in more opportunities for creative accounting. Since our study examines first time reporting phenomenon, the level of reporting quality is found to be varied in the levels of disclosure actually complied with and inconsistent with the spirit of the standard thus echoing the thoughts of Ball (2006) that whilst we can achieve convergence in rules (dejour), we may not be able to achieve convergence in practice (de facto). In the light of unprecedented global financial turmoil which we are currently going through, businesses are wrecked with serious issues of cash flows, funding and asset valuations. Significant downturn in business level activity could lead to significant losses and hence business would have to deal with impairment of assets. Assets such as goodwill, which were deemed valuable, now, are suddenly fair valued to carrying values. With severe decrease in earnings, goodwill could suffer severe write downs as well. This paper has shown how firms struggle to implement fair value accounting to goodwill. Whilst the spirit is to provide a more meaningful valuation of goodwill, FRS136 may have created more bad than good in the quality of financial reporting as the extent of 35

5 required disclosure is not fully met. At the same time the will to make impairment testing approximate fair value has created what Clarke & Dean (2007) calls indecent disclosures whereby estimates of future cash flows could impair rather than enhance the usefulness of financial reports. Future studies should consider the quantum of impairment during business down turns and extend this study to other sectors of the economy. References: Ball, R.. (2006). International financial reporting standards: Pros and cons for investors. Accounting and Business Research, Beatty, R. & Weber, J.. (2006). Accounting discretion in fair value estimates: An examination of SFAS 142 goodwill impairment. Journal of Accounting Research, 44, Clarke, F. L. & Dean, G. W.. (2007). Indecent disclosure: Gilding the corporate lily. Cambridge University Press. FRS 3. Business Combinations. FRS 136. Impairment of Assets. Godfrey, J. M. & Koh, P. S.. (2009). Goodwill impairment as a reflection of investment opportunities. Accounting and Finance, 49, Lapointe-Antunes, P., Comler, D. & Madnan, M.. (2008). Equity recognition of mandatory accounting changes: The case of transitional goodwill impairment losses. Canadian Journal of Administrative Sciences, 25, Massoud, M. F. & Raiborn, C. A.. (Spring, 2003). Accounting for goodwill: Are we better off? Review of Business, 24(2), Masters-Stout, B.. (2008). CEO tenure and impairment of goodwill. Critical Perspectives in Accounting, 19, (Edited by Linda and Mary) 36