IFRS 3 is severely limited and has been poorly implemented so far, argues Thayne Forbes, joint managing director of Intangible Business

Introduction
IFRS 3 was introduced with a fanfare. It was heralded as a new way to make company accounts more transparent by requiring all acquired intangible assets to be valued and put on the balance sheet. As a consequence, the nebulous figure of goodwill was supposed to be reduced and shareholders would have a better idea of what they had paid for.

Research Intangible Business conducted into how the FTSE 100 accounted for their acquisitions in the first year of reporting under IFRS 3, reveals pervasive inadequacies and exposes the limitations of IFRS 3.

The research, ‘IFRS 3: The First Year', found that of the £40billion that was spent on acquisitions over half (53%) was unaccounted for and dumped into goodwill. There was also little or no explanation as to what this £21 billion was. Only 30% was assigned to intangible assets with the remaining 17% allocated to tangible assets less liabilities.

The limitations of IFRS 3
Perhaps it is not surprising that IFRS 3 has only been implemented half-heartedly as it has several inherent limitations which exposes its good intentions to abuse. For example:

• Only acquired intangible assets may be valued and put on the balance sheet. Internally generated intangibles are not included under IFRS 3. The majority of most companies' value is therefore excluded from the balance sheet making company reports even further removed from reality.

• Only a decrease in the value of an intangible asset may be recognised under impairment review. If a brand has increased in value, this is not recognised under IFRS 3. This incentivises management to under value intangibles to avoid such an impairment charge.

• Goodwill also has to be tested for impairment but it should be tested together with the goodwill for the rest of the associated cash generating unit. As such, the criteria are not so rigorous which reduces the risk of having to recognise impairment charges - a further incentive to allocate heavy amounts to goodwill.

• Intangible assets need to be amortised and the amortisation charged to profits, if they have a finite useful life. Goodwill cannot be amortised. So minimising the values of intangible assets and maximising goodwill means that amortisation charges to profits would most likely be reduced.

• Values of goodwill and intangible assets as recorded on company balance sheets are at historic amounts and not revalued. This clouds further the true value of the intangible asset.

• IFRS 3 stipulates that the valuations must be carried out independently of the audit process. But with only four auditors auditing 99% of the FTSE 100 and having such a strong influence on how companies report, the true independence of these valuations is questionable.

Examples of inadequate reporting
These limitations have resulted in a number of examples whereby IFRS 3 has not been applied adequately. These include:

Standard Chartered
Standard Chartered bought Korea First Bank for £3.4 billion in April 2005. Korea First Bank was a substantial organisation consisting of 407 branches, 2100 ATMs and 7 kilometres of signage - it clearly had a brand which was supported by a substantial customer base. Standard Chartered, however, perceived little value to these two assets, assigning £115m to customer value and £86m to brand - just 7% of the total purchase price. 52% of the purchase price was allocated to goodwill. Far from transparent accounting.

WPP
WPP is one of the world's largest advertising and communication networks. In March 2005, it bolstered its position further with the acquisition of Grey Global Group. Grey was a well established advertising agency with a successful network in 90 countries, a blue chip client base including one fifth of all Fortune 500 companies. However, no value was allocated to Grey's brand or customer relationships. It wasn't as if WPP didn't know about it either, as it had reported the values of previously acquired brands such as JWT, Hill & Knowlton, Ogilvy & Mather Worldwide and the Young and Rubicam Group. In this instance, the only description of the intangible assets was just that ‘acquired intangibles'. This is contrary to the stipulations of IFRS 3. The figure assigned to goodwill was three times greater than that of intangibles.

BAE Systems
BAE Systems acquired United Defense in 2005 for £2.2 billion. United Defense was a leader in the design, development and production of combat vehicles, artillery, naval guns, missile launchers and precision munitions used by the US Department of Devense and its allies worldwide. It clearly relied on advanced technology and patents, and had a known and trusted brand. However, the only intangible asset to be recognised by BAE Systems was its acquired order book & on-going programme relationships. This was valued at £356m, 16% of the acquisition cost. No value was attributed to United Defense's technology or brands such as Bradley. Instead, 84% of the purchase price was allocated to goodwill with no description of what it was. Again, hardly transparent reporting.

Aviva
Aviva acquired the RAC in March 2005 for £1.1 billion. The RAC had 7 million customers and one of the most recognised and trusted brands in the UK yet the customers were valued at only 12% of the total deal value and the brand at 23%. Goodwill accounted for the majority of value - four times more than the brand value and nine times more than the value of its customers. This is distorted reporting.

The list of culprits goes on: The Friends Reunited brand accounted for only 26% of what ITV paid for it whereas 69% was allocated to goodwill. 85% of GUS's acquisition of PriceGrabber.com was allocated to goodwill and unexplained. Kingfisher bought a £144m Chinese retail business business, OBI, for B&Q and despite having 13 superstores, nothing at all was allocated to the brand or customer.

How to value goodwill
In additional to placing too much value in goodwill, no company attempted to describe what the goodwill was, as IFRS 3 states. A number of elements constitute goodwill and these can both be identified and measured. IFRS 3 states:

"A description of the factors that contributed to a cost that results in the recognition of goodwill - a description of each intangible asset that was not recognised separately from goodwill and an explanation of why the intangible asset's fair value could not be measured reliably." IFRS 3, Disclosure 66 (h)

Some of these elements of goodwill that could have been identified include workforce in place and synergies. The value of workforce in place is not allowed to be included separately under IFRS 3. It should, however, be included under goodwill. Although it is difficult to quantify it is possible and as such should be described separately under goodwill.

Synergies are a big area which have been almost completely ignored in the implementation of IFRS 3. Any company should have a pretty good idea of what synergistic benefits they would be able to extract from the acquisition - as this is a key motivation for the purchase. Such synergies include cost synergies such as those which can be reduced through removing duplication and through economies of scale. Examples of cost synergies are combining two head offices into one. This synergy can be rigorously quantified and valued. To illustrate this, a saving of annual head office costs might be quantified at £5 million a year, equating to a capital value of say £50 million. Economies of scale can also be quantified as unit costs reduced by using the greater purchasing power achieved through higher volume. For example, if cost of distributing each unit fell by £1 a unit, this equates to a capital value of say £10 a unit - potentially a very large number indeed.

Another synergy is sales synergy whereby the acquirer's existing portfolio of products is bolstered by the acquisition, which makes cross-selling possible as well as increasing sales through the additional leverage a larger portfolio brings. This too can be quantified although no examples of its application were seen in the research.

Conclusion
Teething problems were inevitable as this was the first year of IFRS 3 adoption. Now that the limitations and difficulties of applying IFRS 3, Business Combinations, have been identified, next year's application should hopefully be an improvement and investors will have a better idea of where a company's money invested in acquisitions has gone and whether it has been worthwhile.