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January 27, 2009

Audit profession turns spotlight firmly on goodwill valuation

Auditors are facing greater scrutiny over the valuation of goodwill as the incidence of goodwill impairment charges escalates in the UK.

Nick Rea, a partner in the Pricewater-houseCoopers UK (PwC) market and value advisory practice, told The Accountant impairment disclosures will be a key area of focus for auditors this year.

“We are looking now at some transactions that were conducted at the time when the markets were much higher and that’s led to large amounts of goodwill,” he said.

“PwC, along with all the other accounting firms, are looking at this issue as part of the year-end audits as a key area where the companies need to make very robust calculations. It’s probably a more difficult task now than it has been in previous years.”

Goodwill is the term used to describe intangible assets that cannot be valued separately, such as the value of brand and client base.

Companies are required to stress test the value of goodwill for each of their cash generating units each year. These business units are broken up into the way management reports on business performance, for example by product type or geography.

IAS 36 Impairment of Assets requires companies to disclose the key assumptions and the approach taken to make those assumptions when using valuation models to check that goodwill does not need to be written down.

The standard also requires more detailed quantified and narrative disclosures when a “reasonably possible change” in a key assumption would have caused a material goodwill impairment loss to arise.

IAS 1 Presentation of Financial Statements requires companies to provide additional information about key assumptions and other key sources of estimation uncertainty that have a “significant risk” of causing a material goodwill impairment loss within the next financial year.

Rea said the area of valuation where companies will need to take extra caution is discounted cash flow valuations, which needs to be supported by benchmarking.

“Given the market conditions that we’re facing now I think it is even more important that the assumptions that are in the value-and-use calculation are verified and validated against the market data,” he added.

“What you will see with stock markets coming down so far is saying something about expected growth and profitability for companies.”

The valuations expert said impairment charges of goodwill have been on the rise and this trend is likely to continue well into 2009 as companies with December 2008 year-ends have their accounts audited.

“The valuation practice will be helping our audit teams on reviewing this balance, as we have in previous years… I suspect the other firms are doing the same,” Rea explained.

A visible approach

The Financial Reporting Review Panel (FRRP), a watchdog that reviews the annual accounts and reporting of companies to ensure they comply with UK laws, this year will investigate the impairment disclosures of 30 companies.

In an unusual move, the panel will warn companies before these reviews to encourage “reporting of the highest standard and not to catch people out”.

FRRP chairman Bill Knight explained that the adequacy of impairment disclosures, their extent and clarity, and the assumptions on which they are based, are of key interest to users of accounts prepared during a severe economic downturn.

“It is not the panel’s aim or practice to catch people out. We think it fair to inform the companies concerned of our approach,” he said.

Last October, the Financial Reporting Council published a review of the information disclosed by 32 listed companies on their testing for impairment of goodwill in 2007 accounts.

It found that 53 percent of companies only provide boilerplate disclosures while less than 20 percent provide information that is company specific and very useful.

The report said that narrative reporting on the way in which key assumptions are identified and quantified tended to be vague and in many cases consisted of generalised statements.

Only a minority of the companies surveyed provided information by cash generating unit, even where significant amounts of goodwill had been allocated to more than one cash generating unit.

Arvind Hickman

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