Goodwill Auditing

Goodwill Auditing

Sacho, Zwi Y

When an entity acquires or gains control over the net assets of another entity in a business combination, the excess of the purchase consideration over the acquirer’s interest in the fair value of the net assets of the acquiree at the date of acquisition is usually described as purchased goodwill. Such goodwill represents, among other things, the fair value of the expected synergies and other benefits from combining the acquiree’s net assets with those of the acquirer. According to both the old IAS 22 – Business Combinations and the new IFRS 3(AC 140) – Business Combinations, purchased or acquired goodwill must be recognised as an asset of the acquirer.

Until recently, IAS 22 required purchased goodwill to be amortised on a systematic basis over its useful life, subject to a maximum of 20 years. Amortisation of purchased goodwill is in line with the matching concept of accounting, in that the cost of purchasing the synergistic benefits attributable to purchased goodwill must be charged to earnings over the period of the consumption of such benefits. In 2004 the IASB changed the accounting requirements for goodwill in response to criticism levied by financial statement users on the usefulness of the amortisation charge of goodwill. IFRS 3(AC 140) states that after initial recognition, the acquirer is required to measure goodwil at cost less accumulated impairment losses calculated in accordance with IAS 36 – Impairment of Assets. IAS 36(AC 128) now requires goodwill to be tested for impairment annually or more frequently if events or circumstances indicate that it may be impaired.

The purpose of this article is to highlight the audit implications associated with the new accounting requirements for goodwill. The scope is limited to the subsequent measurement of goodwill and does not include the accounting requirements and audit implications of initial measurement of goodwill.

The effect on the audit approach of IFRS 3 and IAS 36 (revised 2004)

As mentioned earlier, under IAS 22, companies were required to amortise purchased goodwill over its useful life. However, because the useful life of goodwill and the pattern of its consumption are not possible to predict with sufficient accuracy, the amortisation charge to earnings was an arbitrary estimate of the consumption of the economic benefits embodied in goodwill. In fact, analysts concluded that goodwill amortisation has no information relevance to investors and must be eliminated when computing a company’s earnings for valuation purposes.

From an audit perspective, all the auditor could do to audit the amortisation charge was to rely on management’s estimate of the useful life of goodwill and ensure that the amortisation period was not too long. Auditors would also need to perform a review of events for indications of impairment per IAS 36. However, it would not be inappropriate to say that in the main the goodwill amortisation charge was meaningless and even misleading, since it depended on factors which could not be verified with sufficient accuracy.

In contrast, the new annual impairment test contemplated by IFRS 3(AC 140) read with IAS 36(AC 128) involves a rigorous and operational impairment test for goodwill, which should reflect more reliably the consumption of the economic benefits incorporated in purchased goodwill. The impairment test involves the following steps:

1. Allocating the carrying amount of goodwill to the various cash generating units that are expected to benefit from the synergies of the business combination.

2. Measuring the recoverable amount of the cash-generating unit i.e. the higher of its value in use and its fair value less costs to sell.

3. Allocating the impairment loss (if any) to the carrying amount of the assets (including goodwill) of the cash generating units.

The remaining sections of this article summarise briefly the accounting requirements of each of the above tests and examine the audit implications thereof.

Allocating the carrying amount of goodwill

IAS 36(AC 128) requires that purchased goodwill should be allocated among the cash-generating units that are expected to benefit from the synergies of the business combination, irrespective of whether assets or liabilities of the acquiree or acquirer are assigned to those units. Furthermore, it states that goodwill must be tested for impairment at a level at which the entity monitors and manages its operations. Effectively, it requires entities to allocate goodwill among its “reportable segments” as defined in IAS 14(AC 115) – Segment reporting. The more familiar term “segment” will be used in this article as opposed to the term “cashgenerating unit”.

From an audit perspective, the auditor must ensure that the allocation of goodwill among the various segments is valid, accurate and complete. The risks are that goodwill can be allocated incorrectly to a segment and be shielded from impairment as a result thereof. The auditor must first ensure that the allocation of assets, liabilities and income and expenses between segments is reliable. To do this, the auditor must test whether the accounting system has a transaction code which automatically allocates transactions to the various divisions/segments accurately. Access controls on such transaction codes would need to be enforced to prevent manipulation. This would be useful to also identify inter-segment transactions and to facilitate the preparation of accurate segment reports.

Thereafter, based on enquiry of management and inspection of management accounts, purchase agreements, due diligence files and prior year working papers, the auditor would be able to ascertain to which segment the relevant goodwill (or portion thereof) belongs and re-perform management’s allocation of goodwill among the segments. The auditor must also inspect whether the allocation of goodwill and segment data is consistent from period to period.

Measuring the recoverable amount

Once the allocation of goodwill to the various cash-generating units/segments is complete, the auditor must determine the recoverable amount of each segment to which goodwill has been allocated. In most cases, unless the entity wishes to dispose of the segment, the segment’s recoverable amount will be its value in use since there is usually no reliable estimate of a segment’s fair value less costs to sell unless it is being disposed of. Nevertheless, if the entity can determine the segment’s fair value less costs to sell reliably, the auditor will vouch such amount to a sales agreement or assess the reasonableness of the fair value with reference to recent sales transactions of similar segments. The major risk faced by auditors is how to audit a segment’s value in use calculation because it is a management estimate which is subject to bias and manipulation. IAS 36(AC 128) reguires a cash-generating unit’s value in use to be computed by:

(a) Estimating the future cash inflows and outflows to be derived from continuing use of the unit and from its ultimate disposal; and

(b) Applying the appropriate discount rate to those future cash flows.

It is the auditor’s responsibility to verify the validity and accuracy of the cash flows and discount rate associated with the relevant segment’s value in use calculation. Management will have an incentive to overstate the net cash flows of the relevant segment and/or understate the discount rate so as not to recognise an impairment loss for allocated goodwill. Furthermore, management will no doubt be prompted to apply the IAS 36.99 exemption by attempting to use prior year recoverable amounts where in fact such projections are no longer applicable.

IAS 36(AC 128) makes it clear that the starting point for estimating (and therefore auditing) the future cash flows from the segment is management’s budgets/forecasts. To use such budgets/forecasts, the auditor has the following tasks:

1. To establish the reliability of management’s budgeting system in terms of:

Whether budgets are set on a segmental basis and budget targets are realistic and in line with industry trends.

Whether actual results meet forecasts.

Whether budgets can be manipulated or altered after being set.

2. To establish whether the estimated future cash flows and discount rate applied to the relevant segment accord with the requirements of IAS 36(AC128).

To establish the reliability of the segmental budgeting system, the auditor would need to test the controls over the budgeting system as follows:

* Enquire of management as to the procedures, policy and frequency of setting the segmental budgets. The auditor would need to scrutinise actual authorised monthly budgets for each segment to see whether budgets are drawn up monthly. An inspection of the attendance registers at the monthly management meetings would indicate whether all parties concerned (i.e. marketing, production and finance managers for the relevant segment) are present at the meetings and participate in the budgeting process. Internal audit’s work on the reliability of the budgeting system for each segment would also be of use to the external auditor.

* Inspect the segmental budgets and examine the variances between actual results and budget for large variances. Such variances should be noted in the monthly budgets and reasonable explanations should be provided by management in the reports. By ensuring this, the auditor will be able to assess the reliability of management’s estimation ability and the budgetary process.

* Enquire of the IT department and inspect the user-profiles as to whether only management are able to have access to the budgeting module of the accounting system. To avoid manipulation, the system must disallow the backdating of budgets.

Once the reliability of the segmental budgeting system has been established, the auditor would then need to audit each segment’s year-end forecasts to see whether they comply with the requirements of IAS 36.33. Should favourable audit results be achieved with the tests of the segmental budgeting controls, the auditor would have obtained some assurance regarding the reliability of the year-end cash flow forecast for the segment. The auditor would need to extend his tests on each segment’s year-end cash flow budget by verifying the management’s assumptions to segmental market research reports, media reports of economic forecasts for the relevant industry and sales order books for the segment. In addition, the results achieved by management over an extended period of time as well as trends and relationships identified from past results should correlate with the cash flow projections. The auditor must specifically examine whether the forecasts exclude estimated future cash flows expected to arise from future restructurings or from improving or enhancing the relevant segment’s performance.

In addition, since budgets are usually set for only a year, IAS 36(AC 128) has specific requirements for projection of the segment’s year-end forecasts. The growth rate used to extrapolate the forecasts into the future should be a steady or declining growth rate unless an increasing rate can be justified. The auditor would need to audit the growth rate used by management with reference to industry forecasts, inflation projections in the economy in which the segment operates and evaluate whether it is reasonable in the light of his knowledge of the client’s business. This is because IAS 36.33(c) states that the growth rate should not exceed the “long-term growth rate for the products, industries, or country or countries in which the entity operates, or for the market in which the asset is used, unless a higher rate can be justified”. Furthermore, the auditor must ensure that the relevant segment’s cash flow forecast covers a maximum period of five years, unless a longer period can be justified and disclosed by management in the financial statements.

Finally, the auditor would need to vouch the discount rate used to discount the cash flow forecasts to a market-related interest rate or the weighted average cost of capital of the segment’s liabilities. According to IAS 36.55(b), such a discount rate would need to be adjusted to take into account the risks specific to the asset for which the future cash flow estimates have not been adjusted. Such adjustments can be audited for reasonableness by assessing management’s ability to forecast figures in line with actual results. The auditor would require further adjustments to the discount rate if management projections in the forecasts are based on assumptions that cannot be verified with external sources.

Allocating the impairment loss

Once the auditor has audited management’s value in use and/or fair value less costs to see calculation for each segment, the segment’s recoverable amount can be computed. The auditor can then recompute the segment’s impairment loss (if any) as being the difference between the segment’s carrying amount (including allocated goodwill) and its recoverable amount (i.e. higher of value in use and fair value less costs to sell). Thereafter, the allocation of the impairment loss to the individual assets of the segment can be reperformed to see whether it complies with the requirements of IAS 36.104.

Summary and conclusion

The audit procedures and risks identified in this article point to the fact that the auditor’s obligations to audit goodwill are onerous. The auditor is faced with the risk that management will attempt to manipulate its forecasts to avoid goodwill impairment. In addition, much of the audit evidence to audit goodwill depends on management’s assessment of future events. There is a further risk for the auditor since Hirschey and Richardson found that goodwill data helps analysts and users of financial statements to understand the future changes in the company’s earnings. Thus, it is the signals which goodwill brings to the market, which are important from an audit perspective. The auditor must ensure that the goodwill write-off and disclosure relating thereto are meaningful and do not mislead the market as to the company’s future prospects.

The requirements of IAS 36(AC 128) stress the importance of the auditor not only obtaining a knowledge of the client’s business and industry, but also an understanding thereof. Such understanding will be the most powerful tool of the auditor to audit management budgets and forecasts used for goodwill impairment testing. This will in turn benefit the auditor in terms of its use in evaluating audit evidence in other audit areas as well as its use on future audits. On the other hand, management of the client will need to have a transparent and reliable budgeting system which reports and compares actual segmental results to budget on a monthly basis. This will no doubt benefit the business as management will be required to measure past performance against budgets. This helps management discharge its risk management responsibility in terms of the King Code (para 3)

Although the requirements of IAS 36(AC 128) are demanding, the focus from an audit perspective will be on the auditor gaining a better understanding of the client’s business and the management controls around the business. A comprehensive audit of a client’s budgeting system will not only provide audit evidence, but will also provide value added comments to the client. This should ultimately benefit shareholders who would now be given assurance that the risk management element of the business is effectively being audited by the external auditors.


Brunovs, R. Et Kirsch, RJ. 1991. Goodwill Accounting in Selected Countries and the Harmonization of International Accounting Standards, ABACUS, September 1991, Vol. 27, No. 2, pp. 135-161.

Hirschey, M Et Richardson, VJ. 2003. Investor underreaction to goodwill write-offs, Financial Analysts Journal, November/December 2003, Vol. 59, No. 6, pp. 75-84.

International Accounting Standards Board (IASB). 2004. IFRS 3 – Business Combinations, Issued March 2004. London: IASB.

International Accounting Standards Committee (IASC). 1993. IAS 22 – Business combinations, issued December 1993 and revised October 1998. London: IASC.

International Accounting Standards Committee (IASC). 1998. IAS 14 – Segment Reporting, Issued July 1998. London: IASC.

International Accounting Standards Committee (IASC). 1999. IAS 36 – Impairment of assets, issued July 1999 and revised March 2004. London: IASC.

King Committee on Corporate Governance. 2002. King report on corporate governance for South Africa 2002, March 2002. Johannesburg: Institute of Directors in Southern Africa. Chairman: M. King.

Massoud, M.F. Et Raiborn, CA 2003. Accounting for Goodwill: Are we better off? Review of Business, Spring 2003, Vol. 24, No. 2.

Zwi Y. Sacho, BCompt (Cum Laude) BCompt Hons (Cum Laude) MCompt Advanced Certificate Auditing (RAU), is an academic research assistant in the School of Applied Accountancy at the University of South Africa (UNISA)

Copyright South African Institute of Chartered Accountants Feb 2005

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