Blind Freddy – Common errors in accounting for impairment – Part 5 – Testing goodwill for impairment

The ‘Blind Freddy’ proposition is a term used by Justice Middleton in the case of ASIC v Healey & Ors [2011] (Centro case) to describe glaringly obvious mistakes.

Background

The nature of goodwill leads to a number of complex rules as to how it should be treated for impairment testing. This in turn leads to a number of potential ‘Blind Freddy’ errors that could lead to a material misstatement.

Goodwill acquired in a business combination does not in itself generate cash flows, otherwise it would most likely have been classified as an identifiable intangible asset. In theory, goodwill represents synergies and an assembled workforce that only generates cash flows in association with other assets. It is not amortised but is subject to an annual impairment test, and must, in addition to the annual test, be tested for impairment if there has been an impairment trigger.

There are special impairment rules around allocating goodwill to cash generating units (CGUs) which are designed to simplify impairment testing for goodwill, and to minimise the need to change reporting information. Unfortunately these rules can cause errors to arise, both when testing goodwill for impairment, and when testing other assets for impairment.

Allocating goodwill to cash-generating units

The principles for allocating goodwill acquired in a business combination to CGUs or groups of CGUs for the purpose of impairment testing are described in AASB 136 Impairment of Assets, paragraph 80.

Goodwill

Allocating goodwill to cash-generating units

For the purpose of impairment testing, goodwill acquired in a business combination shall, from the acquisition date, be allocated to each of the acquirer’s cash-generating units, or groups of cash-generating units, that is expected to benefit from the synergies of the combination, irrespective of whether other assets or liabilities of the acquiree are assigned to those units or groups of units. Each unit or group of units to which the goodwill is so allocated shall:

  1. represent the lowest level within the entity at which the goodwill is monitored for internal management purposes; and
  2. not be larger than an operating segment as defined by paragraph 5 of AASB 8 Operating Segments before aggregation.

AASB 136, paragraph 80

Allocation based on expected synergies

The first principle in paragraph 80 is that goodwill acquired in a business combination must be allocated to CGUs or groups of CGUs that are expected to benefit from the synergies of the combination.

Example 1

Professional Practice Firm has a tax division, assurance division and a consulting division, with a centralised back office to support administration, HR and marketing. Each division represents a CGU.

Professional Practice Firm acquires Small Firm, resulting in goodwill of $2 million. The acquired firm’s revenue derives 90% from the tax division and 10% from assurance, with no consulting division. Part of the business rationale for the acquisition of Small Firm is to sell additional assurance services and consulting services to Small Firm’s ‘tax’ client base.

Professional Practice Firm allocates all of the goodwill to the tax GCU.

This is an error as some of the goodwill should have been allocated to both the assurance CGU, and the consulting CGU.

Blind Freddy Error 1

Not allocating goodwill acquired in a business combination to the acquirer’s CGUs or groups of CGUs that are expected to benefit from the synergies of the combination.

Allocation to lowest level at which goodwill is monitored for internal management purposes

The second principle in paragraph 80 is that goodwill must be allocated to CGUs or groups of CGUs that represent the lowest level within the entity/group at which goodwill is monitored by internal management.

Example 2

Bus Company A acquires Small City Bus Co, a local company (business) in Small City. Bus Company A had never previously operated in Small City.

Small City Bus Co has five bus routes. Each bus route is likely to be a separate CGU, but for the purpose of management reporting, the performance of the acquisition is measured based on the profitability from the whole operation in Small City.
It would therefore be reasonable to test goodwill for impairment at the Small City Bus Co level, i.e. all five bus routes on an aggregated basis.

Example 3

Bus Company B acquires Small City Bus Co, a local bus company in Small City.

Bus Company B has an existing operation in Small City, running ten bus routes.

Small City Bus Co operates five bus routes. Each bus route is likely to be a separate CGU, but for the purpose of management reporting, the performance of the acquisition is measured based on the profitability from the whole operation in Small City.
It would therefore be reasonable to test goodwill for impairment at the Small City level, i.e. all 15 bus routes on an aggregated basis.

Blind Freddy Error 2

Allocating goodwill to CGUs at a level lower than that at which goodwill is monitored for internal management purposes.

Allocation not higher than an operating segment, before aggregation

Lastly, paragraph 80 requires that each CGU or group of CGUs to which goodwill is allocated cannot be larger than an operating segment as defined in paragraph 5 of AASB 8 Operating Segments.

An operating segment is a component of an entity:

  1. that engages in business activities from which it may earn revenues and incur expenses (including revenues and expenses relating to transactions with other components of the same entity),
  2. whose operating results are regularly reviewed by the entity’s chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance, and
  3. for which discrete financial information is available.

AASB 8, paragraph 5

Points worth noting:

  1. An operating segment (before aggregation) is typically represented by ‘a column’ in management accounts presented to the chief operating decision maker (CODM). If, for example, operating reports/management accounts presented to the CODM of a chain of shoe stores includes separate columns for each store, each store would typically be a separate CGU, and also an operating segment (before aggregation). While all shoe stores may share similar economic characteristics, and therefore be aggregated when presenting segment disclosures in the financial statements, goodwill will need to be allocated to each shoe store when performing the annual impairment test.
  2. This requirement applies equally to private companies that are not required to present the segment disclosures in AASB 8. This means that you would need to first identify all your operating segments (before aggregation) prior to allocating goodwill.

Example 4

Bus Company C, historically based in New South Wales, has created a national business through acquisitions and now operates in Victoria, Tasmania and Western Australia. For the purpose of reporting under AASB 8, it aggregates all of its operating segments because they share similar economic characteristics.

Bus Company C tests goodwill for impairment at the Australian level.

This is an error because each state is likely to meet the definition of an operating segment.

Example 5

Bus Company D, historically based in New South Wales, has created a national business through acquisitions and now operates in Victoria, Tasmania and Western Australia. Bus Company D is not required to report under AASB 8 Segment Reporting.

Bus Company D tests goodwill for impairment at the Australian level.

Again, this is an error because each state is likely to meet the definition of an operating segment. The requirement in AASB 136 to test at a level no larger than an operating segment applies, regardless of whether the entity is required to report under AASB 8.

Blind Freddy Error 3

Allocating goodwill to CGUs at a level higher than an operating segment, before aggregation.

Disposals

When an entity disposes of part of a business operation making up a CGU, paragraph 86 requires that goodwill associated with the operation disposed must be measured and allocated to the carrying amount of net assets sold. This will result in a reduction in the gain, or increase in loss, on disposal of the operation.

If goodwill has been allocated to a cash-generating unit and the entity disposes of an operation within that unit, the goodwill associated with the operation disposed of shall be:

  1. included in the carrying amount of the operation when determining the gain or loss on disposal; and
  2. measured on the basis of the relative values of the operation disposed of and the portion of the cash-generating unit retained, unless the entity can demonstrate that some other method better reflects the goodwill associated with the operation disposed of.

AASB 136, paragraph 86

 

Example 6

An entity sells an operation for $100,000 that was part of a CGU to which goodwill has been allocated. The goodwill allocated to the unit cannot be identified or associated with an asset group at a level lower than that CGU, except arbitrarily. The recoverable amount of the portion of the CGU retained is $300,000.

Scenario A

Entity attributes no goodwill to the disposed of operation.

This is a ‘Blind Freddy’ error, resulting in an overstatement of the gain on disposal.

25% of the goodwill ($100,000/$400,000 based on relative fair values of operations disposed of and portion of CGU retained) should have been allocated to the disposal group.

Scenario B

Entity attributes 10% of the goodwill to the operation disposed of.

This is also a ‘Blind Freddy’ error, resulting in an overstatement of the gain on disposal.

25% of the goodwill ($100,000/$400,000) should have been allocated to the disposal group.

Blind Freddy Error 4

Not allocating goodwill to an operation that has been disposed of.

Blind Freddy Error 5

Not calculating the amount of goodwill to be allocated to an operation disposed of in a reasonable manner, e.g. using relative fair values of the operation disposed and the portion of the CGU retained.

Reorganisations

AASB 136, paragraph 87 also includes requirements for reallocation of goodwill when an entity reorganises its reporting structure so that there is a change in the composition of CGUs to which goodwill has been allocated.

If an entity reorganises its reporting structure in a way that changes the composition of one or more cash-generating units to which goodwill has been allocated, the goodwill shall be reallocated to the units affected. This reallocation shall be performed using a relative value approach similar to that used when an entity disposes of an operation within a cash-generating unit, unless the entity can demonstrate that some other method better reflects the goodwill associated with the reorganised units.

AASB 136, paragraph 87

Example 7

Historically, Bus Company E operates 20 bus routes across various cities in Australia. The operation comprises 20 CGUs and has been monitored on a city basis.

In a reorganisation, the operation is now to be operated as three separate divisions (groups of CGUs):

  • Urban (ten CGUs)
  • Rural (six CGUs), and
  • A separate education transport unit (school buses) (four CGUs).

This new structure reflects Bus Company E’s national reporting structure, and no financial reporting will be produced based on city results.
Bus Company E does not allocate goodwill to these three new units. This is a ‘Blind Freddy’ error as the three new units have no goodwill allocated.

Blind Freddy Error 6

Not reallocating goodwill to the CGUs affected by a group reorganisation.

Example 8

Goodwill had previously been allocated to CGU A. The goodwill allocated to CGU A cannot be identified or associated with an asset group at a level lower than CGU A, except arbitrarily.

CGU A is to be divided and integrated into three other CGUs: B, C and D.

The entity allocates all the goodwill to CGU B.

Blind Freddy Error 7

Not reallocating goodwill based on the relative value approach to the units affected by a group reorganisation.

Bottom up - top down assessment

As described in last month’s accounting news article, a common cause of errors is preparers not distinguishing between the special rules that apply to testing goodwill in respect of allocating to a CGU or a group of CGUs, and the basic requirement to test assets, other than goodwill, for impairment.

When, as described in paragraph 81, goodwill relates to a cash-generating unit but has not been allocated to that unit, the unit shall be tested for impairment, whenever there is an indication that the unit may be impaired, by comparing the unit’s carrying amount, excluding any goodwill, with its recoverable amount. Any impairment loss shall be recognised in accordance with paragraph 104.

AASB 136, paragraph 88

Example 9

Big Co has three operating divisions: Division A, Division B and Division C, which are all a group of CGUs. Division A sells Samsung Galaxy 7s.

Big Co is unable to allocate goodwill to each division (CGU), except arbitrarily. Goodwill is therefore allocated to the group of CGUs (Divisions A, B and C) and impairment testing performed at the level of the A-B-C group.

During the year, iPhone 7 was released and Division A will need to heavily discount its large stocks of Samsung Galaxy 7s, resulting in reduced expected sales in Division A.

Big Co continues to test impairment only at the level of the A-B-C group. This is a ‘Blind Freddy’ error because Big Co has failed to comply with the requirement in paragraph 88 to perform ‘bottom up’ impairment testing.

Blind Freddy Error 8

Failing to perform ‘bottom up’ impairment testing when there are impairment indicators for an individual CGU that is part of a group of CGUs to which goodwill has been allocated.

Timing of impairment tests

A goodwill impairment test must be performed at least once a year. It can be performed at any time during the year, but at the same time each year.

The annual impairment test for a cash-generating unit to which goodwill has been allocated may be performed at any time during an annual period, provided the test is performed at the same time every year. Different cash-generating units may be tested for impairment at different times. However, if some or all of the goodwill allocated to a cash-generating unit was acquired in a business combination during the current annual period, that unit shall be tested for impairment before the end of the current annual period.

AASB 136, paragraph 96

Example 10

Entity F has a 30 June year end.

Entity F only tests goodwill for impairment at year end because it assumes that testing must take place at the end of the reporting period. This places significant stress on the reporting process and risks delays in producing its annual financial statements.

This is another ‘Blind Freddy’ error because impairment testing can be performed at any time during an annual period, provided the test is performed at the same time every year.

Blind Freddy Error 9

Only testing goodwill for impairment at the reporting date.

Example 11

Entity G has a 30 June year end.

In 2016, it tested its goodwill for impairment in May 2016. It proposes to update the impairment model in July 2016, in order to meet the requirement for impairment testing for 2017.
This is a ‘Blind Freddy’ error because impairment testing must be performed at the same time every year. Changing the timing of impairment testing is not permitted in AASB 136.

Blind Freddy Error 10

Changing the date of impairment testing of goodwill.

Example 12

Entity H has a 30 June year end.

It acquires a business in May 2016, and does not test this goodwill for impairment for its 30 June 2016 financial report.

This is a ‘Blind Freddy’ error because goodwill must be tested for impairment even if it arises from an acquisition in the year.

Blind Freddy Error 11

Not testing goodwill acquired for impairment in the first year.

Example 13

Entity I has a 30 June year end. It tests its goodwill for impairment in May each year.

Entity I performed its impairment test in May 2016 and concluded there was no impairment because its market capitalisation was $200 million at 31 May 2016, compared with a net asset position of $180 million.

At 30 June 2016, Entity I’s market capitalisation had fallen to $120 million. It did not reperform its impairment testing at 30 June 2016.

This is a ‘Blind Freddy’ error because goodwill must be tested for impairment when there is an impairment indicator, regardless if it has been tested earlier as part of the annual impairment testing cycle.

Blind Freddy Error 12

Not retesting goodwill for impairment when there has been an impairment indicator subsequent to the annual impairment test.

Example 14

Entity J A has a 30 June year end and has half-year reporting obligations at 31 December each year.

It tests its goodwill for impairment in May each year.

Entity J performed its impairment test in May 2016 and concluded there was no impairment because its market capitalisation was $200 million at 31 May 2016 compared with a net asset position of $180 million.

At 31 December 2016, Entity J’s market capitalisation had fallen to $120 million. It did not perform its impairment testing, arguing that goodwill was not due for testing until May 2017.

This is a ‘Blind Freddy’ error because goodwill must be tested for impairment when an impairment event has occurred, regardless if it will be tested later as part of the annual impairment testing cycle.

Blind Freddy Error 13

Not testing goodwill for impairment when there has been an impairment indicator prior to the scheduled annual testing.

Testing individual assets for impairment first

Where there are impairment indicators for assets in a CGU, other than goodwill, paragraph 98 requires that these assets are tested for impairment, and written down if necessary, prior to conducting the impairment test on the whole CGU, or group of CGUs.

At the time of impairment testing a cash-generating unit to which goodwill has been allocated, there may be an indication of an impairment of an asset within the unit containing the goodwill. In such circumstances, the entity tests the asset for impairment first, and recognises any impairment loss for that asset before testing for impairment the cash-generating unit containing the goodwill. Similarly, there may be an indication of an impairment of a cash-generating unit within a group of units containing the goodwill. In such circumstances, the entity tests the cash-generating unit for impairment first, and recognises any impairment loss for that unit, before testing for impairment the group of units to which the goodwill is allocated

AASB 136, paragraph 98

Example 15

Bus Company K runs a bus route which is operated using three buses.

The carrying value of the buses is $750,000 ($250,000 each). The bus route represents a CGU to which $1 million of goodwill has been allocated.

One of the buses is not performing to required standards on safety and omissions and is idle. It is estimated the bus will be sold for $50,000 and that a new replacement bus will cost $300,000.

The recoverable amount of the CGU, taking into account the need to replace the one bus, is $1.6 million. Assuming the carrying amount of the CGU is $1.75 million, comprising goodwill of $1 million and property, plant and equipment (PPE) of $750,000, Bus Company K recognises an impairment loss of $150,000 against goodwill.

This is a ‘Blind Freddy’ error and an impairment loss of $200,000 should have first been recognised in respect of the underperforming bus (i.e. $250,000 carrying value less $50,000 recoverable amount). Therefore the impairment test in respect of goodwill should have been $1.6 million compared to a CGU with a value of $1.55 million (goodwill of $1 million plus PPE of $550,000).

Blind Freddy Error 14

Writing down goodwill, rather than an individual asset.

Example 16

Bus Company L operates five bus routes (each represents a separate CGU). Goodwill of $1 million has not been allocated to individual routes.

  Route 1 Route 2 Route 3 Route 4 Route 5 Total
  $’000 $’000 $’000 $’000 $’000 $’000
Fixed assets – carrying amount (buses) 200 200 200 200 200 1,000
Recoverable amount 200 200 600 500 300 1,800

The table above shows that none of the buses are impaired because their recoverable amounts exceed fair value.

The total carrying amount of assets for impairment testing of the combined group is $2 million, being $1 million goodwill plus $1 million for the buses.

Bus Company L recognises an impairment loss of $200,000 ($2 million -$1.8 million) for the group and allocates it against each of the CGUs assets (buses).

This is a ‘Blind Freddy’ error. The $200,000 impairment loss should have been recognised against goodwill and not the fixed assets as none of the fixed assets are impaired.

Blind Freddy Error 15

Writing down an individual asset, rather than goodwill.

Summary

This concludes our series of Blind Freddy articles on impairment of non-financial assets. We will recommence this series in the new year.

You can access all the previous Blind Freddy impairment articles on our web site: