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IASB: progress towards global standards

In an extract from a speech given at the Accounting Standards Board of Japan conference in Tokyo, Hans Hoogervorst looks at a possible return of the amortisation of goodwill to IFRS, and the standards’ progress in Japan

Most of you will be familiar with the IFRS story. Since 2001, an ever-increasing number of jurisdictions have adopted our standards.

The use of IFRS standards now covers most parts of the globe, and this progress may seem to have come almost effortlessly. The reality is somewhat different. Like a swan floating gracefully over water, it can take a lot of paddling beneath the water to keep everything moving forward, and in some cases to avoid going into reverse.

I became chair of the IASB in 2011. At that time, IFRS adoption was at a crossroads. A first wave of jurisdictions had followed Europe’s lead and decided to adopt from 2005 onwards, including Australia, Hong Kong and South Africa. The IASB and the FASB were working together to improve and converge IFRS Standards and US GAAP – towards a shared goal of a single set of standards.

However, when push came to shove, the US became hesitant about transitioning from US GAAP to global standards. After being hit by the terrible tsunami of 2011, Japan also slowed down its adoption of IFRS Standards.

At the time, many questioned whether the US stalling on IFRS would lead to the whole IFRS project unwinding. Seven years later, that has not happened. Far from stalling, use of IFRS around the world has continued to move forward.

Different jurisdictions have chosen different paths to IFRS. For most jurisdictions, the ‘big bang’ approach of adoption has continued to be the best approach. Since 2011, we have seen the G20 jurisdictions of Argentina, Canada, Korea, Mexico, Russia and Saudi Arabia all fully adopt IFRS Standards.

Three-quarters of the G20 have now adopted IFRS standards. Our latest research of 166 jurisdictions shows that 144 have now adopted our standards.

Other jurisdictions, such as China and India, have achieved substantial convergence between their national accounting requirements and IFRS standards, although some differences remain. Especially China is now very close; many of its big companies show identical results under IFRS and Chinese GAAP.

Japan took yet another road to IFRS adoption; your country decided to ‘let the market decide’. It also provided the rest of the world with a very interesting economic experiment. When companies are given free choice, do they stick with national GAAP or US GAAP, or do they switch to international standards? And if they do switch, do they choose pure IFRS standards or a version of IFRS standards modified to meet local preferences? Unlike most jurisdictions, no Japanese company was forced to use a particular set of standards.

Your experiment delivered some truly fascinating results.

As of today, around 200 mostly big, multinational Japanese companies have chosen to adopt full IFRS standards, representing more than 30% of the total market capitalisation of the Tokyo Stock Exchange. In addition, some very big Japanese companies are seriously looking at adoption of IFRS Standards. Before long, 50% of the Tokyo market cap could be IFRS-denominated.

The number of Japanese companies using US GAAP has been steadily shrinking, and is expected to be less than 10 soon.

As well as providing a path for Japan to move forward with IFRS standards, the approach has provided policymakers and academics around the world with some very useful information.

First, it shows, given a free choice, companies are prepared to voluntarily incur the cost of transition in order to reap the benefits and international recognition that come with IFRS Standards. We suspected that may be the case, but now we have information to support that assumption.

Second, among those companies transitioning, 100% have chosen full IFRS rather than to use a version modified to meet local preferences.

Third, Japan has now explored a ‘third way’ for jurisdictions to move forward with IFRS Standards, in addition to the existing ‘adopt’ and ‘converge’ models. This approach allowed the larger, more international Japanese companies to apply IFRS, without forcing all Japanese companies to switch.

This could be an interesting option for other jurisdictions for whom IFRS-adoption for all companies in one go might be challenging, if only because they may need time to build up IFRS expertise. For this reason, a few Asian countries are looking seriously at the Japanese model of IFRS adoption.

As the world grapples with the challenges of increased nationalism and economic protectionism, it is great to see Japan’s continued commitment to an international approach – not only in accounting, but also evident from Japan’s leadership in rescuing the Trans-Pacific Partnership and the recent free trade agreement between the EU and Japan. It covers almost a third of the global economy, and is seen as a thumbs-up for international trading and a clear stance against protectionism.

Goodwill

With the adoption of IFRS 3 Business Combinations in 2004, the IASB abolished the amortisation of goodwill, relying instead on the impairment-only approach.

In Japanese GAAP, amortisation of goodwill still exists. Many Japanese stakeholders like the conservatism of goodwill amortisation, and it is one of the two IFRS modifications in Japanese Modified International Standards.

As you know, the IASB has been discussing the issue of goodwill following the Post-implementation Review of IFRS 3. Initially, the board did not intend to revisit the idea of reintroducing amortisation of goodwill. We felt there was insufficient new evidence to merit investigating such an idea. However, the board decided in its July meeting to include a comprehensive analysis of the accounting for goodwill in our upcoming discussion paper, including a discussion of the possibility of re-introducing amortisation. So, what caused the board to change its mind?

The Post-implementation Review identified a couple of problems with the impairment-only approach to goodwill. Some of these shortcomings were already known: the annual impairment test is both costly and subjective. Often, the projections of future cash flows from cash-generating units tend to be on the rosy side. Impairment losses, therefore, tend to be identified too late. And when an impairment loss is finally booked, the resulting information has only weak confirmatory value for investors.

Our staff did some excellent research to look for possible ways to make the impairment test more effective. They showed convincingly how goodwill tends to be shielded by what they called a ‘headroom’ of internally generated goodwill. Before I explain what we mean by this, let us take a step back to look at the impairment test as it is done currently.

So what do we do today? In broad terms, an company measures the value of a unit of business – often by looking at expected future cash flows. Subsequently, it compares that value with the carrying amount of the business for accounting purposes – the book value. Goodwill impairment is only recognised if the value of that unit of business is less than the carrying amount of the business on the balance sheet.

Often businesses are acquired and combined with existing businesses. So when impairment is tested, the value of the business being tested for impairment includes not only the value of the new business but also of the old business.
Let us assume an acquirer has a very successful existing business they have built up over time. Its economic value would be well in excess of its book value because there is significant internally generated goodwill that is not recognised for accounting purposes.

Now the company makes an acquisition that is added into that existing business. Even if that acquisition is truly terrible, as long as the value of the old part of the business remains high enough, the value of the combined business may stay above its book value, protected by the headroom of the internally generated goodwill from the old business. In such cases, no goodwill impairment will be recognised.

Our staff referred to this pre-acquisition – and therefore unrecognised – goodwill as ‘headroom’. In practice, a company must burn through all of this headroom before the acquired goodwill becomes visibly impaired. Since the headroom can be quite substantial, our staff research made it clearer than ever before that it is almost inevitable that the results of the impairment test will be ‘too little, too late’.

Given that IFRS 3 relies completely on the impairment test to ensure that goodwill really exists, this is a far from satisfactory situation. The risk is that goodwill just keeps on accumulating over time, even when the economics do not justify this. In such cases, the balance sheet may give an overly optimistic representation of a company’s financial health.
Although sophisticated investors should be able to see through inflated goodwill numbers, others may not. For example, I was recently surprised to see how crude ‘book-to-value’ indicators seem to be commonly used in automated factor investing without making any adjustments for goodwill.

These are all good reasons for us to bring the question of reintroduction of amortisation of goodwill back to our stakeholders in the form of a discussion paper.

Before Japan puts out the flags, however, let me warn you that it is far from a foregone conclusion that this discussion paper will lead to a reintroduction of amortisation. After all, there were many good reasons why our predecessors on the board decided to get rid of it in 2004.

The information value of amortisation is very low, as it is impossible to determine objectively the timeline over which amortisation should occur. Goodwill is an asset with indefinite life, and in some cases its value might not decrease over time. We also know that many investors will ignore amortisation and will immediately add it back in their projections. Given our efforts to push back on non-GAAP measurements, this would not be a great development.

Finally, any major accounting change needs to pass a clear cost-benefit analysis. It is not immediately clear that reintroduction of amortisation would clear that hurdle.

However, whatever the outcome of this exercise will be, the discussion paper should serve to make our stakeholders better aware of the shortcomings of the impairment-only approach. It may be that there is no better alternative, but in that case we should accept the current shortcomings of IFRS 3 with our eyes wide open.

Should the discussion paper lead to better awareness of the possible pitfalls of current accounting for goodwill, this would in itself be a positive development.

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