IFRS 3, Business Combinations, was designed to give greater transparency to how companies accounted for acquisitions. Now is the first time that an analysis of its implementation has been carried out, following the first year of adoption. The results, as detailed in Intangible Business' report, 'IFRS 3: The First Year', illustrate that IFRS 3 has not been applied correctly by the majority of the UK's leading companies.

Some £40bn was spent by the FTSE 100 on acquisitions and over half of this (53%) was allocated to goodwill. This is directly opposed to the spirit of IFRS 3. Intangible assets accounted for only 30% of all acquisitions with the remaining 17% attributed to tangible assets less liabilities.

A certain amount of goodwill is, of course, inevitable. A premium will generally have to be paid to convince shareholders to sell their investment. While this premium by definition is more than the sum of the company's assets, it can still be identified. And you would hope that it already had been identified prior to the takeover approach or else how would the acquiring company know that it can make a return on its investment, thereby justifying the acquisition?

Prior to an acquisition, companies would generally identify likely benefits. This would generate a range within which the acquiring company must remain for the deal to make commercial sense. This could include a premium for value the buyer can bring. The premium could be justified by economies of sale, or synergies that are possible such as reducing overheads like head office costs.

Reasons for inadequate reporting
Unfortunately, our research has proven that this is not being done when reporting under IFRS 3 - goodwill is not being broken out and intangibles are not being identified. There are several reasons for this, including:

1. To increase profits through reduced amortisation charges
As goodwill cannot be amortised and intangible assets with finite lives can be, and amortisation is charged to profits, companies are motivated to bolster goodwill and reduce the intangibles.

2. To minimise impairment charges
Acquired intangible assets must be tested for impairment annually. Any increase may not be recognised but a fall in value must be reported - implicating management for poor performance. Goodwill also has to be tested for impairment, but the criteria are not so stringent.

3. Lack of specialist skills
As this is the first time which companies have been required to report the value of acquired intangibles, they may lack the specialist skills and knowledge required. They may also lack the confidence to value them accurately.

4. Failure to see the big picture
As there are so many regulations to comply with and the rules are so complex, there is a danger that companies got so bogged down in the detail that they failed to reassess overall what the business acquisition was about. They fail to see the wood for the trees.

Examples of inadequate reporting
There are many examples of this inadequate reporting, including:

1. Standard Chartered: In April 2005, Standard Chartered acquired Korea First Bank for $3.4bn. Korea First Bank was clearly a substantial business, with 407 branches, 2100 ATMs and 7km of signage. And although Standard Chartered admits to the significance of Korea First Bank's brand and customers, they only accounted for 7% of the deal value. Goodwill accounted for over half of the acquisition value and is largely unexplained.

2. WPP: In March 2005, WPP, one of the world's largest marketing services companies purchased Grey Global Group, for £928m and allocated no value to its brand. What value was allocated to intangible assets was not broken out - as IFRS 3 stipulates and as WPP has done in the past for acquisitions of similar brands such as JWT, Hill & Knowlton, Ogilvy & Mather and Young and Rubicam Group.

3. Aviva: In March 2005, Aviva bought the RAC for £1.1bn. The RAC has 7 million customers and is one of the most trusted brands in the UK. The brand and customer relationships should most likely have accounted for the majority of the acquisition price where as they were reported as being worth only £260m and £132m respectively, 35% of the total cost. Goodwill, dominates and is unexplained.

4. Kingfisher: In June 2005 Kingfisher bought OBI, a chain of 13 DIY superstores in China, for its B&Q brand for £144m, placing no value whatsoever on its brand or customer relationships.

How to define goodwill
Some of the reasons for this inadequate reporting have already been discussed. But how can goodwill be broken out and valued? Assuming the most common intangible assets, such as brands and customer relationships (which the brand often subsumes anyway), have been valued to reflect reality, the remaining intangibles which are dumped into goodwill can still be valued. In fact, the recognition criteria under IFRS 3 are so broad that it is unlikely that much could actually be included in goodwill. And even if there are such assets, IFRS 3 requires full disclosure and reasons why they have not been valued. This was usually no seen in our research.

There are a number of ways in which goodwill can be identified and valued, some of which are:

1. Workforce in place: A business' workforce may not be valued under IFRS 3. Its value, therefore, must be recognised within goodwill. Although difficulties exist in valuing people, it is still possible under certain circumstances.

2. Synergies: Synergies are one of the main motivations for acquisitions - being able to strip out certain costs which will increase the efficiency of the acquired company and the acquiring company as well. Such as:

a) Cost synergies: Cost synergies can be rigorously analysed, such as the duplication of head offices or a sales force.
b) Sales synergies: Combining two portfolios of products can achieve synergies through cross selling, or leveraging the combined portfolio. This can be quantified.

The implications
The implications of this inadequate reporting are far reaching. It renders annual reports more useless than they currently are, it makes a standard ineffective when applied and the financial bodies that govern them, it sets a dangerous precedent for future years and it opens a new era of creative accounting that distances shareholders and investors further from reality.

With a year's experience of implementing IFRS 3 and with a greater understanding of the potential pitfalls, next year's reporting under IFRS 3 will hopefully be executed more accurately. And if this is achieved then more assets will be identified, more intangibles valued and half of what is spent on acquisitions will be better understood and managed.