Goodwill, balance sheet structures and accounting standards Recent developments and issues for French groups

This article aims to assess the economic issues related to the accounting treatment of goodwill, and more specifically the likely repercussions of the transition to International Financial Reporting Standards (IFRS) on the consolidated accounts of listed companies with effect from 1 January 2005. Based on observations derived from a representative database of French groups, the article demonstrates a marked increase in the amount of goodwill and similar intangible assets in the balance sheets of large groups, and especially of CAC 40 groups, for whom the ratio of such assets to equity reached 82% in 2002. The difficulties experienced in some sectors, especially telecoms and media, led some groups to record substantial write-downs of goodwill and similar intangibles, leading to huge accounting losses being reported in 2001 and 2002. The gearing of these groups, which had risen as a result of external growth strategies partly based on debt financing, then increased further due to the contraction in equity caused by these losses. Hence the observation of a deterioration in balance sheet structure in 2002, extending into 2003. In the light of these observations, can accounting standards yield information that accurately reflects deterioration in a company’s financial structure as early as possible? In view of the rapid developments in recent years described in this article, the question of whether or not to amortise goodwill is no longer a relevant issue. Nevertheless, in a broader perspective, the virtual disappearance of goodwill amortisation that is likely to result from the adoption of IFRS could, in an economic downturn, induce greater volatility in financial statements, at the level of both earnings and equity. This is because downward adjustments of valuations are likely to take the form of one-off charges rather than being spread over time. Notwithstanding this potential additional volatility, the approach recommended by IFRS 3 on business combinations nonetheless gives financial statement users important information about changes in the wealth of a group during an economic downturn, and indicates any loss of that wealth due to over-priced acquisitions. Recognition of goodwill as a separate asset thus has the effect of highlighting the potential fragility of corporate wealth which is based partly on goodwill. Furthermore, it contributes to the general drive towards greater international comparability of accounting standards. However, impairment tests cannot always rely on market prices. There is no guarantee that there will be a deep and liquid market in assets comparable with those that generated the goodwill, and the more specific the asset and the longer the period since acquisition, the more this will apply. It therefore becomes necessary to devise hypotheses, which provide some latitude in the choice of valuations. Moreover, the extent of impairment losses may in itself send out a strong signal, leading to a reappraisal of expectations and share prices. This could trigger a downward spiral, which could only be contained in an efficient market. In the final analysis, the impact of the reform of the accounting treatment of business combinations, and of goodwill arising on such combinations, will largely hinge on how the preparers of financial statements apply IFRS 3, and on the scrutiny brought to bear on the accuracy and meaning of the figures by auditors and analysts. Users will no doubt be able to place more reliance on financial statement preparation and analysis in sectors where only a few large groups have goodwill in their balance sheets, making comparisons between groups easier. Information will be harder to assess where valuations of goodwill and intangibles relate to highly specific or relatively new activities.