httpwwwmanagementumbedudocumentsUGHonorsKaushik-Thesispdf

1 CONVERGENCE OF ACCOUNTING STANDARDS

10487081048708An examination of the treatment of business combinations under the UK and US GAAP and the IFRS

10487081048708A review of the reconciliatory Balance Sheets of 10 European companies

POOJA KAUSHIK ABSTRACT This thesis supports global convergence of accounting standards ie adoption of the International Financial Reporting Standards I have chosen the accounting treatment of intangible assets to compare and analyze the increased transparency that IFRS provides in relation to the pre-IFRS UK GAAP and US GAAP Analysis of the lsquo reconciliation of UK GAAP to IFRSrsquo balance sheets of 10 companies in the United Kingdom who have adopted IFRS and their previous GAAP numbers has been used to prove the effectiveness and usefulness of the IFRS In this thesis I have used the stakeholder theory to sum up the benefits of increased transparency to stakeholders 2

INTRODUCTION THESIS GOALS AND PURPOSE With increased globalization in todayrsquos world there is a lot of talk in the accounting world for a unified set of standards that would serve investors and other users of financial statements worldwide Besides cutting financial reporting costs and helping fund raising for corporations analysts say that the standards would also provide investors with a better global insight in their companyrsquos performance The IFRS which promulgated by the IASB in London are predicted by many to be the adopted global set of standards by many My thesis supports the global convergence of standards or the adoption of the IFRSI have chosen to concentrate on one area- the accounting for business combinations under the pre-IFRS UK GAAP US GAAP and the IFRS to prove that the adoption of the IFRS increases transparency in reporting The increased transparency has been proven-

10487081048708By a comparison and evaluation of the accounting treatment under the US GAAP pre-IFRS UK GAAP and the IFRS

10487081048708By the sample testing of the reconciliatory lsquoUK GAAP to IFRSrsquo Balance Sheets of 10 companies

The stakeholder theory has been applied to summarize the benefits of the increased transparency to different stakeholders The stakeholder theory has been applied to the IFRS as a whole to prove the benefits of the IFRS using surveys conducted by KPMG and PWC I divided the thesis body into three stages in order to organize my findings Stage 1- Comparison and evaluation of accounting for business combinations Stage 2-Sample analysis and Stage 3-Application of the stakeholder theory 3

BACKGROUND INFORMATION ON THE IFRS US GAAP UK GAAP AND AREAS OF DIFFERENCES IN ACCOUNTING INTRODUCTION TO THE IFRS International Accounting Standards (IASs) were issued by the IASC from 1973 to 2000 The IASB replaced the IASC in 2001 Since then the IASB has amended some IASs has proposed to amend other IASs has proposed to replace some IASs with new International Financial Reporting Standards (IFRSs) and has adopted or proposed certain new IFRSs on topics for which there was no previous IAS Through committees both the IASC and the IASB also have issued Interpretations of Standards Financial statements may not be described as complying with IFRSs unless they comply with all of the requirements of each applicable standard and each applicable interpretation (Deloitte Touche Tohmatsu 2006) IASBrsquos framework IFRS and Interpretations provides guidelines and explanations for the methods of accounting The Framework was published by the IASC in 1989 to provide an outline and explanations for financial reporting concepts The Framework serves as a guide to both international and national standard setters to set consistent accounting standards and assists preparers and auditors in interpreting standards and dealing with issues that the standards do not cover There are 34 IFRS currently in effect The Standards provide guidance for preparers to deal with the recognition measurement presentation and disclosure requirements for transactions and events Most IFRS are intended for application across industries with only one standard outlining disclosure requirements for banks and other financial institutions A second tier 4

of guidance comes from the Interpretations developed by the Standing Interpretations Committee now IFRIC These pronouncements clarify or interpret the standards where the preparer community identifies the need for improved guidance (PricewaterhouseCoopers2002) The adoption of International Financial Reporting Standards (IFRS) which was required for listed companies of all 25 EU countries on January 1 2005 is being witnessed throughout the rest of the world at an increasing rate with Japan Australia Russia Canada Hong Kong and several Middle East and African countries already having decided on a comprehensive mandatory change To date the more significant holdouts including the United States South Africa Singapore and Malaysia are committed to modifying local standards to these international standards (Bahal and Ross1 2002) International accounting standards regulate multinational behavior to a certain extent They ensure efficient functioning of capital markets Most importantly they facilitate greater comparability of information as without these standards a financial statement from India and UK would be very different from one from the United States They provide a basis on which performance of a multinational can be evaluated and compared not just nationally but internationally These standards also lead to better communication between accountants all over the globe and the sharing of information could always lead to ideas for ameliorating accounting reporting standards and techniques The above-mentioned reasons ultimately lead to investor confidence Investors possess a better understanding of international finance and stock markets and this in turn helps them make better portfolio decisions 5

IFRS IN EUROPE All European quoted companies were required to prepare their consolidated financial statements in accordance with the International Financial Reporting Standards since 2005 The transition dates for different companies ranged from 31 December 2003 to 30 December 2004 The EU policy is aimed at the removal of barriers to cross border trading in securities by ensuring that company financial statements throughout the EU are transparent and comparable The economic gains to be derived from an integrated European financial and capital market are considerable (Lian 2 2004) Prior to the IAS European countries were either using US GAAP or their own national standards The European Commission has said ldquoIAS will offer [those now using US GAAP] the same high quality level of financial information as US GAAP with the additional advantage that IAS have been conceived in a truly international perspective and are not modeled by a particular national environment The Commission hopes and expects that the US Securities and Exchange Commission (SEC) will accept in the near future financial statements prepared by EU issuers without requiring a reconciliation to US GAAPrdquo As this thesis compares the pre-IFRS UK GAAP to IFRS I would like to write a little about the IFRS situation in the UK The Accounting Standards Committee (ASC) and the Accounting Standards Board (ASB) were previously producing UK SSAPs and FRSs Since the implementation of the International Financial Reporting Standards a number of changes have taken place in the accounting and presentation of financial 6

statements Some of the areas in which the IFRS differs from the pre-IFRS UK GAAP are-

bull Tangible Fixed Assets

bull Intangible assets

bull Impairment of Assets

bull Stock and Long Term Contracts

bull Deferred taxes

bull Leases

bull Retirement Benefits

IFRS AND US GAAP DIFFERENCES Accountants will encounter US GAAP either with American groups or with foreign groups that have a listing on US stock markets US GAAP are standards developed for the 12000 or so listed companies in the USA and required by the Securities and Exchange Commission (SEC) Foreign companies that have shares or bonds listed in the USA need not publish US GAAP accounts as such but must in effect prepare them in order to provide a reconciliation statement This details for their US investors the differences between net profit and net assets as reported and how they would have been stated under US GAAP Though there is no general filing requirement for accounts of unlisted companies in the USA it is thought that about 15000 other companies prepare GAAP-compliant accounts as a requirement of bank borrowings or on 7

a voluntary basis GAAP principally developed by the Financial Accounting Standards Board (FASB) are more extensive than IFRS - comprising hundreds of standards interpretations opinions and other authoritative rules (Martin 2004) Some of the accounting areas in which the US GAAP differs from the IFRS are-

bull Tangible assets

bull Available for sale marketable securities

bull Intangible assets

bull Research and development expenditures

bull Leases

bull Inventory

IASB-FASB CONVERGENCE PROJECTS In September 2002 the FASB and the IASB reached an agreement to conduct a short-term project to work towards eliminating the differences between the IFRS and US GAAP The SEC also made an announcement in the same month in which it said that starting in 2007 it might allow foreign companies which are trying to raise capital in the US to use the IFRS rather than reconciling to US GAAP as they do right now Convergence is supposed to ease the task of raising capital Once the process is complete investors will need less help comparing results of competing firms based in different countries US companies that conform to GAAP will be able to raise capital abroad without reconciling their results to IFRS (Reason 2005 2) The FASB and IASB are 8

also working together on a number of long-term projects that deal with concepts like business combinations employee benefits and comprehensive income

LITERATURE REVIEW I have analyzed and compare the reconciliatory Balance Sheets of 10 European countries I chose these companies from different sectors of the European economy and have written about their performance For the theoretical framework I use the stakeholder theory The stakeholder research tradition began to unfold in the wake of R Edward Freemanrsquos seminal book Strategic Management A Stakeholders Approach which was published in the mid-1980s The book initiated a still ongoing academic discussion It demonstrated in a comprehensive fashion that strategic management of private sector firms could become much more effective and efficient if managerial efforts regard various stakeholders concerns Or in other words shareholders benefit long-term if other legitimate interests in the firm do not fall by the wayside (Scholl 2)Thus besides shareholders the interests of other stakeholders in and outside the organization had to be taken into consideration while making managerial decisions and implementing policies Stakeholder theory suggests that an organization has relationships with many constituent groups or stakeholders(Covell 2004) that affect and are affected by its decisions (Freeman 1984) A major purpose of stakeholder theory is to help corporate managers understand their stakeholder environments and manage more effectively within the nexus of relationships that exists for their companies However a larger purpose of stakeholder theory is to help corporate managers improve the value of the outcomes of 9

their actions and minimize the harms to stakeholders The whole point of stakeholder theory in fact lies in what happens when corporations and stakeholders act out of their relationships (Logsdon and Wood 3) The stakeholder theory involves answering three important questions- Who are the organizationrsquos stakeholders for accounting standards This step involves identification of the organizationrsquos stakeholders Stakeholders are defined as those individuals that have a stake in the performance of an organization that the interests of all legitimate stakeholders have intrinsic value and that no set of interests is assumed to dominate the others (Donaldson amp Preston 1995) In the Ivey Business Journal Robert Philips writes that stakeholders are those groups from whom the organization has voluntarily accepted benefits and to whom the organization has therefore incurred obligations of fairness Typically this includes groups such as financiers employees customers suppliers and local communities (Philips 2004 2) Stakeholder theory holds that besides these legitimate stakeholders derivative stakeholders like competitors or activist groups are important as their actions can influence the corporation Why are the stakeholders important for accounting standards Brenner and Cochran comment that the stakeholder theory of the firm posits that the nature of an organizations stakeholders their values their relative influence on decisions and the nature of the situation are all relevant information for predicting organizational behavior(1991 p 462) Milton Friedman uses the property rights argument stating that shareholders own an organization as they own the equity shares and if they desire to 10

maximize the value of their investment it is the managerrsquos duty to work in accordance Managers who fail to do so violate the moral property right (Mitchell et al 1997) note that stakeholder theory has managerial importance because it can determine to what and to whom managers need to listen and give attention What do Stakeholders want Different people want different things from their relationships with organizations Stakeholder discussions often focus on allocating some measure of organizational value or outcome (eg who gets how much money from the firm) The question of how the organization creates this value usually gets less attention but it is certainly not less important Not all stakeholders want a voice in organizational decision-making but those who do desire a voice should have it (Philips 2004 2) My literature sources had to be organized into three data sets-IFRS standards US GAAP and pre ndashIFRS UK GAAP My documents for analyzing the IFRS were the web summaries put up on the International Accounting Standards Board site For pre-IFRS UK GAAP I referred primarily to the Deloitte and Touche publication lsquoGAAP 2004rsquo For the US GAAP I referred to the textbook being used right now in UMass Boston for AF310 and AF311 lsquoIntermediate Accountingrsquo by Kieso Weygandt and Warfield The IFRS accounting for intangible assets was the x variable I used to prove my y variables which are increased transparency and better stakeholder management I must mention that this research greatly benefited from the articles posted by Intangibles Business Ltd The research resources I have used are archives real data literature interviews reviews and the research facilities available at UMASS in the Healey library database The databases I have used are Business Source Premier Lexis Nexis Academic 11

Ebrary and the Wall Street Journal for articles Besides these I have also used other UMB resources like the CM faculty the CM Business Center and the advice and guidance of the Accounting and Management Department faculty

METHODOLOGY I have used an analytical as well as a theoretical framework to prove my research objective My research can be divided into three stages Stage one involves analysis involves looking at the standards for intangible assets and goodwill under IFRS UK GAAP and US GAAP and making comparisons This is followed by Stage two- the analysis of the reconciliations of Balance Sheets of a sample of 10 companies and interpret the data to prove the increased transparency under IFRS In Stage three The stakeholder theory which I have explained in detailed in a later section has been to used to prove how this increased transparency has lead to better stakeholder management ie provides managers with a number of alternatives to serve stakeholders in a better manner which would ultimately prove beneficial to business In the end I use the stakeholder theory again to prove the general effectiveness of the IFRS using the information in surveys conducted Empirically my research could be summarized in the following steps- collection of data questioning of the information collected forming conclusions and finally putting together all of my research on paper The diagram on the next page summarizes the structure and organization of my thesis 12

Accounting for intangible assets Sample analysis Using the stakeholder theory

IFRS 3 US GAAP

SFAS 141

SFAS 142

UK GAAP

FRS 10

Comparisons and differences

Analysis of reconciliatory statements of sample of 10 European companies that have transitioned to the IFRS

INCREASED TRANSPARENCY

Interpretation of data on intangible assets and goodwill

IFRS

IFRS 3

Investors

Government

Suppliers Customers Creditors

Society 13

US GAAP

ANALYSIS

STAGE 1 ACCOUNTING FOR INTANGIBLE ASSETS This stage involves a comparison of accounting for intangibles under IFRS US GAAP and UK GAAP

SFAS 141

SFAS 142

UK GAAP

FRS 10

Comparisons

and

differences IFRS 3 14

Introducing concepts Intangible assets Goodwill Intangible assets The Uniform Commercial Code (Section 9-102(a)(42)) defines general intangibles as any personal property other than accounts chattel paper commercial tort claims deposit accounts documents goods instruments investment property letter of credit rights letters of credit money and oil gas or other minerals before extraction The term includes payment intangibles and software In todayrsquos global economy dominated by information and service providers intangible assets constitute a major proportion of total assets Intangible assets command an increasingly large proportion of a companyrsquos value and this value has largely not been recognized In heavily branded consumer businesses such as Coca Cola or Nike brands account to up to 80 of the companyrsquos value In other industries such as pharmaceutical patents and copyrights are more prominent(Thaynes1 ) Thus Microsoftrsquos software Cokersquos secret formula and America Onlinersquos subscription base are the most important assets on their balance sheets Infact the value of tangible assets as a percentage of all assets has been steadily decreasing as shown in the graph below which is provided by the Federal Reserve Board but which is recreated by me for this thesisrsquos purpose The original graph is attached 80 70 60 5055 Years lsquo00 15

While intangibles are potential sources of income their values can erode just as quickly Just before Winstar Communications filed for bankruptcy in 2001 their assets were listed at 5 billion dollars However on liquidation the assets fetched just 42 million dollars due to decline in the value of intangibles Traditional assessment of national economic performance has relied upon understanding the GDP in terms of traditional factors of production ndash land labor and capital Knowledge assets may be distinguished from the traditional factors of production ndash in that they are governed by what has been described as the lsquolaw of increasing returnsrsquo In contrast to the traditional factors of production that were governed by diminishing returns every additional unit of knowledge used effectively results in a marginal increase in performance Success of companies such as Microsoft is often attributed to the fact that every additional unit of information-based product or service would result in an increase in the marginal returns Given the changing dynamics underlying national performance it is not surprising that some less developed economies with significant assets in ICT knowledge and Internet-related expertise are hoping to leapfrog more developed economies ( Malhotra2000) Intangible assets have two main characteristics- they lack physical existence and they are not financial instruments Intangible assets derive their value from the rights and privileges granted to the company using them (Kieso Weygandt and Warfield570) Intangible assets are further classified as limited life intangibles or indefinite life intangibles Limited life intangibles have a known useful life and indefinite life intangibles are intangibles whose useful life cannot be determined Accounting treatment for the intangibles vary according to their type which we shall look more in detail in the next section When intangibles are purchased from other parties they are most recorded at the 16

cost of purchase or fair market value under most accounting systems This cost includes all the expenses incurred to make the asset ready for use These include its purchase price legal fees and incidental expenses Internally generated intangibles are generally expensed as incurred All the research and development costs that companies have to incur to come up with the asset are expensed in the income statement The six major categories of intangible assets are marketing ndashrelated intangible assets customer-related intangible assets artistic-related intangible assets contract-related intangible assets technology-related intangible assets and goodwill Marketing - related intangibles assets are those assets used in the marketing or promotion of products These include trademark trade names and internet domain names Customer-related intangible assets include assets such as customer contracts customer relationships subscriber lists customer orders and backlogs and core deposits Artistic ndash related intangible assets include ownership rights to plays literary works musical works etc Contract ndashrelated intangible assets include licenses non-competition agreements and various other agreements and contract rights Goodwill is an important component of intangible assets and comes into play during business acquisitions and mergers Goodwill can be internally created or purchased goodwill Accounting treatment for goodwill differs according to its type and the accounting standards followed 17

Goodwill Goodwill is the excess of the purchase price over the fair market value of an asset during a business combination Some of the reasons why a business would be worth more than the sum of the fair values of the accountable and identifiable net assets of that business are- The expertise of the workforce mdash current accounting practices do not normally recognize the value of human resources as an asset on the balance sheet The reputation of the product(s) of the business mdash if the product has a well known name attached to it then sales and profits will be boosted on the basis of reputation alone The general economic environment mdash levels of interest rates and exchange rates and levels of investor confidence generally will clearly have a major influence on the value of businesses and hence on the amount of goodwill attaching to a business( Robins2000) Goodwill is often referred to as the most intangible of all intangible assets The problem of determining the proper cost to allocate to intangible assets in a business combination is complex because of the many different types of intangibles that might be considered It is extremely difficult not only to identify certain types of intangibles but also to assign a value to them in a business combination As a result the approach followed is to record identifiable intangible assets that can be reliably measured Other intangible assets that are difficult to identify or measure are recorded as goodwill (KiesoWeygandt and Warfield 578) 18

IFRS accounting for business combinations The three IFRS standards impacting accounting for intangible assets are IFRS3 Business Combinations IAS36 Impairment of Assets and IAS38 Intangible Assets These three standards are applicable to intangible assets and goodwill acquired on or after 31 March 2004IAS38 prescribes accounting treatment for the recognition of internally generated and acquired intangible assets IAS38 prescribes the rules for impairment testing of assets and goodwill IFRS3 prescribes the overall treatment for accounting for acquired assets and goodwill in a business combination The three standards can be summarized as follows- Acquired intangible assets Business combinations are accounted for using the purchase method ie accounting from the perspective of the acquirer Intangible assets are initially recognized at cost based on the following criteria-

1) They are identifiable

2) The probable future economic benefits created by them will benefit the organization

3) The measurement of their cost is reliable

After their initial recognition intangible assets may be carried at their cost or revalued amount less any accumulated amortization or impairment losses Their revaluation amount is their fair value at the date of revaluation If there is an increase in the amount of carrying value after revaluation is credited to a revaluation surplus account 19

Internally Generated Intangible assets Internally generated goodwill brands mastheads publishing titles customer lists are not recognized as intangible assets Research and development costs are generally expensed They can however be treated as an intangible asset if they meet the following criteria-

bull They are identifiable

bull The probable future economic benefits created by them will benefit the organization

bull The measurement of their cost is reliable

Goodwill Internally generated goodwill is not recognized The only goodwill recognized is as a result of business combinations Goodwill represents the difference between the total purchase consideration and the total of the fair value of all acquired assets and liabilities assumed If the fair value of the assets exceed the purchase consideration then the acquirer must reassess and identify all the assets and immediately after reassessment must recognize the negative goodwill as a profit in the income statement Impairment testing The useful life of the asset is determined If the asset has a finite useful life it should be amortized over its life For assets with indefinite useful life annual impairment testing is required The test involves a comparison of the carrying value of the asset with its 20

estimated recoverable amount The recoverable is defined as the higher of the value less costs to sell and the value in use The in use is generally based on the discounted future cash flows from the asset When the recoverable amount is found to be lower than the carrying value the carrying value is reduced to the recoverable amount with a charge to profits(Caldwell4)

US GAAP accounting for Business Combinations The standards that prescribe treatment for accounting for Business Combinations are SFAS141 Business Combinations and SFAS 142 Goodwill and other intangible assets The treatment can be summarized as follows- Acquired intangible assets Recorded cost 1)Acquired intangibles are recorded at cost and this cost includes the purchase price and all costs incurred to bring the asset to its intended use 2) In cases where the asset is acquired in exchange for stock or other assets the cost of the asset is the fair value of the consideration given or the fair value of the intangible received whichever is more clear 3) In the case of a lsquobasket purchasersquo cost is allocated on the basis of fair market values of assets acquired Amortization Assets with limited useful life are amortized over life of the asset The asset generates cash flows over such a useful life and the amortization method should to a certain extent 21

reflect the pattern in which the asset is used up if that could be determined If the usage pattern cannot be determined then the straight-line method is used Assets with indefinite life are not amortized Internally Generated Intangibles Costs related to internally generated intangibles are expensed as incurred Research and development costs related to intangibles are expensed and appear in the income statement Only direct costs incurred in obtaining intangibles including legal costs are capitalized Goodwill Goodwill recognized is the difference between the purchase consideration and the fair value of assets It appears on the balance sheet Internally generated goodwill is not recognized The impairment rule for goodwill involves two steps First the fair value of the reporting unit should be compared to its carrying amount including goodwill If the fair value of the reporting unit is greater than the carrying amount goodwill is considered not to be impaired and the company does not have to do anything else (Kieso Weygandt and Warfield593) Impairment testing of intangibles Impairment refers to the write-off or reduction in value of the asset that has to be carried out when the carrying amount of a long-lived asset is not recoverable When the carrying value of an intangible is not recoverable impairment is carried Impairment testing for indefinite life intangibles just involves a fair value test For limited life intangibles impairment is based on a recoverability test and a fair value test Goodwill impairments are based on a fair value test 22

Types of intangible asset Impairment test Limited life Recoverability test then fair value test Indefinite life other than goodwill Fair value test Goodwill Fair value test on reporting unit then fair value test on implied goodwill (Kieso Weygandt and Warfield584)

Pre-IFRS UK GAAP accounting for Business Combinations Starting 2005 all the 25 nations in the European Union including the United Kingdom have adopted the IFRS The pre-IFRS UK GAAP is no longer functional The FRS10 Goodwill and Intangible assets used to prescribe the rules for accounting for Intangibles and Goodwill The Deloitte and Touche publication lsquoGAAP 2004rsquo summarizes the key features of this standard as follows-

bull Internally generated goodwill may not be recognized Purchased goodwill is capitalized and classified as an asset

bull Internally developed intangible assets are recognized only if they have a readily ascertainable market value Purchased intangible assets are capitalized Intangible assets acquired as a part of a business combination are recognized only if they are separable and can be measured reliably

bull Goodwill and intangible assets are amortized over their useful economic lives if this is finite or not amortized if this is indefinite Negative goodwill is classified alongside positive goodwill and amortized

23

bull When the period of amortization exceeds 20 years an impairment test is carried out annually In other cases an impairment test at the end of the first full year after acquisition and then if there is an indicator of impairment

COMPARING THE IFRS TO US GAAP AND PRE-IFRS UK GAAP BUSINESS COMBINATIONS IFRS 3 vs UK GAAP The major differences between the IFRS 3 and FRS provisions for accounting for business combinations are as follows- End of merger accounting and pooling of assets An important requirement of the IFRS 3 is that business acquisitions be accounted for using the purchase method from the perspective of the acquirer This nullifies the UK GAAP provision of allowing companies to use merger accounting where they simply pooled together their balance sheet thus not recognizing goodwill The IFRS provision makes it mandatory for companies to recognize goodwill Goodwill no longer amortized Goodwill is no longer amortized but is instead subjected to a stringent annual impairment test In the event that it is impaired an immediate charge will be taken to the profit and loss account so poor performing acquisitions will be highlighted through such a charge sooner rather than later This represents a fundamental shift in the way goodwill 24

is viewed Goodwill is seen no longer a s steadily wasting asset but instead as one that should be expected to maintain its value(Hadjiloucas and Winter2) More Intangible Assets recognized Historically under UK GAAP when a deal was completed acquired intangible assets would generally just be subsumed within a pot marked lsquogoodwillrsquo The major benefit was that by amortizing this goodwill evenly over a period of usually 20 years you could predict with greater accuracy the impact on earnings (Stevenson and Mc Phee 82) However IFRS 3 requires that all identifiable and valuable intangible assets be reported on the balance sheet The acquirer needs to recognize purchased intangibles on the Balance Sheet More Disclosures The IFRS 3 requires that detailed disclosures be made about transactions and the purchase price allocation method utilized Detailed information about impairment testing of assets and goodwill also needs to be disclosed Strict criteria for determining useful life Limited life intangibles can be amortized over their useful life However management now needs to be more stringent about classifying assets as having a definite or indefinite useful life An indefinite life assertion needs to be backed by evidence and analysis supporting that no legal regulatory contractual competitive economic or other factors limit the life of the asset (Hadjiloucas and Winter3) 25

UK GAAP IFRS Merging accounting and pooling of assets used

No merger accounting allowed all combinations accounted for using the purchase method

Goodwill amortized over life of the asset

Goodwill tested for impairment annually

Fewer capitalized intangible assets More intangibles identified and recognized on acquisition

Details of purchase price allocation not essentially required to be disclosed

Details of purchase price allocation need to be disclosed

BACKGROUND INFORMATION ON THE IFRS US GAAP UK GAAP AND AREAS OF DIFFERENCES IN ACCOUNTING INTRODUCTION TO THE IFRS International Accounting Standards (IASs) were issued by the IASC from 1973 to 2000 The IASB replaced the IASC in 2001 Since then the IASB has amended some IASs has proposed to amend other IASs has proposed to replace some IASs with new International Financial Reporting Standards (IFRSs) and has adopted or proposed certain new IFRSs on topics for which there was no previous IAS Through committees both the IASC and the IASB also have issued Interpretations of Standards Financial statements may not be described as complying with IFRSs unless they comply with all of the requirements of each applicable standard and each applicable interpretation (Deloitte Touche Tohmatsu 2006) IASBrsquos framework IFRS and Interpretations provides guidelines and explanations for the methods of accounting The Framework was published by the IASC in 1989 to provide an outline and explanations for financial reporting concepts The Framework serves as a guide to both international and national standard setters to set consistent accounting standards and assists preparers and auditors in interpreting standards and dealing with issues that the standards do not cover There are 34 IFRS currently in effect The Standards provide guidance for preparers to deal with the recognition measurement presentation and disclosure requirements for transactions and events Most IFRS are intended for application across industries with only one standard outlining disclosure requirements for banks and other financial institutions A second tier 4

of guidance comes from the Interpretations developed by the Standing Interpretations Committee now IFRIC These pronouncements clarify or interpret the standards where the preparer community identifies the need for improved guidance (PricewaterhouseCoopers2002) The adoption of International Financial Reporting Standards (IFRS) which was required for listed companies of all 25 EU countries on January 1 2005 is being witnessed throughout the rest of the world at an increasing rate with Japan Australia Russia Canada Hong Kong and several Middle East and African countries already having decided on a comprehensive mandatory change To date the more significant holdouts including the United States South Africa Singapore and Malaysia are committed to modifying local standards to these international standards (Bahal and Ross1 2002) International accounting standards regulate multinational behavior to a certain extent They ensure efficient functioning of capital markets Most importantly they facilitate greater comparability of information as without these standards a financial statement from India and UK would be very different from one from the United States They provide a basis on which performance of a multinational can be evaluated and compared not just nationally but internationally These standards also lead to better communication between accountants all over the globe and the sharing of information could always lead to ideas for ameliorating accounting reporting standards and techniques The above-mentioned reasons ultimately lead to investor confidence Investors possess a better understanding of international finance and stock markets and this in turn helps them make better portfolio decisions 5

IFRS IN EUROPE All European quoted companies were required to prepare their consolidated financial statements in accordance with the International Financial Reporting Standards since 2005 The transition dates for different companies ranged from 31 December 2003 to 30 December 2004 The EU policy is aimed at the removal of barriers to cross border trading in securities by ensuring that company financial statements throughout the EU are transparent and comparable The economic gains to be derived from an integrated European financial and capital market are considerable (Lian 2 2004) Prior to the IAS European countries were either using US GAAP or their own national standards The European Commission has said ldquoIAS will offer [those now using US GAAP] the same high quality level of financial information as US GAAP with the additional advantage that IAS have been conceived in a truly international perspective and are not modeled by a particular national environment The Commission hopes and expects that the US Securities and Exchange Commission (SEC) will accept in the near future financial statements prepared by EU issuers without requiring a reconciliation to US GAAPrdquo As this thesis compares the pre-IFRS UK GAAP to IFRS I would like to write a little about the IFRS situation in the UK The Accounting Standards Committee (ASC) and the Accounting Standards Board (ASB) were previously producing UK SSAPs and FRSs Since the implementation of the International Financial Reporting Standards a number of changes have taken place in the accounting and presentation of financial 6

statements Some of the areas in which the IFRS differs from the pre-IFRS UK GAAP are-

bull Tangible Fixed Assets

bull Intangible assets

bull Impairment of Assets

bull Stock and Long Term Contracts

bull Deferred taxes

bull Leases

bull Retirement Benefits

IFRS AND US GAAP DIFFERENCES Accountants will encounter US GAAP either with American groups or with foreign groups that have a listing on US stock markets US GAAP are standards developed for the 12000 or so listed companies in the USA and required by the Securities and Exchange Commission (SEC) Foreign companies that have shares or bonds listed in the USA need not publish US GAAP accounts as such but must in effect prepare them in order to provide a reconciliation statement This details for their US investors the differences between net profit and net assets as reported and how they would have been stated under US GAAP Though there is no general filing requirement for accounts of unlisted companies in the USA it is thought that about 15000 other companies prepare GAAP-compliant accounts as a requirement of bank borrowings or on 7

a voluntary basis GAAP principally developed by the Financial Accounting Standards Board (FASB) are more extensive than IFRS - comprising hundreds of standards interpretations opinions and other authoritative rules (Martin 2004) Some of the accounting areas in which the US GAAP differs from the IFRS are-

bull Tangible assets

bull Available for sale marketable securities

bull Intangible assets

bull Research and development expenditures

bull Leases

bull Inventory

IASB-FASB CONVERGENCE PROJECTS In September 2002 the FASB and the IASB reached an agreement to conduct a short-term project to work towards eliminating the differences between the IFRS and US GAAP The SEC also made an announcement in the same month in which it said that starting in 2007 it might allow foreign companies which are trying to raise capital in the US to use the IFRS rather than reconciling to US GAAP as they do right now Convergence is supposed to ease the task of raising capital Once the process is complete investors will need less help comparing results of competing firms based in different countries US companies that conform to GAAP will be able to raise capital abroad without reconciling their results to IFRS (Reason 2005 2) The FASB and IASB are 8

also working together on a number of long-term projects that deal with concepts like business combinations employee benefits and comprehensive income

LITERATURE REVIEW I have analyzed and compare the reconciliatory Balance Sheets of 10 European countries I chose these companies from different sectors of the European economy and have written about their performance For the theoretical framework I use the stakeholder theory The stakeholder research tradition began to unfold in the wake of R Edward Freemanrsquos seminal book Strategic Management A Stakeholders Approach which was published in the mid-1980s The book initiated a still ongoing academic discussion It demonstrated in a comprehensive fashion that strategic management of private sector firms could become much more effective and efficient if managerial efforts regard various stakeholders concerns Or in other words shareholders benefit long-term if other legitimate interests in the firm do not fall by the wayside (Scholl 2)Thus besides shareholders the interests of other stakeholders in and outside the organization had to be taken into consideration while making managerial decisions and implementing policies Stakeholder theory suggests that an organization has relationships with many constituent groups or stakeholders(Covell 2004) that affect and are affected by its decisions (Freeman 1984) A major purpose of stakeholder theory is to help corporate managers understand their stakeholder environments and manage more effectively within the nexus of relationships that exists for their companies However a larger purpose of stakeholder theory is to help corporate managers improve the value of the outcomes of 9

their actions and minimize the harms to stakeholders The whole point of stakeholder theory in fact lies in what happens when corporations and stakeholders act out of their relationships (Logsdon and Wood 3) The stakeholder theory involves answering three important questions- Who are the organizationrsquos stakeholders for accounting standards This step involves identification of the organizationrsquos stakeholders Stakeholders are defined as those individuals that have a stake in the performance of an organization that the interests of all legitimate stakeholders have intrinsic value and that no set of interests is assumed to dominate the others (Donaldson amp Preston 1995) In the Ivey Business Journal Robert Philips writes that stakeholders are those groups from whom the organization has voluntarily accepted benefits and to whom the organization has therefore incurred obligations of fairness Typically this includes groups such as financiers employees customers suppliers and local communities (Philips 2004 2) Stakeholder theory holds that besides these legitimate stakeholders derivative stakeholders like competitors or activist groups are important as their actions can influence the corporation Why are the stakeholders important for accounting standards Brenner and Cochran comment that the stakeholder theory of the firm posits that the nature of an organizations stakeholders their values their relative influence on decisions and the nature of the situation are all relevant information for predicting organizational behavior(1991 p 462) Milton Friedman uses the property rights argument stating that shareholders own an organization as they own the equity shares and if they desire to 10

maximize the value of their investment it is the managerrsquos duty to work in accordance Managers who fail to do so violate the moral property right (Mitchell et al 1997) note that stakeholder theory has managerial importance because it can determine to what and to whom managers need to listen and give attention What do Stakeholders want Different people want different things from their relationships with organizations Stakeholder discussions often focus on allocating some measure of organizational value or outcome (eg who gets how much money from the firm) The question of how the organization creates this value usually gets less attention but it is certainly not less important Not all stakeholders want a voice in organizational decision-making but those who do desire a voice should have it (Philips 2004 2) My literature sources had to be organized into three data sets-IFRS standards US GAAP and pre ndashIFRS UK GAAP My documents for analyzing the IFRS were the web summaries put up on the International Accounting Standards Board site For pre-IFRS UK GAAP I referred primarily to the Deloitte and Touche publication lsquoGAAP 2004rsquo For the US GAAP I referred to the textbook being used right now in UMass Boston for AF310 and AF311 lsquoIntermediate Accountingrsquo by Kieso Weygandt and Warfield The IFRS accounting for intangible assets was the x variable I used to prove my y variables which are increased transparency and better stakeholder management I must mention that this research greatly benefited from the articles posted by Intangibles Business Ltd The research resources I have used are archives real data literature interviews reviews and the research facilities available at UMASS in the Healey library database The databases I have used are Business Source Premier Lexis Nexis Academic 11

Ebrary and the Wall Street Journal for articles Besides these I have also used other UMB resources like the CM faculty the CM Business Center and the advice and guidance of the Accounting and Management Department faculty

METHODOLOGY I have used an analytical as well as a theoretical framework to prove my research objective My research can be divided into three stages Stage one involves analysis involves looking at the standards for intangible assets and goodwill under IFRS UK GAAP and US GAAP and making comparisons This is followed by Stage two- the analysis of the reconciliations of Balance Sheets of a sample of 10 companies and interpret the data to prove the increased transparency under IFRS In Stage three The stakeholder theory which I have explained in detailed in a later section has been to used to prove how this increased transparency has lead to better stakeholder management ie provides managers with a number of alternatives to serve stakeholders in a better manner which would ultimately prove beneficial to business In the end I use the stakeholder theory again to prove the general effectiveness of the IFRS using the information in surveys conducted Empirically my research could be summarized in the following steps- collection of data questioning of the information collected forming conclusions and finally putting together all of my research on paper The diagram on the next page summarizes the structure and organization of my thesis 12

Accounting for intangible assets Sample analysis Using the stakeholder theory

IFRS 3 US GAAP

SFAS 141

SFAS 142

UK GAAP

FRS 10

Comparisons and differences

Analysis of reconciliatory statements of sample of 10 European companies that have transitioned to the IFRS

INCREASED TRANSPARENCY

Interpretation of data on intangible assets and goodwill

IFRS

IFRS 3

Investors

Government

Suppliers Customers Creditors

Society 13

US GAAP

ANALYSIS

STAGE 1 ACCOUNTING FOR INTANGIBLE ASSETS This stage involves a comparison of accounting for intangibles under IFRS US GAAP and UK GAAP

SFAS 141

SFAS 142

UK GAAP

FRS 10

Comparisons

and

differences IFRS 3 14

Introducing concepts Intangible assets Goodwill Intangible assets The Uniform Commercial Code (Section 9-102(a)(42)) defines general intangibles as any personal property other than accounts chattel paper commercial tort claims deposit accounts documents goods instruments investment property letter of credit rights letters of credit money and oil gas or other minerals before extraction The term includes payment intangibles and software In todayrsquos global economy dominated by information and service providers intangible assets constitute a major proportion of total assets Intangible assets command an increasingly large proportion of a companyrsquos value and this value has largely not been recognized In heavily branded consumer businesses such as Coca Cola or Nike brands account to up to 80 of the companyrsquos value In other industries such as pharmaceutical patents and copyrights are more prominent(Thaynes1 ) Thus Microsoftrsquos software Cokersquos secret formula and America Onlinersquos subscription base are the most important assets on their balance sheets Infact the value of tangible assets as a percentage of all assets has been steadily decreasing as shown in the graph below which is provided by the Federal Reserve Board but which is recreated by me for this thesisrsquos purpose The original graph is attached 80 70 60 5055 Years lsquo00 15

While intangibles are potential sources of income their values can erode just as quickly Just before Winstar Communications filed for bankruptcy in 2001 their assets were listed at 5 billion dollars However on liquidation the assets fetched just 42 million dollars due to decline in the value of intangibles Traditional assessment of national economic performance has relied upon understanding the GDP in terms of traditional factors of production ndash land labor and capital Knowledge assets may be distinguished from the traditional factors of production ndash in that they are governed by what has been described as the lsquolaw of increasing returnsrsquo In contrast to the traditional factors of production that were governed by diminishing returns every additional unit of knowledge used effectively results in a marginal increase in performance Success of companies such as Microsoft is often attributed to the fact that every additional unit of information-based product or service would result in an increase in the marginal returns Given the changing dynamics underlying national performance it is not surprising that some less developed economies with significant assets in ICT knowledge and Internet-related expertise are hoping to leapfrog more developed economies ( Malhotra2000) Intangible assets have two main characteristics- they lack physical existence and they are not financial instruments Intangible assets derive their value from the rights and privileges granted to the company using them (Kieso Weygandt and Warfield570) Intangible assets are further classified as limited life intangibles or indefinite life intangibles Limited life intangibles have a known useful life and indefinite life intangibles are intangibles whose useful life cannot be determined Accounting treatment for the intangibles vary according to their type which we shall look more in detail in the next section When intangibles are purchased from other parties they are most recorded at the 16

cost of purchase or fair market value under most accounting systems This cost includes all the expenses incurred to make the asset ready for use These include its purchase price legal fees and incidental expenses Internally generated intangibles are generally expensed as incurred All the research and development costs that companies have to incur to come up with the asset are expensed in the income statement The six major categories of intangible assets are marketing ndashrelated intangible assets customer-related intangible assets artistic-related intangible assets contract-related intangible assets technology-related intangible assets and goodwill Marketing - related intangibles assets are those assets used in the marketing or promotion of products These include trademark trade names and internet domain names Customer-related intangible assets include assets such as customer contracts customer relationships subscriber lists customer orders and backlogs and core deposits Artistic ndash related intangible assets include ownership rights to plays literary works musical works etc Contract ndashrelated intangible assets include licenses non-competition agreements and various other agreements and contract rights Goodwill is an important component of intangible assets and comes into play during business acquisitions and mergers Goodwill can be internally created or purchased goodwill Accounting treatment for goodwill differs according to its type and the accounting standards followed 17

Goodwill Goodwill is the excess of the purchase price over the fair market value of an asset during a business combination Some of the reasons why a business would be worth more than the sum of the fair values of the accountable and identifiable net assets of that business are- The expertise of the workforce mdash current accounting practices do not normally recognize the value of human resources as an asset on the balance sheet The reputation of the product(s) of the business mdash if the product has a well known name attached to it then sales and profits will be boosted on the basis of reputation alone The general economic environment mdash levels of interest rates and exchange rates and levels of investor confidence generally will clearly have a major influence on the value of businesses and hence on the amount of goodwill attaching to a business( Robins2000) Goodwill is often referred to as the most intangible of all intangible assets The problem of determining the proper cost to allocate to intangible assets in a business combination is complex because of the many different types of intangibles that might be considered It is extremely difficult not only to identify certain types of intangibles but also to assign a value to them in a business combination As a result the approach followed is to record identifiable intangible assets that can be reliably measured Other intangible assets that are difficult to identify or measure are recorded as goodwill (KiesoWeygandt and Warfield 578) 18

IFRS accounting for business combinations The three IFRS standards impacting accounting for intangible assets are IFRS3 Business Combinations IAS36 Impairment of Assets and IAS38 Intangible Assets These three standards are applicable to intangible assets and goodwill acquired on or after 31 March 2004IAS38 prescribes accounting treatment for the recognition of internally generated and acquired intangible assets IAS38 prescribes the rules for impairment testing of assets and goodwill IFRS3 prescribes the overall treatment for accounting for acquired assets and goodwill in a business combination The three standards can be summarized as follows- Acquired intangible assets Business combinations are accounted for using the purchase method ie accounting from the perspective of the acquirer Intangible assets are initially recognized at cost based on the following criteria-

1) They are identifiable

2) The probable future economic benefits created by them will benefit the organization

3) The measurement of their cost is reliable

After their initial recognition intangible assets may be carried at their cost or revalued amount less any accumulated amortization or impairment losses Their revaluation amount is their fair value at the date of revaluation If there is an increase in the amount of carrying value after revaluation is credited to a revaluation surplus account 19

Internally Generated Intangible assets Internally generated goodwill brands mastheads publishing titles customer lists are not recognized as intangible assets Research and development costs are generally expensed They can however be treated as an intangible asset if they meet the following criteria-

bull They are identifiable

bull The probable future economic benefits created by them will benefit the organization

bull The measurement of their cost is reliable

Goodwill Internally generated goodwill is not recognized The only goodwill recognized is as a result of business combinations Goodwill represents the difference between the total purchase consideration and the total of the fair value of all acquired assets and liabilities assumed If the fair value of the assets exceed the purchase consideration then the acquirer must reassess and identify all the assets and immediately after reassessment must recognize the negative goodwill as a profit in the income statement Impairment testing The useful life of the asset is determined If the asset has a finite useful life it should be amortized over its life For assets with indefinite useful life annual impairment testing is required The test involves a comparison of the carrying value of the asset with its 20

estimated recoverable amount The recoverable is defined as the higher of the value less costs to sell and the value in use The in use is generally based on the discounted future cash flows from the asset When the recoverable amount is found to be lower than the carrying value the carrying value is reduced to the recoverable amount with a charge to profits(Caldwell4)

US GAAP accounting for Business Combinations The standards that prescribe treatment for accounting for Business Combinations are SFAS141 Business Combinations and SFAS 142 Goodwill and other intangible assets The treatment can be summarized as follows- Acquired intangible assets Recorded cost 1)Acquired intangibles are recorded at cost and this cost includes the purchase price and all costs incurred to bring the asset to its intended use 2) In cases where the asset is acquired in exchange for stock or other assets the cost of the asset is the fair value of the consideration given or the fair value of the intangible received whichever is more clear 3) In the case of a lsquobasket purchasersquo cost is allocated on the basis of fair market values of assets acquired Amortization Assets with limited useful life are amortized over life of the asset The asset generates cash flows over such a useful life and the amortization method should to a certain extent 21

reflect the pattern in which the asset is used up if that could be determined If the usage pattern cannot be determined then the straight-line method is used Assets with indefinite life are not amortized Internally Generated Intangibles Costs related to internally generated intangibles are expensed as incurred Research and development costs related to intangibles are expensed and appear in the income statement Only direct costs incurred in obtaining intangibles including legal costs are capitalized Goodwill Goodwill recognized is the difference between the purchase consideration and the fair value of assets It appears on the balance sheet Internally generated goodwill is not recognized The impairment rule for goodwill involves two steps First the fair value of the reporting unit should be compared to its carrying amount including goodwill If the fair value of the reporting unit is greater than the carrying amount goodwill is considered not to be impaired and the company does not have to do anything else (Kieso Weygandt and Warfield593) Impairment testing of intangibles Impairment refers to the write-off or reduction in value of the asset that has to be carried out when the carrying amount of a long-lived asset is not recoverable When the carrying value of an intangible is not recoverable impairment is carried Impairment testing for indefinite life intangibles just involves a fair value test For limited life intangibles impairment is based on a recoverability test and a fair value test Goodwill impairments are based on a fair value test 22

Types of intangible asset Impairment test Limited life Recoverability test then fair value test Indefinite life other than goodwill Fair value test Goodwill Fair value test on reporting unit then fair value test on implied goodwill (Kieso Weygandt and Warfield584)

Pre-IFRS UK GAAP accounting for Business Combinations Starting 2005 all the 25 nations in the European Union including the United Kingdom have adopted the IFRS The pre-IFRS UK GAAP is no longer functional The FRS10 Goodwill and Intangible assets used to prescribe the rules for accounting for Intangibles and Goodwill The Deloitte and Touche publication lsquoGAAP 2004rsquo summarizes the key features of this standard as follows-

bull Internally generated goodwill may not be recognized Purchased goodwill is capitalized and classified as an asset

bull Internally developed intangible assets are recognized only if they have a readily ascertainable market value Purchased intangible assets are capitalized Intangible assets acquired as a part of a business combination are recognized only if they are separable and can be measured reliably

bull Goodwill and intangible assets are amortized over their useful economic lives if this is finite or not amortized if this is indefinite Negative goodwill is classified alongside positive goodwill and amortized

23

bull When the period of amortization exceeds 20 years an impairment test is carried out annually In other cases an impairment test at the end of the first full year after acquisition and then if there is an indicator of impairment

COMPARING THE IFRS TO US GAAP AND PRE-IFRS UK GAAP BUSINESS COMBINATIONS IFRS 3 vs UK GAAP The major differences between the IFRS 3 and FRS provisions for accounting for business combinations are as follows- End of merger accounting and pooling of assets An important requirement of the IFRS 3 is that business acquisitions be accounted for using the purchase method from the perspective of the acquirer This nullifies the UK GAAP provision of allowing companies to use merger accounting where they simply pooled together their balance sheet thus not recognizing goodwill The IFRS provision makes it mandatory for companies to recognize goodwill Goodwill no longer amortized Goodwill is no longer amortized but is instead subjected to a stringent annual impairment test In the event that it is impaired an immediate charge will be taken to the profit and loss account so poor performing acquisitions will be highlighted through such a charge sooner rather than later This represents a fundamental shift in the way goodwill 24

is viewed Goodwill is seen no longer a s steadily wasting asset but instead as one that should be expected to maintain its value(Hadjiloucas and Winter2) More Intangible Assets recognized Historically under UK GAAP when a deal was completed acquired intangible assets would generally just be subsumed within a pot marked lsquogoodwillrsquo The major benefit was that by amortizing this goodwill evenly over a period of usually 20 years you could predict with greater accuracy the impact on earnings (Stevenson and Mc Phee 82) However IFRS 3 requires that all identifiable and valuable intangible assets be reported on the balance sheet The acquirer needs to recognize purchased intangibles on the Balance Sheet More Disclosures The IFRS 3 requires that detailed disclosures be made about transactions and the purchase price allocation method utilized Detailed information about impairment testing of assets and goodwill also needs to be disclosed Strict criteria for determining useful life Limited life intangibles can be amortized over their useful life However management now needs to be more stringent about classifying assets as having a definite or indefinite useful life An indefinite life assertion needs to be backed by evidence and analysis supporting that no legal regulatory contractual competitive economic or other factors limit the life of the asset (Hadjiloucas and Winter3) 25

UK GAAP IFRS Merging accounting and pooling of assets used

No merger accounting allowed all combinations accounted for using the purchase method

Goodwill amortized over life of the asset

Goodwill tested for impairment annually

Fewer capitalized intangible assets More intangibles identified and recognized on acquisition

Details of purchase price allocation not essentially required to be disclosed

Details of purchase price allocation need to be disclosed

of guidance comes from the Interpretations developed by the Standing Interpretations Committee now IFRIC These pronouncements clarify or interpret the standards where the preparer community identifies the need for improved guidance (PricewaterhouseCoopers2002) The adoption of International Financial Reporting Standards (IFRS) which was required for listed companies of all 25 EU countries on January 1 2005 is being witnessed throughout the rest of the world at an increasing rate with Japan Australia Russia Canada Hong Kong and several Middle East and African countries already having decided on a comprehensive mandatory change To date the more significant holdouts including the United States South Africa Singapore and Malaysia are committed to modifying local standards to these international standards (Bahal and Ross1 2002) International accounting standards regulate multinational behavior to a certain extent They ensure efficient functioning of capital markets Most importantly they facilitate greater comparability of information as without these standards a financial statement from India and UK would be very different from one from the United States They provide a basis on which performance of a multinational can be evaluated and compared not just nationally but internationally These standards also lead to better communication between accountants all over the globe and the sharing of information could always lead to ideas for ameliorating accounting reporting standards and techniques The above-mentioned reasons ultimately lead to investor confidence Investors possess a better understanding of international finance and stock markets and this in turn helps them make better portfolio decisions 5

IFRS IN EUROPE All European quoted companies were required to prepare their consolidated financial statements in accordance with the International Financial Reporting Standards since 2005 The transition dates for different companies ranged from 31 December 2003 to 30 December 2004 The EU policy is aimed at the removal of barriers to cross border trading in securities by ensuring that company financial statements throughout the EU are transparent and comparable The economic gains to be derived from an integrated European financial and capital market are considerable (Lian 2 2004) Prior to the IAS European countries were either using US GAAP or their own national standards The European Commission has said ldquoIAS will offer [those now using US GAAP] the same high quality level of financial information as US GAAP with the additional advantage that IAS have been conceived in a truly international perspective and are not modeled by a particular national environment The Commission hopes and expects that the US Securities and Exchange Commission (SEC) will accept in the near future financial statements prepared by EU issuers without requiring a reconciliation to US GAAPrdquo As this thesis compares the pre-IFRS UK GAAP to IFRS I would like to write a little about the IFRS situation in the UK The Accounting Standards Committee (ASC) and the Accounting Standards Board (ASB) were previously producing UK SSAPs and FRSs Since the implementation of the International Financial Reporting Standards a number of changes have taken place in the accounting and presentation of financial 6

statements Some of the areas in which the IFRS differs from the pre-IFRS UK GAAP are-

bull Tangible Fixed Assets

bull Intangible assets

bull Impairment of Assets

bull Stock and Long Term Contracts

bull Deferred taxes

bull Leases

bull Retirement Benefits

IFRS AND US GAAP DIFFERENCES Accountants will encounter US GAAP either with American groups or with foreign groups that have a listing on US stock markets US GAAP are standards developed for the 12000 or so listed companies in the USA and required by the Securities and Exchange Commission (SEC) Foreign companies that have shares or bonds listed in the USA need not publish US GAAP accounts as such but must in effect prepare them in order to provide a reconciliation statement This details for their US investors the differences between net profit and net assets as reported and how they would have been stated under US GAAP Though there is no general filing requirement for accounts of unlisted companies in the USA it is thought that about 15000 other companies prepare GAAP-compliant accounts as a requirement of bank borrowings or on 7

a voluntary basis GAAP principally developed by the Financial Accounting Standards Board (FASB) are more extensive than IFRS - comprising hundreds of standards interpretations opinions and other authoritative rules (Martin 2004) Some of the accounting areas in which the US GAAP differs from the IFRS are-

bull Tangible assets

bull Available for sale marketable securities

bull Intangible assets

bull Research and development expenditures

bull Leases

bull Inventory

IASB-FASB CONVERGENCE PROJECTS In September 2002 the FASB and the IASB reached an agreement to conduct a short-term project to work towards eliminating the differences between the IFRS and US GAAP The SEC also made an announcement in the same month in which it said that starting in 2007 it might allow foreign companies which are trying to raise capital in the US to use the IFRS rather than reconciling to US GAAP as they do right now Convergence is supposed to ease the task of raising capital Once the process is complete investors will need less help comparing results of competing firms based in different countries US companies that conform to GAAP will be able to raise capital abroad without reconciling their results to IFRS (Reason 2005 2) The FASB and IASB are 8

also working together on a number of long-term projects that deal with concepts like business combinations employee benefits and comprehensive income

LITERATURE REVIEW I have analyzed and compare the reconciliatory Balance Sheets of 10 European countries I chose these companies from different sectors of the European economy and have written about their performance For the theoretical framework I use the stakeholder theory The stakeholder research tradition began to unfold in the wake of R Edward Freemanrsquos seminal book Strategic Management A Stakeholders Approach which was published in the mid-1980s The book initiated a still ongoing academic discussion It demonstrated in a comprehensive fashion that strategic management of private sector firms could become much more effective and efficient if managerial efforts regard various stakeholders concerns Or in other words shareholders benefit long-term if other legitimate interests in the firm do not fall by the wayside (Scholl 2)Thus besides shareholders the interests of other stakeholders in and outside the organization had to be taken into consideration while making managerial decisions and implementing policies Stakeholder theory suggests that an organization has relationships with many constituent groups or stakeholders(Covell 2004) that affect and are affected by its decisions (Freeman 1984) A major purpose of stakeholder theory is to help corporate managers understand their stakeholder environments and manage more effectively within the nexus of relationships that exists for their companies However a larger purpose of stakeholder theory is to help corporate managers improve the value of the outcomes of 9

their actions and minimize the harms to stakeholders The whole point of stakeholder theory in fact lies in what happens when corporations and stakeholders act out of their relationships (Logsdon and Wood 3) The stakeholder theory involves answering three important questions- Who are the organizationrsquos stakeholders for accounting standards This step involves identification of the organizationrsquos stakeholders Stakeholders are defined as those individuals that have a stake in the performance of an organization that the interests of all legitimate stakeholders have intrinsic value and that no set of interests is assumed to dominate the others (Donaldson amp Preston 1995) In the Ivey Business Journal Robert Philips writes that stakeholders are those groups from whom the organization has voluntarily accepted benefits and to whom the organization has therefore incurred obligations of fairness Typically this includes groups such as financiers employees customers suppliers and local communities (Philips 2004 2) Stakeholder theory holds that besides these legitimate stakeholders derivative stakeholders like competitors or activist groups are important as their actions can influence the corporation Why are the stakeholders important for accounting standards Brenner and Cochran comment that the stakeholder theory of the firm posits that the nature of an organizations stakeholders their values their relative influence on decisions and the nature of the situation are all relevant information for predicting organizational behavior(1991 p 462) Milton Friedman uses the property rights argument stating that shareholders own an organization as they own the equity shares and if they desire to 10

maximize the value of their investment it is the managerrsquos duty to work in accordance Managers who fail to do so violate the moral property right (Mitchell et al 1997) note that stakeholder theory has managerial importance because it can determine to what and to whom managers need to listen and give attention What do Stakeholders want Different people want different things from their relationships with organizations Stakeholder discussions often focus on allocating some measure of organizational value or outcome (eg who gets how much money from the firm) The question of how the organization creates this value usually gets less attention but it is certainly not less important Not all stakeholders want a voice in organizational decision-making but those who do desire a voice should have it (Philips 2004 2) My literature sources had to be organized into three data sets-IFRS standards US GAAP and pre ndashIFRS UK GAAP My documents for analyzing the IFRS were the web summaries put up on the International Accounting Standards Board site For pre-IFRS UK GAAP I referred primarily to the Deloitte and Touche publication lsquoGAAP 2004rsquo For the US GAAP I referred to the textbook being used right now in UMass Boston for AF310 and AF311 lsquoIntermediate Accountingrsquo by Kieso Weygandt and Warfield The IFRS accounting for intangible assets was the x variable I used to prove my y variables which are increased transparency and better stakeholder management I must mention that this research greatly benefited from the articles posted by Intangibles Business Ltd The research resources I have used are archives real data literature interviews reviews and the research facilities available at UMASS in the Healey library database The databases I have used are Business Source Premier Lexis Nexis Academic 11

Ebrary and the Wall Street Journal for articles Besides these I have also used other UMB resources like the CM faculty the CM Business Center and the advice and guidance of the Accounting and Management Department faculty

METHODOLOGY I have used an analytical as well as a theoretical framework to prove my research objective My research can be divided into three stages Stage one involves analysis involves looking at the standards for intangible assets and goodwill under IFRS UK GAAP and US GAAP and making comparisons This is followed by Stage two- the analysis of the reconciliations of Balance Sheets of a sample of 10 companies and interpret the data to prove the increased transparency under IFRS In Stage three The stakeholder theory which I have explained in detailed in a later section has been to used to prove how this increased transparency has lead to better stakeholder management ie provides managers with a number of alternatives to serve stakeholders in a better manner which would ultimately prove beneficial to business In the end I use the stakeholder theory again to prove the general effectiveness of the IFRS using the information in surveys conducted Empirically my research could be summarized in the following steps- collection of data questioning of the information collected forming conclusions and finally putting together all of my research on paper The diagram on the next page summarizes the structure and organization of my thesis 12

Accounting for intangible assets Sample analysis Using the stakeholder theory

IFRS 3 US GAAP

SFAS 141

SFAS 142

UK GAAP

FRS 10

Comparisons and differences

Analysis of reconciliatory statements of sample of 10 European companies that have transitioned to the IFRS

INCREASED TRANSPARENCY

Interpretation of data on intangible assets and goodwill

IFRS

IFRS 3

Investors

Government

Suppliers Customers Creditors

Society 13

US GAAP

ANALYSIS

STAGE 1 ACCOUNTING FOR INTANGIBLE ASSETS This stage involves a comparison of accounting for intangibles under IFRS US GAAP and UK GAAP

SFAS 141

SFAS 142

UK GAAP

FRS 10

Comparisons

and

differences IFRS 3 14

Introducing concepts Intangible assets Goodwill Intangible assets The Uniform Commercial Code (Section 9-102(a)(42)) defines general intangibles as any personal property other than accounts chattel paper commercial tort claims deposit accounts documents goods instruments investment property letter of credit rights letters of credit money and oil gas or other minerals before extraction The term includes payment intangibles and software In todayrsquos global economy dominated by information and service providers intangible assets constitute a major proportion of total assets Intangible assets command an increasingly large proportion of a companyrsquos value and this value has largely not been recognized In heavily branded consumer businesses such as Coca Cola or Nike brands account to up to 80 of the companyrsquos value In other industries such as pharmaceutical patents and copyrights are more prominent(Thaynes1 ) Thus Microsoftrsquos software Cokersquos secret formula and America Onlinersquos subscription base are the most important assets on their balance sheets Infact the value of tangible assets as a percentage of all assets has been steadily decreasing as shown in the graph below which is provided by the Federal Reserve Board but which is recreated by me for this thesisrsquos purpose The original graph is attached 80 70 60 5055 Years lsquo00 15

While intangibles are potential sources of income their values can erode just as quickly Just before Winstar Communications filed for bankruptcy in 2001 their assets were listed at 5 billion dollars However on liquidation the assets fetched just 42 million dollars due to decline in the value of intangibles Traditional assessment of national economic performance has relied upon understanding the GDP in terms of traditional factors of production ndash land labor and capital Knowledge assets may be distinguished from the traditional factors of production ndash in that they are governed by what has been described as the lsquolaw of increasing returnsrsquo In contrast to the traditional factors of production that were governed by diminishing returns every additional unit of knowledge used effectively results in a marginal increase in performance Success of companies such as Microsoft is often attributed to the fact that every additional unit of information-based product or service would result in an increase in the marginal returns Given the changing dynamics underlying national performance it is not surprising that some less developed economies with significant assets in ICT knowledge and Internet-related expertise are hoping to leapfrog more developed economies ( Malhotra2000) Intangible assets have two main characteristics- they lack physical existence and they are not financial instruments Intangible assets derive their value from the rights and privileges granted to the company using them (Kieso Weygandt and Warfield570) Intangible assets are further classified as limited life intangibles or indefinite life intangibles Limited life intangibles have a known useful life and indefinite life intangibles are intangibles whose useful life cannot be determined Accounting treatment for the intangibles vary according to their type which we shall look more in detail in the next section When intangibles are purchased from other parties they are most recorded at the 16

cost of purchase or fair market value under most accounting systems This cost includes all the expenses incurred to make the asset ready for use These include its purchase price legal fees and incidental expenses Internally generated intangibles are generally expensed as incurred All the research and development costs that companies have to incur to come up with the asset are expensed in the income statement The six major categories of intangible assets are marketing ndashrelated intangible assets customer-related intangible assets artistic-related intangible assets contract-related intangible assets technology-related intangible assets and goodwill Marketing - related intangibles assets are those assets used in the marketing or promotion of products These include trademark trade names and internet domain names Customer-related intangible assets include assets such as customer contracts customer relationships subscriber lists customer orders and backlogs and core deposits Artistic ndash related intangible assets include ownership rights to plays literary works musical works etc Contract ndashrelated intangible assets include licenses non-competition agreements and various other agreements and contract rights Goodwill is an important component of intangible assets and comes into play during business acquisitions and mergers Goodwill can be internally created or purchased goodwill Accounting treatment for goodwill differs according to its type and the accounting standards followed 17

Goodwill Goodwill is the excess of the purchase price over the fair market value of an asset during a business combination Some of the reasons why a business would be worth more than the sum of the fair values of the accountable and identifiable net assets of that business are- The expertise of the workforce mdash current accounting practices do not normally recognize the value of human resources as an asset on the balance sheet The reputation of the product(s) of the business mdash if the product has a well known name attached to it then sales and profits will be boosted on the basis of reputation alone The general economic environment mdash levels of interest rates and exchange rates and levels of investor confidence generally will clearly have a major influence on the value of businesses and hence on the amount of goodwill attaching to a business( Robins2000) Goodwill is often referred to as the most intangible of all intangible assets The problem of determining the proper cost to allocate to intangible assets in a business combination is complex because of the many different types of intangibles that might be considered It is extremely difficult not only to identify certain types of intangibles but also to assign a value to them in a business combination As a result the approach followed is to record identifiable intangible assets that can be reliably measured Other intangible assets that are difficult to identify or measure are recorded as goodwill (KiesoWeygandt and Warfield 578) 18

IFRS accounting for business combinations The three IFRS standards impacting accounting for intangible assets are IFRS3 Business Combinations IAS36 Impairment of Assets and IAS38 Intangible Assets These three standards are applicable to intangible assets and goodwill acquired on or after 31 March 2004IAS38 prescribes accounting treatment for the recognition of internally generated and acquired intangible assets IAS38 prescribes the rules for impairment testing of assets and goodwill IFRS3 prescribes the overall treatment for accounting for acquired assets and goodwill in a business combination The three standards can be summarized as follows- Acquired intangible assets Business combinations are accounted for using the purchase method ie accounting from the perspective of the acquirer Intangible assets are initially recognized at cost based on the following criteria-

1) They are identifiable

2) The probable future economic benefits created by them will benefit the organization

3) The measurement of their cost is reliable

After their initial recognition intangible assets may be carried at their cost or revalued amount less any accumulated amortization or impairment losses Their revaluation amount is their fair value at the date of revaluation If there is an increase in the amount of carrying value after revaluation is credited to a revaluation surplus account 19

Internally Generated Intangible assets Internally generated goodwill brands mastheads publishing titles customer lists are not recognized as intangible assets Research and development costs are generally expensed They can however be treated as an intangible asset if they meet the following criteria-

bull They are identifiable

bull The probable future economic benefits created by them will benefit the organization

bull The measurement of their cost is reliable

Goodwill Internally generated goodwill is not recognized The only goodwill recognized is as a result of business combinations Goodwill represents the difference between the total purchase consideration and the total of the fair value of all acquired assets and liabilities assumed If the fair value of the assets exceed the purchase consideration then the acquirer must reassess and identify all the assets and immediately after reassessment must recognize the negative goodwill as a profit in the income statement Impairment testing The useful life of the asset is determined If the asset has a finite useful life it should be amortized over its life For assets with indefinite useful life annual impairment testing is required The test involves a comparison of the carrying value of the asset with its 20

estimated recoverable amount The recoverable is defined as the higher of the value less costs to sell and the value in use The in use is generally based on the discounted future cash flows from the asset When the recoverable amount is found to be lower than the carrying value the carrying value is reduced to the recoverable amount with a charge to profits(Caldwell4)

US GAAP accounting for Business Combinations The standards that prescribe treatment for accounting for Business Combinations are SFAS141 Business Combinations and SFAS 142 Goodwill and other intangible assets The treatment can be summarized as follows- Acquired intangible assets Recorded cost 1)Acquired intangibles are recorded at cost and this cost includes the purchase price and all costs incurred to bring the asset to its intended use 2) In cases where the asset is acquired in exchange for stock or other assets the cost of the asset is the fair value of the consideration given or the fair value of the intangible received whichever is more clear 3) In the case of a lsquobasket purchasersquo cost is allocated on the basis of fair market values of assets acquired Amortization Assets with limited useful life are amortized over life of the asset The asset generates cash flows over such a useful life and the amortization method should to a certain extent 21

reflect the pattern in which the asset is used up if that could be determined If the usage pattern cannot be determined then the straight-line method is used Assets with indefinite life are not amortized Internally Generated Intangibles Costs related to internally generated intangibles are expensed as incurred Research and development costs related to intangibles are expensed and appear in the income statement Only direct costs incurred in obtaining intangibles including legal costs are capitalized Goodwill Goodwill recognized is the difference between the purchase consideration and the fair value of assets It appears on the balance sheet Internally generated goodwill is not recognized The impairment rule for goodwill involves two steps First the fair value of the reporting unit should be compared to its carrying amount including goodwill If the fair value of the reporting unit is greater than the carrying amount goodwill is considered not to be impaired and the company does not have to do anything else (Kieso Weygandt and Warfield593) Impairment testing of intangibles Impairment refers to the write-off or reduction in value of the asset that has to be carried out when the carrying amount of a long-lived asset is not recoverable When the carrying value of an intangible is not recoverable impairment is carried Impairment testing for indefinite life intangibles just involves a fair value test For limited life intangibles impairment is based on a recoverability test and a fair value test Goodwill impairments are based on a fair value test 22

Types of intangible asset Impairment test Limited life Recoverability test then fair value test Indefinite life other than goodwill Fair value test Goodwill Fair value test on reporting unit then fair value test on implied goodwill (Kieso Weygandt and Warfield584)

Pre-IFRS UK GAAP accounting for Business Combinations Starting 2005 all the 25 nations in the European Union including the United Kingdom have adopted the IFRS The pre-IFRS UK GAAP is no longer functional The FRS10 Goodwill and Intangible assets used to prescribe the rules for accounting for Intangibles and Goodwill The Deloitte and Touche publication lsquoGAAP 2004rsquo summarizes the key features of this standard as follows-

bull Internally generated goodwill may not be recognized Purchased goodwill is capitalized and classified as an asset

bull Internally developed intangible assets are recognized only if they have a readily ascertainable market value Purchased intangible assets are capitalized Intangible assets acquired as a part of a business combination are recognized only if they are separable and can be measured reliably

bull Goodwill and intangible assets are amortized over their useful economic lives if this is finite or not amortized if this is indefinite Negative goodwill is classified alongside positive goodwill and amortized

23

bull When the period of amortization exceeds 20 years an impairment test is carried out annually In other cases an impairment test at the end of the first full year after acquisition and then if there is an indicator of impairment

COMPARING THE IFRS TO US GAAP AND PRE-IFRS UK GAAP BUSINESS COMBINATIONS IFRS 3 vs UK GAAP The major differences between the IFRS 3 and FRS provisions for accounting for business combinations are as follows- End of merger accounting and pooling of assets An important requirement of the IFRS 3 is that business acquisitions be accounted for using the purchase method from the perspective of the acquirer This nullifies the UK GAAP provision of allowing companies to use merger accounting where they simply pooled together their balance sheet thus not recognizing goodwill The IFRS provision makes it mandatory for companies to recognize goodwill Goodwill no longer amortized Goodwill is no longer amortized but is instead subjected to a stringent annual impairment test In the event that it is impaired an immediate charge will be taken to the profit and loss account so poor performing acquisitions will be highlighted through such a charge sooner rather than later This represents a fundamental shift in the way goodwill 24

is viewed Goodwill is seen no longer a s steadily wasting asset but instead as one that should be expected to maintain its value(Hadjiloucas and Winter2) More Intangible Assets recognized Historically under UK GAAP when a deal was completed acquired intangible assets would generally just be subsumed within a pot marked lsquogoodwillrsquo The major benefit was that by amortizing this goodwill evenly over a period of usually 20 years you could predict with greater accuracy the impact on earnings (Stevenson and Mc Phee 82) However IFRS 3 requires that all identifiable and valuable intangible assets be reported on the balance sheet The acquirer needs to recognize purchased intangibles on the Balance Sheet More Disclosures The IFRS 3 requires that detailed disclosures be made about transactions and the purchase price allocation method utilized Detailed information about impairment testing of assets and goodwill also needs to be disclosed Strict criteria for determining useful life Limited life intangibles can be amortized over their useful life However management now needs to be more stringent about classifying assets as having a definite or indefinite useful life An indefinite life assertion needs to be backed by evidence and analysis supporting that no legal regulatory contractual competitive economic or other factors limit the life of the asset (Hadjiloucas and Winter3) 25

UK GAAP IFRS Merging accounting and pooling of assets used

No merger accounting allowed all combinations accounted for using the purchase method

Goodwill amortized over life of the asset

Goodwill tested for impairment annually

Fewer capitalized intangible assets More intangibles identified and recognized on acquisition

Details of purchase price allocation not essentially required to be disclosed

Details of purchase price allocation need to be disclosed

IFRS IN EUROPE All European quoted companies were required to prepare their consolidated financial statements in accordance with the International Financial Reporting Standards since 2005 The transition dates for different companies ranged from 31 December 2003 to 30 December 2004 The EU policy is aimed at the removal of barriers to cross border trading in securities by ensuring that company financial statements throughout the EU are transparent and comparable The economic gains to be derived from an integrated European financial and capital market are considerable (Lian 2 2004) Prior to the IAS European countries were either using US GAAP or their own national standards The European Commission has said ldquoIAS will offer [those now using US GAAP] the same high quality level of financial information as US GAAP with the additional advantage that IAS have been conceived in a truly international perspective and are not modeled by a particular national environment The Commission hopes and expects that the US Securities and Exchange Commission (SEC) will accept in the near future financial statements prepared by EU issuers without requiring a reconciliation to US GAAPrdquo As this thesis compares the pre-IFRS UK GAAP to IFRS I would like to write a little about the IFRS situation in the UK The Accounting Standards Committee (ASC) and the Accounting Standards Board (ASB) were previously producing UK SSAPs and FRSs Since the implementation of the International Financial Reporting Standards a number of changes have taken place in the accounting and presentation of financial 6

statements Some of the areas in which the IFRS differs from the pre-IFRS UK GAAP are-

bull Tangible Fixed Assets

bull Intangible assets

bull Impairment of Assets

bull Stock and Long Term Contracts

bull Deferred taxes

bull Leases

bull Retirement Benefits

IFRS AND US GAAP DIFFERENCES Accountants will encounter US GAAP either with American groups or with foreign groups that have a listing on US stock markets US GAAP are standards developed for the 12000 or so listed companies in the USA and required by the Securities and Exchange Commission (SEC) Foreign companies that have shares or bonds listed in the USA need not publish US GAAP accounts as such but must in effect prepare them in order to provide a reconciliation statement This details for their US investors the differences between net profit and net assets as reported and how they would have been stated under US GAAP Though there is no general filing requirement for accounts of unlisted companies in the USA it is thought that about 15000 other companies prepare GAAP-compliant accounts as a requirement of bank borrowings or on 7

a voluntary basis GAAP principally developed by the Financial Accounting Standards Board (FASB) are more extensive than IFRS - comprising hundreds of standards interpretations opinions and other authoritative rules (Martin 2004) Some of the accounting areas in which the US GAAP differs from the IFRS are-

bull Tangible assets

bull Available for sale marketable securities

bull Intangible assets

bull Research and development expenditures

bull Leases

bull Inventory

IASB-FASB CONVERGENCE PROJECTS In September 2002 the FASB and the IASB reached an agreement to conduct a short-term project to work towards eliminating the differences between the IFRS and US GAAP The SEC also made an announcement in the same month in which it said that starting in 2007 it might allow foreign companies which are trying to raise capital in the US to use the IFRS rather than reconciling to US GAAP as they do right now Convergence is supposed to ease the task of raising capital Once the process is complete investors will need less help comparing results of competing firms based in different countries US companies that conform to GAAP will be able to raise capital abroad without reconciling their results to IFRS (Reason 2005 2) The FASB and IASB are 8

also working together on a number of long-term projects that deal with concepts like business combinations employee benefits and comprehensive income

LITERATURE REVIEW I have analyzed and compare the reconciliatory Balance Sheets of 10 European countries I chose these companies from different sectors of the European economy and have written about their performance For the theoretical framework I use the stakeholder theory The stakeholder research tradition began to unfold in the wake of R Edward Freemanrsquos seminal book Strategic Management A Stakeholders Approach which was published in the mid-1980s The book initiated a still ongoing academic discussion It demonstrated in a comprehensive fashion that strategic management of private sector firms could become much more effective and efficient if managerial efforts regard various stakeholders concerns Or in other words shareholders benefit long-term if other legitimate interests in the firm do not fall by the wayside (Scholl 2)Thus besides shareholders the interests of other stakeholders in and outside the organization had to be taken into consideration while making managerial decisions and implementing policies Stakeholder theory suggests that an organization has relationships with many constituent groups or stakeholders(Covell 2004) that affect and are affected by its decisions (Freeman 1984) A major purpose of stakeholder theory is to help corporate managers understand their stakeholder environments and manage more effectively within the nexus of relationships that exists for their companies However a larger purpose of stakeholder theory is to help corporate managers improve the value of the outcomes of 9

their actions and minimize the harms to stakeholders The whole point of stakeholder theory in fact lies in what happens when corporations and stakeholders act out of their relationships (Logsdon and Wood 3) The stakeholder theory involves answering three important questions- Who are the organizationrsquos stakeholders for accounting standards This step involves identification of the organizationrsquos stakeholders Stakeholders are defined as those individuals that have a stake in the performance of an organization that the interests of all legitimate stakeholders have intrinsic value and that no set of interests is assumed to dominate the others (Donaldson amp Preston 1995) In the Ivey Business Journal Robert Philips writes that stakeholders are those groups from whom the organization has voluntarily accepted benefits and to whom the organization has therefore incurred obligations of fairness Typically this includes groups such as financiers employees customers suppliers and local communities (Philips 2004 2) Stakeholder theory holds that besides these legitimate stakeholders derivative stakeholders like competitors or activist groups are important as their actions can influence the corporation Why are the stakeholders important for accounting standards Brenner and Cochran comment that the stakeholder theory of the firm posits that the nature of an organizations stakeholders their values their relative influence on decisions and the nature of the situation are all relevant information for predicting organizational behavior(1991 p 462) Milton Friedman uses the property rights argument stating that shareholders own an organization as they own the equity shares and if they desire to 10

maximize the value of their investment it is the managerrsquos duty to work in accordance Managers who fail to do so violate the moral property right (Mitchell et al 1997) note that stakeholder theory has managerial importance because it can determine to what and to whom managers need to listen and give attention What do Stakeholders want Different people want different things from their relationships with organizations Stakeholder discussions often focus on allocating some measure of organizational value or outcome (eg who gets how much money from the firm) The question of how the organization creates this value usually gets less attention but it is certainly not less important Not all stakeholders want a voice in organizational decision-making but those who do desire a voice should have it (Philips 2004 2) My literature sources had to be organized into three data sets-IFRS standards US GAAP and pre ndashIFRS UK GAAP My documents for analyzing the IFRS were the web summaries put up on the International Accounting Standards Board site For pre-IFRS UK GAAP I referred primarily to the Deloitte and Touche publication lsquoGAAP 2004rsquo For the US GAAP I referred to the textbook being used right now in UMass Boston for AF310 and AF311 lsquoIntermediate Accountingrsquo by Kieso Weygandt and Warfield The IFRS accounting for intangible assets was the x variable I used to prove my y variables which are increased transparency and better stakeholder management I must mention that this research greatly benefited from the articles posted by Intangibles Business Ltd The research resources I have used are archives real data literature interviews reviews and the research facilities available at UMASS in the Healey library database The databases I have used are Business Source Premier Lexis Nexis Academic 11

Ebrary and the Wall Street Journal for articles Besides these I have also used other UMB resources like the CM faculty the CM Business Center and the advice and guidance of the Accounting and Management Department faculty

METHODOLOGY I have used an analytical as well as a theoretical framework to prove my research objective My research can be divided into three stages Stage one involves analysis involves looking at the standards for intangible assets and goodwill under IFRS UK GAAP and US GAAP and making comparisons This is followed by Stage two- the analysis of the reconciliations of Balance Sheets of a sample of 10 companies and interpret the data to prove the increased transparency under IFRS In Stage three The stakeholder theory which I have explained in detailed in a later section has been to used to prove how this increased transparency has lead to better stakeholder management ie provides managers with a number of alternatives to serve stakeholders in a better manner which would ultimately prove beneficial to business In the end I use the stakeholder theory again to prove the general effectiveness of the IFRS using the information in surveys conducted Empirically my research could be summarized in the following steps- collection of data questioning of the information collected forming conclusions and finally putting together all of my research on paper The diagram on the next page summarizes the structure and organization of my thesis 12

Accounting for intangible assets Sample analysis Using the stakeholder theory

IFRS 3 US GAAP

SFAS 141

SFAS 142

UK GAAP

FRS 10

Comparisons and differences

Analysis of reconciliatory statements of sample of 10 European companies that have transitioned to the IFRS

INCREASED TRANSPARENCY

Interpretation of data on intangible assets and goodwill

IFRS

IFRS 3

Investors

Government

Suppliers Customers Creditors

Society 13

US GAAP

ANALYSIS

STAGE 1 ACCOUNTING FOR INTANGIBLE ASSETS This stage involves a comparison of accounting for intangibles under IFRS US GAAP and UK GAAP

SFAS 141

SFAS 142

UK GAAP

FRS 10

Comparisons

and

differences IFRS 3 14

Introducing concepts Intangible assets Goodwill Intangible assets The Uniform Commercial Code (Section 9-102(a)(42)) defines general intangibles as any personal property other than accounts chattel paper commercial tort claims deposit accounts documents goods instruments investment property letter of credit rights letters of credit money and oil gas or other minerals before extraction The term includes payment intangibles and software In todayrsquos global economy dominated by information and service providers intangible assets constitute a major proportion of total assets Intangible assets command an increasingly large proportion of a companyrsquos value and this value has largely not been recognized In heavily branded consumer businesses such as Coca Cola or Nike brands account to up to 80 of the companyrsquos value In other industries such as pharmaceutical patents and copyrights are more prominent(Thaynes1 ) Thus Microsoftrsquos software Cokersquos secret formula and America Onlinersquos subscription base are the most important assets on their balance sheets Infact the value of tangible assets as a percentage of all assets has been steadily decreasing as shown in the graph below which is provided by the Federal Reserve Board but which is recreated by me for this thesisrsquos purpose The original graph is attached 80 70 60 5055 Years lsquo00 15

While intangibles are potential sources of income their values can erode just as quickly Just before Winstar Communications filed for bankruptcy in 2001 their assets were listed at 5 billion dollars However on liquidation the assets fetched just 42 million dollars due to decline in the value of intangibles Traditional assessment of national economic performance has relied upon understanding the GDP in terms of traditional factors of production ndash land labor and capital Knowledge assets may be distinguished from the traditional factors of production ndash in that they are governed by what has been described as the lsquolaw of increasing returnsrsquo In contrast to the traditional factors of production that were governed by diminishing returns every additional unit of knowledge used effectively results in a marginal increase in performance Success of companies such as Microsoft is often attributed to the fact that every additional unit of information-based product or service would result in an increase in the marginal returns Given the changing dynamics underlying national performance it is not surprising that some less developed economies with significant assets in ICT knowledge and Internet-related expertise are hoping to leapfrog more developed economies ( Malhotra2000) Intangible assets have two main characteristics- they lack physical existence and they are not financial instruments Intangible assets derive their value from the rights and privileges granted to the company using them (Kieso Weygandt and Warfield570) Intangible assets are further classified as limited life intangibles or indefinite life intangibles Limited life intangibles have a known useful life and indefinite life intangibles are intangibles whose useful life cannot be determined Accounting treatment for the intangibles vary according to their type which we shall look more in detail in the next section When intangibles are purchased from other parties they are most recorded at the 16

cost of purchase or fair market value under most accounting systems This cost includes all the expenses incurred to make the asset ready for use These include its purchase price legal fees and incidental expenses Internally generated intangibles are generally expensed as incurred All the research and development costs that companies have to incur to come up with the asset are expensed in the income statement The six major categories of intangible assets are marketing ndashrelated intangible assets customer-related intangible assets artistic-related intangible assets contract-related intangible assets technology-related intangible assets and goodwill Marketing - related intangibles assets are those assets used in the marketing or promotion of products These include trademark trade names and internet domain names Customer-related intangible assets include assets such as customer contracts customer relationships subscriber lists customer orders and backlogs and core deposits Artistic ndash related intangible assets include ownership rights to plays literary works musical works etc Contract ndashrelated intangible assets include licenses non-competition agreements and various other agreements and contract rights Goodwill is an important component of intangible assets and comes into play during business acquisitions and mergers Goodwill can be internally created or purchased goodwill Accounting treatment for goodwill differs according to its type and the accounting standards followed 17

Goodwill Goodwill is the excess of the purchase price over the fair market value of an asset during a business combination Some of the reasons why a business would be worth more than the sum of the fair values of the accountable and identifiable net assets of that business are- The expertise of the workforce mdash current accounting practices do not normally recognize the value of human resources as an asset on the balance sheet The reputation of the product(s) of the business mdash if the product has a well known name attached to it then sales and profits will be boosted on the basis of reputation alone The general economic environment mdash levels of interest rates and exchange rates and levels of investor confidence generally will clearly have a major influence on the value of businesses and hence on the amount of goodwill attaching to a business( Robins2000) Goodwill is often referred to as the most intangible of all intangible assets The problem of determining the proper cost to allocate to intangible assets in a business combination is complex because of the many different types of intangibles that might be considered It is extremely difficult not only to identify certain types of intangibles but also to assign a value to them in a business combination As a result the approach followed is to record identifiable intangible assets that can be reliably measured Other intangible assets that are difficult to identify or measure are recorded as goodwill (KiesoWeygandt and Warfield 578) 18

IFRS accounting for business combinations The three IFRS standards impacting accounting for intangible assets are IFRS3 Business Combinations IAS36 Impairment of Assets and IAS38 Intangible Assets These three standards are applicable to intangible assets and goodwill acquired on or after 31 March 2004IAS38 prescribes accounting treatment for the recognition of internally generated and acquired intangible assets IAS38 prescribes the rules for impairment testing of assets and goodwill IFRS3 prescribes the overall treatment for accounting for acquired assets and goodwill in a business combination The three standards can be summarized as follows- Acquired intangible assets Business combinations are accounted for using the purchase method ie accounting from the perspective of the acquirer Intangible assets are initially recognized at cost based on the following criteria-

1) They are identifiable

2) The probable future economic benefits created by them will benefit the organization

3) The measurement of their cost is reliable

After their initial recognition intangible assets may be carried at their cost or revalued amount less any accumulated amortization or impairment losses Their revaluation amount is their fair value at the date of revaluation If there is an increase in the amount of carrying value after revaluation is credited to a revaluation surplus account 19

Internally Generated Intangible assets Internally generated goodwill brands mastheads publishing titles customer lists are not recognized as intangible assets Research and development costs are generally expensed They can however be treated as an intangible asset if they meet the following criteria-

bull They are identifiable

bull The probable future economic benefits created by them will benefit the organization

bull The measurement of their cost is reliable

Goodwill Internally generated goodwill is not recognized The only goodwill recognized is as a result of business combinations Goodwill represents the difference between the total purchase consideration and the total of the fair value of all acquired assets and liabilities assumed If the fair value of the assets exceed the purchase consideration then the acquirer must reassess and identify all the assets and immediately after reassessment must recognize the negative goodwill as a profit in the income statement Impairment testing The useful life of the asset is determined If the asset has a finite useful life it should be amortized over its life For assets with indefinite useful life annual impairment testing is required The test involves a comparison of the carrying value of the asset with its 20

estimated recoverable amount The recoverable is defined as the higher of the value less costs to sell and the value in use The in use is generally based on the discounted future cash flows from the asset When the recoverable amount is found to be lower than the carrying value the carrying value is reduced to the recoverable amount with a charge to profits(Caldwell4)

US GAAP accounting for Business Combinations The standards that prescribe treatment for accounting for Business Combinations are SFAS141 Business Combinations and SFAS 142 Goodwill and other intangible assets The treatment can be summarized as follows- Acquired intangible assets Recorded cost 1)Acquired intangibles are recorded at cost and this cost includes the purchase price and all costs incurred to bring the asset to its intended use 2) In cases where the asset is acquired in exchange for stock or other assets the cost of the asset is the fair value of the consideration given or the fair value of the intangible received whichever is more clear 3) In the case of a lsquobasket purchasersquo cost is allocated on the basis of fair market values of assets acquired Amortization Assets with limited useful life are amortized over life of the asset The asset generates cash flows over such a useful life and the amortization method should to a certain extent 21

reflect the pattern in which the asset is used up if that could be determined If the usage pattern cannot be determined then the straight-line method is used Assets with indefinite life are not amortized Internally Generated Intangibles Costs related to internally generated intangibles are expensed as incurred Research and development costs related to intangibles are expensed and appear in the income statement Only direct costs incurred in obtaining intangibles including legal costs are capitalized Goodwill Goodwill recognized is the difference between the purchase consideration and the fair value of assets It appears on the balance sheet Internally generated goodwill is not recognized The impairment rule for goodwill involves two steps First the fair value of the reporting unit should be compared to its carrying amount including goodwill If the fair value of the reporting unit is greater than the carrying amount goodwill is considered not to be impaired and the company does not have to do anything else (Kieso Weygandt and Warfield593) Impairment testing of intangibles Impairment refers to the write-off or reduction in value of the asset that has to be carried out when the carrying amount of a long-lived asset is not recoverable When the carrying value of an intangible is not recoverable impairment is carried Impairment testing for indefinite life intangibles just involves a fair value test For limited life intangibles impairment is based on a recoverability test and a fair value test Goodwill impairments are based on a fair value test 22

Types of intangible asset Impairment test Limited life Recoverability test then fair value test Indefinite life other than goodwill Fair value test Goodwill Fair value test on reporting unit then fair value test on implied goodwill (Kieso Weygandt and Warfield584)

Pre-IFRS UK GAAP accounting for Business Combinations Starting 2005 all the 25 nations in the European Union including the United Kingdom have adopted the IFRS The pre-IFRS UK GAAP is no longer functional The FRS10 Goodwill and Intangible assets used to prescribe the rules for accounting for Intangibles and Goodwill The Deloitte and Touche publication lsquoGAAP 2004rsquo summarizes the key features of this standard as follows-

bull Internally generated goodwill may not be recognized Purchased goodwill is capitalized and classified as an asset

bull Internally developed intangible assets are recognized only if they have a readily ascertainable market value Purchased intangible assets are capitalized Intangible assets acquired as a part of a business combination are recognized only if they are separable and can be measured reliably

bull Goodwill and intangible assets are amortized over their useful economic lives if this is finite or not amortized if this is indefinite Negative goodwill is classified alongside positive goodwill and amortized

23

bull When the period of amortization exceeds 20 years an impairment test is carried out annually In other cases an impairment test at the end of the first full year after acquisition and then if there is an indicator of impairment

COMPARING THE IFRS TO US GAAP AND PRE-IFRS UK GAAP BUSINESS COMBINATIONS IFRS 3 vs UK GAAP The major differences between the IFRS 3 and FRS provisions for accounting for business combinations are as follows- End of merger accounting and pooling of assets An important requirement of the IFRS 3 is that business acquisitions be accounted for using the purchase method from the perspective of the acquirer This nullifies the UK GAAP provision of allowing companies to use merger accounting where they simply pooled together their balance sheet thus not recognizing goodwill The IFRS provision makes it mandatory for companies to recognize goodwill Goodwill no longer amortized Goodwill is no longer amortized but is instead subjected to a stringent annual impairment test In the event that it is impaired an immediate charge will be taken to the profit and loss account so poor performing acquisitions will be highlighted through such a charge sooner rather than later This represents a fundamental shift in the way goodwill 24

is viewed Goodwill is seen no longer a s steadily wasting asset but instead as one that should be expected to maintain its value(Hadjiloucas and Winter2) More Intangible Assets recognized Historically under UK GAAP when a deal was completed acquired intangible assets would generally just be subsumed within a pot marked lsquogoodwillrsquo The major benefit was that by amortizing this goodwill evenly over a period of usually 20 years you could predict with greater accuracy the impact on earnings (Stevenson and Mc Phee 82) However IFRS 3 requires that all identifiable and valuable intangible assets be reported on the balance sheet The acquirer needs to recognize purchased intangibles on the Balance Sheet More Disclosures The IFRS 3 requires that detailed disclosures be made about transactions and the purchase price allocation method utilized Detailed information about impairment testing of assets and goodwill also needs to be disclosed Strict criteria for determining useful life Limited life intangibles can be amortized over their useful life However management now needs to be more stringent about classifying assets as having a definite or indefinite useful life An indefinite life assertion needs to be backed by evidence and analysis supporting that no legal regulatory contractual competitive economic or other factors limit the life of the asset (Hadjiloucas and Winter3) 25

UK GAAP IFRS Merging accounting and pooling of assets used

No merger accounting allowed all combinations accounted for using the purchase method

Goodwill amortized over life of the asset

Goodwill tested for impairment annually

Fewer capitalized intangible assets More intangibles identified and recognized on acquisition

Details of purchase price allocation not essentially required to be disclosed

Details of purchase price allocation need to be disclosed

statements Some of the areas in which the IFRS differs from the pre-IFRS UK GAAP are-

bull Tangible Fixed Assets

bull Intangible assets

bull Impairment of Assets

bull Stock and Long Term Contracts

bull Deferred taxes

bull Leases

bull Retirement Benefits

IFRS AND US GAAP DIFFERENCES Accountants will encounter US GAAP either with American groups or with foreign groups that have a listing on US stock markets US GAAP are standards developed for the 12000 or so listed companies in the USA and required by the Securities and Exchange Commission (SEC) Foreign companies that have shares or bonds listed in the USA need not publish US GAAP accounts as such but must in effect prepare them in order to provide a reconciliation statement This details for their US investors the differences between net profit and net assets as reported and how they would have been stated under US GAAP Though there is no general filing requirement for accounts of unlisted companies in the USA it is thought that about 15000 other companies prepare GAAP-compliant accounts as a requirement of bank borrowings or on 7

a voluntary basis GAAP principally developed by the Financial Accounting Standards Board (FASB) are more extensive than IFRS - comprising hundreds of standards interpretations opinions and other authoritative rules (Martin 2004) Some of the accounting areas in which the US GAAP differs from the IFRS are-

bull Tangible assets

bull Available for sale marketable securities

bull Intangible assets

bull Research and development expenditures

bull Leases

bull Inventory

IASB-FASB CONVERGENCE PROJECTS In September 2002 the FASB and the IASB reached an agreement to conduct a short-term project to work towards eliminating the differences between the IFRS and US GAAP The SEC also made an announcement in the same month in which it said that starting in 2007 it might allow foreign companies which are trying to raise capital in the US to use the IFRS rather than reconciling to US GAAP as they do right now Convergence is supposed to ease the task of raising capital Once the process is complete investors will need less help comparing results of competing firms based in different countries US companies that conform to GAAP will be able to raise capital abroad without reconciling their results to IFRS (Reason 2005 2) The FASB and IASB are 8

also working together on a number of long-term projects that deal with concepts like business combinations employee benefits and comprehensive income

LITERATURE REVIEW I have analyzed and compare the reconciliatory Balance Sheets of 10 European countries I chose these companies from different sectors of the European economy and have written about their performance For the theoretical framework I use the stakeholder theory The stakeholder research tradition began to unfold in the wake of R Edward Freemanrsquos seminal book Strategic Management A Stakeholders Approach which was published in the mid-1980s The book initiated a still ongoing academic discussion It demonstrated in a comprehensive fashion that strategic management of private sector firms could become much more effective and efficient if managerial efforts regard various stakeholders concerns Or in other words shareholders benefit long-term if other legitimate interests in the firm do not fall by the wayside (Scholl 2)Thus besides shareholders the interests of other stakeholders in and outside the organization had to be taken into consideration while making managerial decisions and implementing policies Stakeholder theory suggests that an organization has relationships with many constituent groups or stakeholders(Covell 2004) that affect and are affected by its decisions (Freeman 1984) A major purpose of stakeholder theory is to help corporate managers understand their stakeholder environments and manage more effectively within the nexus of relationships that exists for their companies However a larger purpose of stakeholder theory is to help corporate managers improve the value of the outcomes of 9

their actions and minimize the harms to stakeholders The whole point of stakeholder theory in fact lies in what happens when corporations and stakeholders act out of their relationships (Logsdon and Wood 3) The stakeholder theory involves answering three important questions- Who are the organizationrsquos stakeholders for accounting standards This step involves identification of the organizationrsquos stakeholders Stakeholders are defined as those individuals that have a stake in the performance of an organization that the interests of all legitimate stakeholders have intrinsic value and that no set of interests is assumed to dominate the others (Donaldson amp Preston 1995) In the Ivey Business Journal Robert Philips writes that stakeholders are those groups from whom the organization has voluntarily accepted benefits and to whom the organization has therefore incurred obligations of fairness Typically this includes groups such as financiers employees customers suppliers and local communities (Philips 2004 2) Stakeholder theory holds that besides these legitimate stakeholders derivative stakeholders like competitors or activist groups are important as their actions can influence the corporation Why are the stakeholders important for accounting standards Brenner and Cochran comment that the stakeholder theory of the firm posits that the nature of an organizations stakeholders their values their relative influence on decisions and the nature of the situation are all relevant information for predicting organizational behavior(1991 p 462) Milton Friedman uses the property rights argument stating that shareholders own an organization as they own the equity shares and if they desire to 10

maximize the value of their investment it is the managerrsquos duty to work in accordance Managers who fail to do so violate the moral property right (Mitchell et al 1997) note that stakeholder theory has managerial importance because it can determine to what and to whom managers need to listen and give attention What do Stakeholders want Different people want different things from their relationships with organizations Stakeholder discussions often focus on allocating some measure of organizational value or outcome (eg who gets how much money from the firm) The question of how the organization creates this value usually gets less attention but it is certainly not less important Not all stakeholders want a voice in organizational decision-making but those who do desire a voice should have it (Philips 2004 2) My literature sources had to be organized into three data sets-IFRS standards US GAAP and pre ndashIFRS UK GAAP My documents for analyzing the IFRS were the web summaries put up on the International Accounting Standards Board site For pre-IFRS UK GAAP I referred primarily to the Deloitte and Touche publication lsquoGAAP 2004rsquo For the US GAAP I referred to the textbook being used right now in UMass Boston for AF310 and AF311 lsquoIntermediate Accountingrsquo by Kieso Weygandt and Warfield The IFRS accounting for intangible assets was the x variable I used to prove my y variables which are increased transparency and better stakeholder management I must mention that this research greatly benefited from the articles posted by Intangibles Business Ltd The research resources I have used are archives real data literature interviews reviews and the research facilities available at UMASS in the Healey library database The databases I have used are Business Source Premier Lexis Nexis Academic 11

Ebrary and the Wall Street Journal for articles Besides these I have also used other UMB resources like the CM faculty the CM Business Center and the advice and guidance of the Accounting and Management Department faculty

METHODOLOGY I have used an analytical as well as a theoretical framework to prove my research objective My research can be divided into three stages Stage one involves analysis involves looking at the standards for intangible assets and goodwill under IFRS UK GAAP and US GAAP and making comparisons This is followed by Stage two- the analysis of the reconciliations of Balance Sheets of a sample of 10 companies and interpret the data to prove the increased transparency under IFRS In Stage three The stakeholder theory which I have explained in detailed in a later section has been to used to prove how this increased transparency has lead to better stakeholder management ie provides managers with a number of alternatives to serve stakeholders in a better manner which would ultimately prove beneficial to business In the end I use the stakeholder theory again to prove the general effectiveness of the IFRS using the information in surveys conducted Empirically my research could be summarized in the following steps- collection of data questioning of the information collected forming conclusions and finally putting together all of my research on paper The diagram on the next page summarizes the structure and organization of my thesis 12

Accounting for intangible assets Sample analysis Using the stakeholder theory

IFRS 3 US GAAP

SFAS 141

SFAS 142

UK GAAP

FRS 10

Comparisons and differences

Analysis of reconciliatory statements of sample of 10 European companies that have transitioned to the IFRS

INCREASED TRANSPARENCY

Interpretation of data on intangible assets and goodwill

IFRS

IFRS 3

Investors

Government

Suppliers Customers Creditors

Society 13

US GAAP

ANALYSIS

STAGE 1 ACCOUNTING FOR INTANGIBLE ASSETS This stage involves a comparison of accounting for intangibles under IFRS US GAAP and UK GAAP

SFAS 141

SFAS 142

UK GAAP

FRS 10

Comparisons

and

differences IFRS 3 14

Introducing concepts Intangible assets Goodwill Intangible assets The Uniform Commercial Code (Section 9-102(a)(42)) defines general intangibles as any personal property other than accounts chattel paper commercial tort claims deposit accounts documents goods instruments investment property letter of credit rights letters of credit money and oil gas or other minerals before extraction The term includes payment intangibles and software In todayrsquos global economy dominated by information and service providers intangible assets constitute a major proportion of total assets Intangible assets command an increasingly large proportion of a companyrsquos value and this value has largely not been recognized In heavily branded consumer businesses such as Coca Cola or Nike brands account to up to 80 of the companyrsquos value In other industries such as pharmaceutical patents and copyrights are more prominent(Thaynes1 ) Thus Microsoftrsquos software Cokersquos secret formula and America Onlinersquos subscription base are the most important assets on their balance sheets Infact the value of tangible assets as a percentage of all assets has been steadily decreasing as shown in the graph below which is provided by the Federal Reserve Board but which is recreated by me for this thesisrsquos purpose The original graph is attached 80 70 60 5055 Years lsquo00 15

While intangibles are potential sources of income their values can erode just as quickly Just before Winstar Communications filed for bankruptcy in 2001 their assets were listed at 5 billion dollars However on liquidation the assets fetched just 42 million dollars due to decline in the value of intangibles Traditional assessment of national economic performance has relied upon understanding the GDP in terms of traditional factors of production ndash land labor and capital Knowledge assets may be distinguished from the traditional factors of production ndash in that they are governed by what has been described as the lsquolaw of increasing returnsrsquo In contrast to the traditional factors of production that were governed by diminishing returns every additional unit of knowledge used effectively results in a marginal increase in performance Success of companies such as Microsoft is often attributed to the fact that every additional unit of information-based product or service would result in an increase in the marginal returns Given the changing dynamics underlying national performance it is not surprising that some less developed economies with significant assets in ICT knowledge and Internet-related expertise are hoping to leapfrog more developed economies ( Malhotra2000) Intangible assets have two main characteristics- they lack physical existence and they are not financial instruments Intangible assets derive their value from the rights and privileges granted to the company using them (Kieso Weygandt and Warfield570) Intangible assets are further classified as limited life intangibles or indefinite life intangibles Limited life intangibles have a known useful life and indefinite life intangibles are intangibles whose useful life cannot be determined Accounting treatment for the intangibles vary according to their type which we shall look more in detail in the next section When intangibles are purchased from other parties they are most recorded at the 16

cost of purchase or fair market value under most accounting systems This cost includes all the expenses incurred to make the asset ready for use These include its purchase price legal fees and incidental expenses Internally generated intangibles are generally expensed as incurred All the research and development costs that companies have to incur to come up with the asset are expensed in the income statement The six major categories of intangible assets are marketing ndashrelated intangible assets customer-related intangible assets artistic-related intangible assets contract-related intangible assets technology-related intangible assets and goodwill Marketing - related intangibles assets are those assets used in the marketing or promotion of products These include trademark trade names and internet domain names Customer-related intangible assets include assets such as customer contracts customer relationships subscriber lists customer orders and backlogs and core deposits Artistic ndash related intangible assets include ownership rights to plays literary works musical works etc Contract ndashrelated intangible assets include licenses non-competition agreements and various other agreements and contract rights Goodwill is an important component of intangible assets and comes into play during business acquisitions and mergers Goodwill can be internally created or purchased goodwill Accounting treatment for goodwill differs according to its type and the accounting standards followed 17

Goodwill Goodwill is the excess of the purchase price over the fair market value of an asset during a business combination Some of the reasons why a business would be worth more than the sum of the fair values of the accountable and identifiable net assets of that business are- The expertise of the workforce mdash current accounting practices do not normally recognize the value of human resources as an asset on the balance sheet The reputation of the product(s) of the business mdash if the product has a well known name attached to it then sales and profits will be boosted on the basis of reputation alone The general economic environment mdash levels of interest rates and exchange rates and levels of investor confidence generally will clearly have a major influence on the value of businesses and hence on the amount of goodwill attaching to a business( Robins2000) Goodwill is often referred to as the most intangible of all intangible assets The problem of determining the proper cost to allocate to intangible assets in a business combination is complex because of the many different types of intangibles that might be considered It is extremely difficult not only to identify certain types of intangibles but also to assign a value to them in a business combination As a result the approach followed is to record identifiable intangible assets that can be reliably measured Other intangible assets that are difficult to identify or measure are recorded as goodwill (KiesoWeygandt and Warfield 578) 18

IFRS accounting for business combinations The three IFRS standards impacting accounting for intangible assets are IFRS3 Business Combinations IAS36 Impairment of Assets and IAS38 Intangible Assets These three standards are applicable to intangible assets and goodwill acquired on or after 31 March 2004IAS38 prescribes accounting treatment for the recognition of internally generated and acquired intangible assets IAS38 prescribes the rules for impairment testing of assets and goodwill IFRS3 prescribes the overall treatment for accounting for acquired assets and goodwill in a business combination The three standards can be summarized as follows- Acquired intangible assets Business combinations are accounted for using the purchase method ie accounting from the perspective of the acquirer Intangible assets are initially recognized at cost based on the following criteria-

1) They are identifiable

2) The probable future economic benefits created by them will benefit the organization

3) The measurement of their cost is reliable

After their initial recognition intangible assets may be carried at their cost or revalued amount less any accumulated amortization or impairment losses Their revaluation amount is their fair value at the date of revaluation If there is an increase in the amount of carrying value after revaluation is credited to a revaluation surplus account 19

Internally Generated Intangible assets Internally generated goodwill brands mastheads publishing titles customer lists are not recognized as intangible assets Research and development costs are generally expensed They can however be treated as an intangible asset if they meet the following criteria-

bull They are identifiable

bull The probable future economic benefits created by them will benefit the organization

bull The measurement of their cost is reliable

Goodwill Internally generated goodwill is not recognized The only goodwill recognized is as a result of business combinations Goodwill represents the difference between the total purchase consideration and the total of the fair value of all acquired assets and liabilities assumed If the fair value of the assets exceed the purchase consideration then the acquirer must reassess and identify all the assets and immediately after reassessment must recognize the negative goodwill as a profit in the income statement Impairment testing The useful life of the asset is determined If the asset has a finite useful life it should be amortized over its life For assets with indefinite useful life annual impairment testing is required The test involves a comparison of the carrying value of the asset with its 20

estimated recoverable amount The recoverable is defined as the higher of the value less costs to sell and the value in use The in use is generally based on the discounted future cash flows from the asset When the recoverable amount is found to be lower than the carrying value the carrying value is reduced to the recoverable amount with a charge to profits(Caldwell4)

US GAAP accounting for Business Combinations The standards that prescribe treatment for accounting for Business Combinations are SFAS141 Business Combinations and SFAS 142 Goodwill and other intangible assets The treatment can be summarized as follows- Acquired intangible assets Recorded cost 1)Acquired intangibles are recorded at cost and this cost includes the purchase price and all costs incurred to bring the asset to its intended use 2) In cases where the asset is acquired in exchange for stock or other assets the cost of the asset is the fair value of the consideration given or the fair value of the intangible received whichever is more clear 3) In the case of a lsquobasket purchasersquo cost is allocated on the basis of fair market values of assets acquired Amortization Assets with limited useful life are amortized over life of the asset The asset generates cash flows over such a useful life and the amortization method should to a certain extent 21

reflect the pattern in which the asset is used up if that could be determined If the usage pattern cannot be determined then the straight-line method is used Assets with indefinite life are not amortized Internally Generated Intangibles Costs related to internally generated intangibles are expensed as incurred Research and development costs related to intangibles are expensed and appear in the income statement Only direct costs incurred in obtaining intangibles including legal costs are capitalized Goodwill Goodwill recognized is the difference between the purchase consideration and the fair value of assets It appears on the balance sheet Internally generated goodwill is not recognized The impairment rule for goodwill involves two steps First the fair value of the reporting unit should be compared to its carrying amount including goodwill If the fair value of the reporting unit is greater than the carrying amount goodwill is considered not to be impaired and the company does not have to do anything else (Kieso Weygandt and Warfield593) Impairment testing of intangibles Impairment refers to the write-off or reduction in value of the asset that has to be carried out when the carrying amount of a long-lived asset is not recoverable When the carrying value of an intangible is not recoverable impairment is carried Impairment testing for indefinite life intangibles just involves a fair value test For limited life intangibles impairment is based on a recoverability test and a fair value test Goodwill impairments are based on a fair value test 22

Types of intangible asset Impairment test Limited life Recoverability test then fair value test Indefinite life other than goodwill Fair value test Goodwill Fair value test on reporting unit then fair value test on implied goodwill (Kieso Weygandt and Warfield584)

Pre-IFRS UK GAAP accounting for Business Combinations Starting 2005 all the 25 nations in the European Union including the United Kingdom have adopted the IFRS The pre-IFRS UK GAAP is no longer functional The FRS10 Goodwill and Intangible assets used to prescribe the rules for accounting for Intangibles and Goodwill The Deloitte and Touche publication lsquoGAAP 2004rsquo summarizes the key features of this standard as follows-

bull Internally generated goodwill may not be recognized Purchased goodwill is capitalized and classified as an asset

bull Internally developed intangible assets are recognized only if they have a readily ascertainable market value Purchased intangible assets are capitalized Intangible assets acquired as a part of a business combination are recognized only if they are separable and can be measured reliably

bull Goodwill and intangible assets are amortized over their useful economic lives if this is finite or not amortized if this is indefinite Negative goodwill is classified alongside positive goodwill and amortized

23

bull When the period of amortization exceeds 20 years an impairment test is carried out annually In other cases an impairment test at the end of the first full year after acquisition and then if there is an indicator of impairment

COMPARING THE IFRS TO US GAAP AND PRE-IFRS UK GAAP BUSINESS COMBINATIONS IFRS 3 vs UK GAAP The major differences between the IFRS 3 and FRS provisions for accounting for business combinations are as follows- End of merger accounting and pooling of assets An important requirement of the IFRS 3 is that business acquisitions be accounted for using the purchase method from the perspective of the acquirer This nullifies the UK GAAP provision of allowing companies to use merger accounting where they simply pooled together their balance sheet thus not recognizing goodwill The IFRS provision makes it mandatory for companies to recognize goodwill Goodwill no longer amortized Goodwill is no longer amortized but is instead subjected to a stringent annual impairment test In the event that it is impaired an immediate charge will be taken to the profit and loss account so poor performing acquisitions will be highlighted through such a charge sooner rather than later This represents a fundamental shift in the way goodwill 24

is viewed Goodwill is seen no longer a s steadily wasting asset but instead as one that should be expected to maintain its value(Hadjiloucas and Winter2) More Intangible Assets recognized Historically under UK GAAP when a deal was completed acquired intangible assets would generally just be subsumed within a pot marked lsquogoodwillrsquo The major benefit was that by amortizing this goodwill evenly over a period of usually 20 years you could predict with greater accuracy the impact on earnings (Stevenson and Mc Phee 82) However IFRS 3 requires that all identifiable and valuable intangible assets be reported on the balance sheet The acquirer needs to recognize purchased intangibles on the Balance Sheet More Disclosures The IFRS 3 requires that detailed disclosures be made about transactions and the purchase price allocation method utilized Detailed information about impairment testing of assets and goodwill also needs to be disclosed Strict criteria for determining useful life Limited life intangibles can be amortized over their useful life However management now needs to be more stringent about classifying assets as having a definite or indefinite useful life An indefinite life assertion needs to be backed by evidence and analysis supporting that no legal regulatory contractual competitive economic or other factors limit the life of the asset (Hadjiloucas and Winter3) 25

UK GAAP IFRS Merging accounting and pooling of assets used

No merger accounting allowed all combinations accounted for using the purchase method

Goodwill amortized over life of the asset

Goodwill tested for impairment annually

Fewer capitalized intangible assets More intangibles identified and recognized on acquisition

Details of purchase price allocation not essentially required to be disclosed

Details of purchase price allocation need to be disclosed

a voluntary basis GAAP principally developed by the Financial Accounting Standards Board (FASB) are more extensive than IFRS - comprising hundreds of standards interpretations opinions and other authoritative rules (Martin 2004) Some of the accounting areas in which the US GAAP differs from the IFRS are-

bull Tangible assets

bull Available for sale marketable securities

bull Intangible assets

bull Research and development expenditures

bull Leases

bull Inventory

IASB-FASB CONVERGENCE PROJECTS In September 2002 the FASB and the IASB reached an agreement to conduct a short-term project to work towards eliminating the differences between the IFRS and US GAAP The SEC also made an announcement in the same month in which it said that starting in 2007 it might allow foreign companies which are trying to raise capital in the US to use the IFRS rather than reconciling to US GAAP as they do right now Convergence is supposed to ease the task of raising capital Once the process is complete investors will need less help comparing results of competing firms based in different countries US companies that conform to GAAP will be able to raise capital abroad without reconciling their results to IFRS (Reason 2005 2) The FASB and IASB are 8

also working together on a number of long-term projects that deal with concepts like business combinations employee benefits and comprehensive income

LITERATURE REVIEW I have analyzed and compare the reconciliatory Balance Sheets of 10 European countries I chose these companies from different sectors of the European economy and have written about their performance For the theoretical framework I use the stakeholder theory The stakeholder research tradition began to unfold in the wake of R Edward Freemanrsquos seminal book Strategic Management A Stakeholders Approach which was published in the mid-1980s The book initiated a still ongoing academic discussion It demonstrated in a comprehensive fashion that strategic management of private sector firms could become much more effective and efficient if managerial efforts regard various stakeholders concerns Or in other words shareholders benefit long-term if other legitimate interests in the firm do not fall by the wayside (Scholl 2)Thus besides shareholders the interests of other stakeholders in and outside the organization had to be taken into consideration while making managerial decisions and implementing policies Stakeholder theory suggests that an organization has relationships with many constituent groups or stakeholders(Covell 2004) that affect and are affected by its decisions (Freeman 1984) A major purpose of stakeholder theory is to help corporate managers understand their stakeholder environments and manage more effectively within the nexus of relationships that exists for their companies However a larger purpose of stakeholder theory is to help corporate managers improve the value of the outcomes of 9

their actions and minimize the harms to stakeholders The whole point of stakeholder theory in fact lies in what happens when corporations and stakeholders act out of their relationships (Logsdon and Wood 3) The stakeholder theory involves answering three important questions- Who are the organizationrsquos stakeholders for accounting standards This step involves identification of the organizationrsquos stakeholders Stakeholders are defined as those individuals that have a stake in the performance of an organization that the interests of all legitimate stakeholders have intrinsic value and that no set of interests is assumed to dominate the others (Donaldson amp Preston 1995) In the Ivey Business Journal Robert Philips writes that stakeholders are those groups from whom the organization has voluntarily accepted benefits and to whom the organization has therefore incurred obligations of fairness Typically this includes groups such as financiers employees customers suppliers and local communities (Philips 2004 2) Stakeholder theory holds that besides these legitimate stakeholders derivative stakeholders like competitors or activist groups are important as their actions can influence the corporation Why are the stakeholders important for accounting standards Brenner and Cochran comment that the stakeholder theory of the firm posits that the nature of an organizations stakeholders their values their relative influence on decisions and the nature of the situation are all relevant information for predicting organizational behavior(1991 p 462) Milton Friedman uses the property rights argument stating that shareholders own an organization as they own the equity shares and if they desire to 10

maximize the value of their investment it is the managerrsquos duty to work in accordance Managers who fail to do so violate the moral property right (Mitchell et al 1997) note that stakeholder theory has managerial importance because it can determine to what and to whom managers need to listen and give attention What do Stakeholders want Different people want different things from their relationships with organizations Stakeholder discussions often focus on allocating some measure of organizational value or outcome (eg who gets how much money from the firm) The question of how the organization creates this value usually gets less attention but it is certainly not less important Not all stakeholders want a voice in organizational decision-making but those who do desire a voice should have it (Philips 2004 2) My literature sources had to be organized into three data sets-IFRS standards US GAAP and pre ndashIFRS UK GAAP My documents for analyzing the IFRS were the web summaries put up on the International Accounting Standards Board site For pre-IFRS UK GAAP I referred primarily to the Deloitte and Touche publication lsquoGAAP 2004rsquo For the US GAAP I referred to the textbook being used right now in UMass Boston for AF310 and AF311 lsquoIntermediate Accountingrsquo by Kieso Weygandt and Warfield The IFRS accounting for intangible assets was the x variable I used to prove my y variables which are increased transparency and better stakeholder management I must mention that this research greatly benefited from the articles posted by Intangibles Business Ltd The research resources I have used are archives real data literature interviews reviews and the research facilities available at UMASS in the Healey library database The databases I have used are Business Source Premier Lexis Nexis Academic 11

Ebrary and the Wall Street Journal for articles Besides these I have also used other UMB resources like the CM faculty the CM Business Center and the advice and guidance of the Accounting and Management Department faculty

METHODOLOGY I have used an analytical as well as a theoretical framework to prove my research objective My research can be divided into three stages Stage one involves analysis involves looking at the standards for intangible assets and goodwill under IFRS UK GAAP and US GAAP and making comparisons This is followed by Stage two- the analysis of the reconciliations of Balance Sheets of a sample of 10 companies and interpret the data to prove the increased transparency under IFRS In Stage three The stakeholder theory which I have explained in detailed in a later section has been to used to prove how this increased transparency has lead to better stakeholder management ie provides managers with a number of alternatives to serve stakeholders in a better manner which would ultimately prove beneficial to business In the end I use the stakeholder theory again to prove the general effectiveness of the IFRS using the information in surveys conducted Empirically my research could be summarized in the following steps- collection of data questioning of the information collected forming conclusions and finally putting together all of my research on paper The diagram on the next page summarizes the structure and organization of my thesis 12

Accounting for intangible assets Sample analysis Using the stakeholder theory

IFRS 3 US GAAP

SFAS 141

SFAS 142

UK GAAP

FRS 10

Comparisons and differences

Analysis of reconciliatory statements of sample of 10 European companies that have transitioned to the IFRS

INCREASED TRANSPARENCY

Interpretation of data on intangible assets and goodwill

IFRS

IFRS 3

Investors

Government

Suppliers Customers Creditors

Society 13

US GAAP

ANALYSIS

STAGE 1 ACCOUNTING FOR INTANGIBLE ASSETS This stage involves a comparison of accounting for intangibles under IFRS US GAAP and UK GAAP

SFAS 141

SFAS 142

UK GAAP

FRS 10

Comparisons

and

differences IFRS 3 14

Introducing concepts Intangible assets Goodwill Intangible assets The Uniform Commercial Code (Section 9-102(a)(42)) defines general intangibles as any personal property other than accounts chattel paper commercial tort claims deposit accounts documents goods instruments investment property letter of credit rights letters of credit money and oil gas or other minerals before extraction The term includes payment intangibles and software In todayrsquos global economy dominated by information and service providers intangible assets constitute a major proportion of total assets Intangible assets command an increasingly large proportion of a companyrsquos value and this value has largely not been recognized In heavily branded consumer businesses such as Coca Cola or Nike brands account to up to 80 of the companyrsquos value In other industries such as pharmaceutical patents and copyrights are more prominent(Thaynes1 ) Thus Microsoftrsquos software Cokersquos secret formula and America Onlinersquos subscription base are the most important assets on their balance sheets Infact the value of tangible assets as a percentage of all assets has been steadily decreasing as shown in the graph below which is provided by the Federal Reserve Board but which is recreated by me for this thesisrsquos purpose The original graph is attached 80 70 60 5055 Years lsquo00 15

While intangibles are potential sources of income their values can erode just as quickly Just before Winstar Communications filed for bankruptcy in 2001 their assets were listed at 5 billion dollars However on liquidation the assets fetched just 42 million dollars due to decline in the value of intangibles Traditional assessment of national economic performance has relied upon understanding the GDP in terms of traditional factors of production ndash land labor and capital Knowledge assets may be distinguished from the traditional factors of production ndash in that they are governed by what has been described as the lsquolaw of increasing returnsrsquo In contrast to the traditional factors of production that were governed by diminishing returns every additional unit of knowledge used effectively results in a marginal increase in performance Success of companies such as Microsoft is often attributed to the fact that every additional unit of information-based product or service would result in an increase in the marginal returns Given the changing dynamics underlying national performance it is not surprising that some less developed economies with significant assets in ICT knowledge and Internet-related expertise are hoping to leapfrog more developed economies ( Malhotra2000) Intangible assets have two main characteristics- they lack physical existence and they are not financial instruments Intangible assets derive their value from the rights and privileges granted to the company using them (Kieso Weygandt and Warfield570) Intangible assets are further classified as limited life intangibles or indefinite life intangibles Limited life intangibles have a known useful life and indefinite life intangibles are intangibles whose useful life cannot be determined Accounting treatment for the intangibles vary according to their type which we shall look more in detail in the next section When intangibles are purchased from other parties they are most recorded at the 16

cost of purchase or fair market value under most accounting systems This cost includes all the expenses incurred to make the asset ready for use These include its purchase price legal fees and incidental expenses Internally generated intangibles are generally expensed as incurred All the research and development costs that companies have to incur to come up with the asset are expensed in the income statement The six major categories of intangible assets are marketing ndashrelated intangible assets customer-related intangible assets artistic-related intangible assets contract-related intangible assets technology-related intangible assets and goodwill Marketing - related intangibles assets are those assets used in the marketing or promotion of products These include trademark trade names and internet domain names Customer-related intangible assets include assets such as customer contracts customer relationships subscriber lists customer orders and backlogs and core deposits Artistic ndash related intangible assets include ownership rights to plays literary works musical works etc Contract ndashrelated intangible assets include licenses non-competition agreements and various other agreements and contract rights Goodwill is an important component of intangible assets and comes into play during business acquisitions and mergers Goodwill can be internally created or purchased goodwill Accounting treatment for goodwill differs according to its type and the accounting standards followed 17

Goodwill Goodwill is the excess of the purchase price over the fair market value of an asset during a business combination Some of the reasons why a business would be worth more than the sum of the fair values of the accountable and identifiable net assets of that business are- The expertise of the workforce mdash current accounting practices do not normally recognize the value of human resources as an asset on the balance sheet The reputation of the product(s) of the business mdash if the product has a well known name attached to it then sales and profits will be boosted on the basis of reputation alone The general economic environment mdash levels of interest rates and exchange rates and levels of investor confidence generally will clearly have a major influence on the value of businesses and hence on the amount of goodwill attaching to a business( Robins2000) Goodwill is often referred to as the most intangible of all intangible assets The problem of determining the proper cost to allocate to intangible assets in a business combination is complex because of the many different types of intangibles that might be considered It is extremely difficult not only to identify certain types of intangibles but also to assign a value to them in a business combination As a result the approach followed is to record identifiable intangible assets that can be reliably measured Other intangible assets that are difficult to identify or measure are recorded as goodwill (KiesoWeygandt and Warfield 578) 18

IFRS accounting for business combinations The three IFRS standards impacting accounting for intangible assets are IFRS3 Business Combinations IAS36 Impairment of Assets and IAS38 Intangible Assets These three standards are applicable to intangible assets and goodwill acquired on or after 31 March 2004IAS38 prescribes accounting treatment for the recognition of internally generated and acquired intangible assets IAS38 prescribes the rules for impairment testing of assets and goodwill IFRS3 prescribes the overall treatment for accounting for acquired assets and goodwill in a business combination The three standards can be summarized as follows- Acquired intangible assets Business combinations are accounted for using the purchase method ie accounting from the perspective of the acquirer Intangible assets are initially recognized at cost based on the following criteria-

1) They are identifiable

2) The probable future economic benefits created by them will benefit the organization

3) The measurement of their cost is reliable

After their initial recognition intangible assets may be carried at their cost or revalued amount less any accumulated amortization or impairment losses Their revaluation amount is their fair value at the date of revaluation If there is an increase in the amount of carrying value after revaluation is credited to a revaluation surplus account 19

Internally Generated Intangible assets Internally generated goodwill brands mastheads publishing titles customer lists are not recognized as intangible assets Research and development costs are generally expensed They can however be treated as an intangible asset if they meet the following criteria-

bull They are identifiable

bull The probable future economic benefits created by them will benefit the organization

bull The measurement of their cost is reliable

Goodwill Internally generated goodwill is not recognized The only goodwill recognized is as a result of business combinations Goodwill represents the difference between the total purchase consideration and the total of the fair value of all acquired assets and liabilities assumed If the fair value of the assets exceed the purchase consideration then the acquirer must reassess and identify all the assets and immediately after reassessment must recognize the negative goodwill as a profit in the income statement Impairment testing The useful life of the asset is determined If the asset has a finite useful life it should be amortized over its life For assets with indefinite useful life annual impairment testing is required The test involves a comparison of the carrying value of the asset with its 20

estimated recoverable amount The recoverable is defined as the higher of the value less costs to sell and the value in use The in use is generally based on the discounted future cash flows from the asset When the recoverable amount is found to be lower than the carrying value the carrying value is reduced to the recoverable amount with a charge to profits(Caldwell4)

US GAAP accounting for Business Combinations The standards that prescribe treatment for accounting for Business Combinations are SFAS141 Business Combinations and SFAS 142 Goodwill and other intangible assets The treatment can be summarized as follows- Acquired intangible assets Recorded cost 1)Acquired intangibles are recorded at cost and this cost includes the purchase price and all costs incurred to bring the asset to its intended use 2) In cases where the asset is acquired in exchange for stock or other assets the cost of the asset is the fair value of the consideration given or the fair value of the intangible received whichever is more clear 3) In the case of a lsquobasket purchasersquo cost is allocated on the basis of fair market values of assets acquired Amortization Assets with limited useful life are amortized over life of the asset The asset generates cash flows over such a useful life and the amortization method should to a certain extent 21

reflect the pattern in which the asset is used up if that could be determined If the usage pattern cannot be determined then the straight-line method is used Assets with indefinite life are not amortized Internally Generated Intangibles Costs related to internally generated intangibles are expensed as incurred Research and development costs related to intangibles are expensed and appear in the income statement Only direct costs incurred in obtaining intangibles including legal costs are capitalized Goodwill Goodwill recognized is the difference between the purchase consideration and the fair value of assets It appears on the balance sheet Internally generated goodwill is not recognized The impairment rule for goodwill involves two steps First the fair value of the reporting unit should be compared to its carrying amount including goodwill If the fair value of the reporting unit is greater than the carrying amount goodwill is considered not to be impaired and the company does not have to do anything else (Kieso Weygandt and Warfield593) Impairment testing of intangibles Impairment refers to the write-off or reduction in value of the asset that has to be carried out when the carrying amount of a long-lived asset is not recoverable When the carrying value of an intangible is not recoverable impairment is carried Impairment testing for indefinite life intangibles just involves a fair value test For limited life intangibles impairment is based on a recoverability test and a fair value test Goodwill impairments are based on a fair value test 22

Types of intangible asset Impairment test Limited life Recoverability test then fair value test Indefinite life other than goodwill Fair value test Goodwill Fair value test on reporting unit then fair value test on implied goodwill (Kieso Weygandt and Warfield584)

Pre-IFRS UK GAAP accounting for Business Combinations Starting 2005 all the 25 nations in the European Union including the United Kingdom have adopted the IFRS The pre-IFRS UK GAAP is no longer functional The FRS10 Goodwill and Intangible assets used to prescribe the rules for accounting for Intangibles and Goodwill The Deloitte and Touche publication lsquoGAAP 2004rsquo summarizes the key features of this standard as follows-

bull Internally generated goodwill may not be recognized Purchased goodwill is capitalized and classified as an asset

bull Internally developed intangible assets are recognized only if they have a readily ascertainable market value Purchased intangible assets are capitalized Intangible assets acquired as a part of a business combination are recognized only if they are separable and can be measured reliably

bull Goodwill and intangible assets are amortized over their useful economic lives if this is finite or not amortized if this is indefinite Negative goodwill is classified alongside positive goodwill and amortized

23

bull When the period of amortization exceeds 20 years an impairment test is carried out annually In other cases an impairment test at the end of the first full year after acquisition and then if there is an indicator of impairment

COMPARING THE IFRS TO US GAAP AND PRE-IFRS UK GAAP BUSINESS COMBINATIONS IFRS 3 vs UK GAAP The major differences between the IFRS 3 and FRS provisions for accounting for business combinations are as follows- End of merger accounting and pooling of assets An important requirement of the IFRS 3 is that business acquisitions be accounted for using the purchase method from the perspective of the acquirer This nullifies the UK GAAP provision of allowing companies to use merger accounting where they simply pooled together their balance sheet thus not recognizing goodwill The IFRS provision makes it mandatory for companies to recognize goodwill Goodwill no longer amortized Goodwill is no longer amortized but is instead subjected to a stringent annual impairment test In the event that it is impaired an immediate charge will be taken to the profit and loss account so poor performing acquisitions will be highlighted through such a charge sooner rather than later This represents a fundamental shift in the way goodwill 24

is viewed Goodwill is seen no longer a s steadily wasting asset but instead as one that should be expected to maintain its value(Hadjiloucas and Winter2) More Intangible Assets recognized Historically under UK GAAP when a deal was completed acquired intangible assets would generally just be subsumed within a pot marked lsquogoodwillrsquo The major benefit was that by amortizing this goodwill evenly over a period of usually 20 years you could predict with greater accuracy the impact on earnings (Stevenson and Mc Phee 82) However IFRS 3 requires that all identifiable and valuable intangible assets be reported on the balance sheet The acquirer needs to recognize purchased intangibles on the Balance Sheet More Disclosures The IFRS 3 requires that detailed disclosures be made about transactions and the purchase price allocation method utilized Detailed information about impairment testing of assets and goodwill also needs to be disclosed Strict criteria for determining useful life Limited life intangibles can be amortized over their useful life However management now needs to be more stringent about classifying assets as having a definite or indefinite useful life An indefinite life assertion needs to be backed by evidence and analysis supporting that no legal regulatory contractual competitive economic or other factors limit the life of the asset (Hadjiloucas and Winter3) 25

UK GAAP IFRS Merging accounting and pooling of assets used

No merger accounting allowed all combinations accounted for using the purchase method

Goodwill amortized over life of the asset

Goodwill tested for impairment annually

Fewer capitalized intangible assets More intangibles identified and recognized on acquisition

Details of purchase price allocation not essentially required to be disclosed

Details of purchase price allocation need to be disclosed

also working together on a number of long-term projects that deal with concepts like business combinations employee benefits and comprehensive income

LITERATURE REVIEW I have analyzed and compare the reconciliatory Balance Sheets of 10 European countries I chose these companies from different sectors of the European economy and have written about their performance For the theoretical framework I use the stakeholder theory The stakeholder research tradition began to unfold in the wake of R Edward Freemanrsquos seminal book Strategic Management A Stakeholders Approach which was published in the mid-1980s The book initiated a still ongoing academic discussion It demonstrated in a comprehensive fashion that strategic management of private sector firms could become much more effective and efficient if managerial efforts regard various stakeholders concerns Or in other words shareholders benefit long-term if other legitimate interests in the firm do not fall by the wayside (Scholl 2)Thus besides shareholders the interests of other stakeholders in and outside the organization had to be taken into consideration while making managerial decisions and implementing policies Stakeholder theory suggests that an organization has relationships with many constituent groups or stakeholders(Covell 2004) that affect and are affected by its decisions (Freeman 1984) A major purpose of stakeholder theory is to help corporate managers understand their stakeholder environments and manage more effectively within the nexus of relationships that exists for their companies However a larger purpose of stakeholder theory is to help corporate managers improve the value of the outcomes of 9

their actions and minimize the harms to stakeholders The whole point of stakeholder theory in fact lies in what happens when corporations and stakeholders act out of their relationships (Logsdon and Wood 3) The stakeholder theory involves answering three important questions- Who are the organizationrsquos stakeholders for accounting standards This step involves identification of the organizationrsquos stakeholders Stakeholders are defined as those individuals that have a stake in the performance of an organization that the interests of all legitimate stakeholders have intrinsic value and that no set of interests is assumed to dominate the others (Donaldson amp Preston 1995) In the Ivey Business Journal Robert Philips writes that stakeholders are those groups from whom the organization has voluntarily accepted benefits and to whom the organization has therefore incurred obligations of fairness Typically this includes groups such as financiers employees customers suppliers and local communities (Philips 2004 2) Stakeholder theory holds that besides these legitimate stakeholders derivative stakeholders like competitors or activist groups are important as their actions can influence the corporation Why are the stakeholders important for accounting standards Brenner and Cochran comment that the stakeholder theory of the firm posits that the nature of an organizations stakeholders their values their relative influence on decisions and the nature of the situation are all relevant information for predicting organizational behavior(1991 p 462) Milton Friedman uses the property rights argument stating that shareholders own an organization as they own the equity shares and if they desire to 10

maximize the value of their investment it is the managerrsquos duty to work in accordance Managers who fail to do so violate the moral property right (Mitchell et al 1997) note that stakeholder theory has managerial importance because it can determine to what and to whom managers need to listen and give attention What do Stakeholders want Different people want different things from their relationships with organizations Stakeholder discussions often focus on allocating some measure of organizational value or outcome (eg who gets how much money from the firm) The question of how the organization creates this value usually gets less attention but it is certainly not less important Not all stakeholders want a voice in organizational decision-making but those who do desire a voice should have it (Philips 2004 2) My literature sources had to be organized into three data sets-IFRS standards US GAAP and pre ndashIFRS UK GAAP My documents for analyzing the IFRS were the web summaries put up on the International Accounting Standards Board site For pre-IFRS UK GAAP I referred primarily to the Deloitte and Touche publication lsquoGAAP 2004rsquo For the US GAAP I referred to the textbook being used right now in UMass Boston for AF310 and AF311 lsquoIntermediate Accountingrsquo by Kieso Weygandt and Warfield The IFRS accounting for intangible assets was the x variable I used to prove my y variables which are increased transparency and better stakeholder management I must mention that this research greatly benefited from the articles posted by Intangibles Business Ltd The research resources I have used are archives real data literature interviews reviews and the research facilities available at UMASS in the Healey library database The databases I have used are Business Source Premier Lexis Nexis Academic 11

Ebrary and the Wall Street Journal for articles Besides these I have also used other UMB resources like the CM faculty the CM Business Center and the advice and guidance of the Accounting and Management Department faculty

METHODOLOGY I have used an analytical as well as a theoretical framework to prove my research objective My research can be divided into three stages Stage one involves analysis involves looking at the standards for intangible assets and goodwill under IFRS UK GAAP and US GAAP and making comparisons This is followed by Stage two- the analysis of the reconciliations of Balance Sheets of a sample of 10 companies and interpret the data to prove the increased transparency under IFRS In Stage three The stakeholder theory which I have explained in detailed in a later section has been to used to prove how this increased transparency has lead to better stakeholder management ie provides managers with a number of alternatives to serve stakeholders in a better manner which would ultimately prove beneficial to business In the end I use the stakeholder theory again to prove the general effectiveness of the IFRS using the information in surveys conducted Empirically my research could be summarized in the following steps- collection of data questioning of the information collected forming conclusions and finally putting together all of my research on paper The diagram on the next page summarizes the structure and organization of my thesis 12

Accounting for intangible assets Sample analysis Using the stakeholder theory

IFRS 3 US GAAP

SFAS 141

SFAS 142

UK GAAP

FRS 10

Comparisons and differences

Analysis of reconciliatory statements of sample of 10 European companies that have transitioned to the IFRS

INCREASED TRANSPARENCY

Interpretation of data on intangible assets and goodwill

IFRS

IFRS 3

Investors

Government

Suppliers Customers Creditors

Society 13

US GAAP

ANALYSIS

STAGE 1 ACCOUNTING FOR INTANGIBLE ASSETS This stage involves a comparison of accounting for intangibles under IFRS US GAAP and UK GAAP

SFAS 141

SFAS 142

UK GAAP

FRS 10

Comparisons

and

differences IFRS 3 14

Introducing concepts Intangible assets Goodwill Intangible assets The Uniform Commercial Code (Section 9-102(a)(42)) defines general intangibles as any personal property other than accounts chattel paper commercial tort claims deposit accounts documents goods instruments investment property letter of credit rights letters of credit money and oil gas or other minerals before extraction The term includes payment intangibles and software In todayrsquos global economy dominated by information and service providers intangible assets constitute a major proportion of total assets Intangible assets command an increasingly large proportion of a companyrsquos value and this value has largely not been recognized In heavily branded consumer businesses such as Coca Cola or Nike brands account to up to 80 of the companyrsquos value In other industries such as pharmaceutical patents and copyrights are more prominent(Thaynes1 ) Thus Microsoftrsquos software Cokersquos secret formula and America Onlinersquos subscription base are the most important assets on their balance sheets Infact the value of tangible assets as a percentage of all assets has been steadily decreasing as shown in the graph below which is provided by the Federal Reserve Board but which is recreated by me for this thesisrsquos purpose The original graph is attached 80 70 60 5055 Years lsquo00 15

While intangibles are potential sources of income their values can erode just as quickly Just before Winstar Communications filed for bankruptcy in 2001 their assets were listed at 5 billion dollars However on liquidation the assets fetched just 42 million dollars due to decline in the value of intangibles Traditional assessment of national economic performance has relied upon understanding the GDP in terms of traditional factors of production ndash land labor and capital Knowledge assets may be distinguished from the traditional factors of production ndash in that they are governed by what has been described as the lsquolaw of increasing returnsrsquo In contrast to the traditional factors of production that were governed by diminishing returns every additional unit of knowledge used effectively results in a marginal increase in performance Success of companies such as Microsoft is often attributed to the fact that every additional unit of information-based product or service would result in an increase in the marginal returns Given the changing dynamics underlying national performance it is not surprising that some less developed economies with significant assets in ICT knowledge and Internet-related expertise are hoping to leapfrog more developed economies ( Malhotra2000) Intangible assets have two main characteristics- they lack physical existence and they are not financial instruments Intangible assets derive their value from the rights and privileges granted to the company using them (Kieso Weygandt and Warfield570) Intangible assets are further classified as limited life intangibles or indefinite life intangibles Limited life intangibles have a known useful life and indefinite life intangibles are intangibles whose useful life cannot be determined Accounting treatment for the intangibles vary according to their type which we shall look more in detail in the next section When intangibles are purchased from other parties they are most recorded at the 16

cost of purchase or fair market value under most accounting systems This cost includes all the expenses incurred to make the asset ready for use These include its purchase price legal fees and incidental expenses Internally generated intangibles are generally expensed as incurred All the research and development costs that companies have to incur to come up with the asset are expensed in the income statement The six major categories of intangible assets are marketing ndashrelated intangible assets customer-related intangible assets artistic-related intangible assets contract-related intangible assets technology-related intangible assets and goodwill Marketing - related intangibles assets are those assets used in the marketing or promotion of products These include trademark trade names and internet domain names Customer-related intangible assets include assets such as customer contracts customer relationships subscriber lists customer orders and backlogs and core deposits Artistic ndash related intangible assets include ownership rights to plays literary works musical works etc Contract ndashrelated intangible assets include licenses non-competition agreements and various other agreements and contract rights Goodwill is an important component of intangible assets and comes into play during business acquisitions and mergers Goodwill can be internally created or purchased goodwill Accounting treatment for goodwill differs according to its type and the accounting standards followed 17

Goodwill Goodwill is the excess of the purchase price over the fair market value of an asset during a business combination Some of the reasons why a business would be worth more than the sum of the fair values of the accountable and identifiable net assets of that business are- The expertise of the workforce mdash current accounting practices do not normally recognize the value of human resources as an asset on the balance sheet The reputation of the product(s) of the business mdash if the product has a well known name attached to it then sales and profits will be boosted on the basis of reputation alone The general economic environment mdash levels of interest rates and exchange rates and levels of investor confidence generally will clearly have a major influence on the value of businesses and hence on the amount of goodwill attaching to a business( Robins2000) Goodwill is often referred to as the most intangible of all intangible assets The problem of determining the proper cost to allocate to intangible assets in a business combination is complex because of the many different types of intangibles that might be considered It is extremely difficult not only to identify certain types of intangibles but also to assign a value to them in a business combination As a result the approach followed is to record identifiable intangible assets that can be reliably measured Other intangible assets that are difficult to identify or measure are recorded as goodwill (KiesoWeygandt and Warfield 578) 18

IFRS accounting for business combinations The three IFRS standards impacting accounting for intangible assets are IFRS3 Business Combinations IAS36 Impairment of Assets and IAS38 Intangible Assets These three standards are applicable to intangible assets and goodwill acquired on or after 31 March 2004IAS38 prescribes accounting treatment for the recognition of internally generated and acquired intangible assets IAS38 prescribes the rules for impairment testing of assets and goodwill IFRS3 prescribes the overall treatment for accounting for acquired assets and goodwill in a business combination The three standards can be summarized as follows- Acquired intangible assets Business combinations are accounted for using the purchase method ie accounting from the perspective of the acquirer Intangible assets are initially recognized at cost based on the following criteria-

1) They are identifiable

2) The probable future economic benefits created by them will benefit the organization

3) The measurement of their cost is reliable

After their initial recognition intangible assets may be carried at their cost or revalued amount less any accumulated amortization or impairment losses Their revaluation amount is their fair value at the date of revaluation If there is an increase in the amount of carrying value after revaluation is credited to a revaluation surplus account 19

Internally Generated Intangible assets Internally generated goodwill brands mastheads publishing titles customer lists are not recognized as intangible assets Research and development costs are generally expensed They can however be treated as an intangible asset if they meet the following criteria-

bull They are identifiable

bull The probable future economic benefits created by them will benefit the organization

bull The measurement of their cost is reliable

Goodwill Internally generated goodwill is not recognized The only goodwill recognized is as a result of business combinations Goodwill represents the difference between the total purchase consideration and the total of the fair value of all acquired assets and liabilities assumed If the fair value of the assets exceed the purchase consideration then the acquirer must reassess and identify all the assets and immediately after reassessment must recognize the negative goodwill as a profit in the income statement Impairment testing The useful life of the asset is determined If the asset has a finite useful life it should be amortized over its life For assets with indefinite useful life annual impairment testing is required The test involves a comparison of the carrying value of the asset with its 20

estimated recoverable amount The recoverable is defined as the higher of the value less costs to sell and the value in use The in use is generally based on the discounted future cash flows from the asset When the recoverable amount is found to be lower than the carrying value the carrying value is reduced to the recoverable amount with a charge to profits(Caldwell4)

US GAAP accounting for Business Combinations The standards that prescribe treatment for accounting for Business Combinations are SFAS141 Business Combinations and SFAS 142 Goodwill and other intangible assets The treatment can be summarized as follows- Acquired intangible assets Recorded cost 1)Acquired intangibles are recorded at cost and this cost includes the purchase price and all costs incurred to bring the asset to its intended use 2) In cases where the asset is acquired in exchange for stock or other assets the cost of the asset is the fair value of the consideration given or the fair value of the intangible received whichever is more clear 3) In the case of a lsquobasket purchasersquo cost is allocated on the basis of fair market values of assets acquired Amortization Assets with limited useful life are amortized over life of the asset The asset generates cash flows over such a useful life and the amortization method should to a certain extent 21

reflect the pattern in which the asset is used up if that could be determined If the usage pattern cannot be determined then the straight-line method is used Assets with indefinite life are not amortized Internally Generated Intangibles Costs related to internally generated intangibles are expensed as incurred Research and development costs related to intangibles are expensed and appear in the income statement Only direct costs incurred in obtaining intangibles including legal costs are capitalized Goodwill Goodwill recognized is the difference between the purchase consideration and the fair value of assets It appears on the balance sheet Internally generated goodwill is not recognized The impairment rule for goodwill involves two steps First the fair value of the reporting unit should be compared to its carrying amount including goodwill If the fair value of the reporting unit is greater than the carrying amount goodwill is considered not to be impaired and the company does not have to do anything else (Kieso Weygandt and Warfield593) Impairment testing of intangibles Impairment refers to the write-off or reduction in value of the asset that has to be carried out when the carrying amount of a long-lived asset is not recoverable When the carrying value of an intangible is not recoverable impairment is carried Impairment testing for indefinite life intangibles just involves a fair value test For limited life intangibles impairment is based on a recoverability test and a fair value test Goodwill impairments are based on a fair value test 22

Types of intangible asset Impairment test Limited life Recoverability test then fair value test Indefinite life other than goodwill Fair value test Goodwill Fair value test on reporting unit then fair value test on implied goodwill (Kieso Weygandt and Warfield584)

Pre-IFRS UK GAAP accounting for Business Combinations Starting 2005 all the 25 nations in the European Union including the United Kingdom have adopted the IFRS The pre-IFRS UK GAAP is no longer functional The FRS10 Goodwill and Intangible assets used to prescribe the rules for accounting for Intangibles and Goodwill The Deloitte and Touche publication lsquoGAAP 2004rsquo summarizes the key features of this standard as follows-

bull Internally generated goodwill may not be recognized Purchased goodwill is capitalized and classified as an asset

bull Internally developed intangible assets are recognized only if they have a readily ascertainable market value Purchased intangible assets are capitalized Intangible assets acquired as a part of a business combination are recognized only if they are separable and can be measured reliably

bull Goodwill and intangible assets are amortized over their useful economic lives if this is finite or not amortized if this is indefinite Negative goodwill is classified alongside positive goodwill and amortized

23

bull When the period of amortization exceeds 20 years an impairment test is carried out annually In other cases an impairment test at the end of the first full year after acquisition and then if there is an indicator of impairment

COMPARING THE IFRS TO US GAAP AND PRE-IFRS UK GAAP BUSINESS COMBINATIONS IFRS 3 vs UK GAAP The major differences between the IFRS 3 and FRS provisions for accounting for business combinations are as follows- End of merger accounting and pooling of assets An important requirement of the IFRS 3 is that business acquisitions be accounted for using the purchase method from the perspective of the acquirer This nullifies the UK GAAP provision of allowing companies to use merger accounting where they simply pooled together their balance sheet thus not recognizing goodwill The IFRS provision makes it mandatory for companies to recognize goodwill Goodwill no longer amortized Goodwill is no longer amortized but is instead subjected to a stringent annual impairment test In the event that it is impaired an immediate charge will be taken to the profit and loss account so poor performing acquisitions will be highlighted through such a charge sooner rather than later This represents a fundamental shift in the way goodwill 24

is viewed Goodwill is seen no longer a s steadily wasting asset but instead as one that should be expected to maintain its value(Hadjiloucas and Winter2) More Intangible Assets recognized Historically under UK GAAP when a deal was completed acquired intangible assets would generally just be subsumed within a pot marked lsquogoodwillrsquo The major benefit was that by amortizing this goodwill evenly over a period of usually 20 years you could predict with greater accuracy the impact on earnings (Stevenson and Mc Phee 82) However IFRS 3 requires that all identifiable and valuable intangible assets be reported on the balance sheet The acquirer needs to recognize purchased intangibles on the Balance Sheet More Disclosures The IFRS 3 requires that detailed disclosures be made about transactions and the purchase price allocation method utilized Detailed information about impairment testing of assets and goodwill also needs to be disclosed Strict criteria for determining useful life Limited life intangibles can be amortized over their useful life However management now needs to be more stringent about classifying assets as having a definite or indefinite useful life An indefinite life assertion needs to be backed by evidence and analysis supporting that no legal regulatory contractual competitive economic or other factors limit the life of the asset (Hadjiloucas and Winter3) 25

UK GAAP IFRS Merging accounting and pooling of assets used

No merger accounting allowed all combinations accounted for using the purchase method

Goodwill amortized over life of the asset

Goodwill tested for impairment annually

Fewer capitalized intangible assets More intangibles identified and recognized on acquisition

Details of purchase price allocation not essentially required to be disclosed

Details of purchase price allocation need to be disclosed

their actions and minimize the harms to stakeholders The whole point of stakeholder theory in fact lies in what happens when corporations and stakeholders act out of their relationships (Logsdon and Wood 3) The stakeholder theory involves answering three important questions- Who are the organizationrsquos stakeholders for accounting standards This step involves identification of the organizationrsquos stakeholders Stakeholders are defined as those individuals that have a stake in the performance of an organization that the interests of all legitimate stakeholders have intrinsic value and that no set of interests is assumed to dominate the others (Donaldson amp Preston 1995) In the Ivey Business Journal Robert Philips writes that stakeholders are those groups from whom the organization has voluntarily accepted benefits and to whom the organization has therefore incurred obligations of fairness Typically this includes groups such as financiers employees customers suppliers and local communities (Philips 2004 2) Stakeholder theory holds that besides these legitimate stakeholders derivative stakeholders like competitors or activist groups are important as their actions can influence the corporation Why are the stakeholders important for accounting standards Brenner and Cochran comment that the stakeholder theory of the firm posits that the nature of an organizations stakeholders their values their relative influence on decisions and the nature of the situation are all relevant information for predicting organizational behavior(1991 p 462) Milton Friedman uses the property rights argument stating that shareholders own an organization as they own the equity shares and if they desire to 10

maximize the value of their investment it is the managerrsquos duty to work in accordance Managers who fail to do so violate the moral property right (Mitchell et al 1997) note that stakeholder theory has managerial importance because it can determine to what and to whom managers need to listen and give attention What do Stakeholders want Different people want different things from their relationships with organizations Stakeholder discussions often focus on allocating some measure of organizational value or outcome (eg who gets how much money from the firm) The question of how the organization creates this value usually gets less attention but it is certainly not less important Not all stakeholders want a voice in organizational decision-making but those who do desire a voice should have it (Philips 2004 2) My literature sources had to be organized into three data sets-IFRS standards US GAAP and pre ndashIFRS UK GAAP My documents for analyzing the IFRS were the web summaries put up on the International Accounting Standards Board site For pre-IFRS UK GAAP I referred primarily to the Deloitte and Touche publication lsquoGAAP 2004rsquo For the US GAAP I referred to the textbook being used right now in UMass Boston for AF310 and AF311 lsquoIntermediate Accountingrsquo by Kieso Weygandt and Warfield The IFRS accounting for intangible assets was the x variable I used to prove my y variables which are increased transparency and better stakeholder management I must mention that this research greatly benefited from the articles posted by Intangibles Business Ltd The research resources I have used are archives real data literature interviews reviews and the research facilities available at UMASS in the Healey library database The databases I have used are Business Source Premier Lexis Nexis Academic 11

Ebrary and the Wall Street Journal for articles Besides these I have also used other UMB resources like the CM faculty the CM Business Center and the advice and guidance of the Accounting and Management Department faculty

METHODOLOGY I have used an analytical as well as a theoretical framework to prove my research objective My research can be divided into three stages Stage one involves analysis involves looking at the standards for intangible assets and goodwill under IFRS UK GAAP and US GAAP and making comparisons This is followed by Stage two- the analysis of the reconciliations of Balance Sheets of a sample of 10 companies and interpret the data to prove the increased transparency under IFRS In Stage three The stakeholder theory which I have explained in detailed in a later section has been to used to prove how this increased transparency has lead to better stakeholder management ie provides managers with a number of alternatives to serve stakeholders in a better manner which would ultimately prove beneficial to business In the end I use the stakeholder theory again to prove the general effectiveness of the IFRS using the information in surveys conducted Empirically my research could be summarized in the following steps- collection of data questioning of the information collected forming conclusions and finally putting together all of my research on paper The diagram on the next page summarizes the structure and organization of my thesis 12

Accounting for intangible assets Sample analysis Using the stakeholder theory

IFRS 3 US GAAP

SFAS 141

SFAS 142

UK GAAP

FRS 10

Comparisons and differences

Analysis of reconciliatory statements of sample of 10 European companies that have transitioned to the IFRS

INCREASED TRANSPARENCY

Interpretation of data on intangible assets and goodwill

IFRS

IFRS 3

Investors

Government

Suppliers Customers Creditors

Society 13

US GAAP

ANALYSIS

STAGE 1 ACCOUNTING FOR INTANGIBLE ASSETS This stage involves a comparison of accounting for intangibles under IFRS US GAAP and UK GAAP

SFAS 141

SFAS 142

UK GAAP

FRS 10

Comparisons

and

differences IFRS 3 14

Introducing concepts Intangible assets Goodwill Intangible assets The Uniform Commercial Code (Section 9-102(a)(42)) defines general intangibles as any personal property other than accounts chattel paper commercial tort claims deposit accounts documents goods instruments investment property letter of credit rights letters of credit money and oil gas or other minerals before extraction The term includes payment intangibles and software In todayrsquos global economy dominated by information and service providers intangible assets constitute a major proportion of total assets Intangible assets command an increasingly large proportion of a companyrsquos value and this value has largely not been recognized In heavily branded consumer businesses such as Coca Cola or Nike brands account to up to 80 of the companyrsquos value In other industries such as pharmaceutical patents and copyrights are more prominent(Thaynes1 ) Thus Microsoftrsquos software Cokersquos secret formula and America Onlinersquos subscription base are the most important assets on their balance sheets Infact the value of tangible assets as a percentage of all assets has been steadily decreasing as shown in the graph below which is provided by the Federal Reserve Board but which is recreated by me for this thesisrsquos purpose The original graph is attached 80 70 60 5055 Years lsquo00 15

While intangibles are potential sources of income their values can erode just as quickly Just before Winstar Communications filed for bankruptcy in 2001 their assets were listed at 5 billion dollars However on liquidation the assets fetched just 42 million dollars due to decline in the value of intangibles Traditional assessment of national economic performance has relied upon understanding the GDP in terms of traditional factors of production ndash land labor and capital Knowledge assets may be distinguished from the traditional factors of production ndash in that they are governed by what has been described as the lsquolaw of increasing returnsrsquo In contrast to the traditional factors of production that were governed by diminishing returns every additional unit of knowledge used effectively results in a marginal increase in performance Success of companies such as Microsoft is often attributed to the fact that every additional unit of information-based product or service would result in an increase in the marginal returns Given the changing dynamics underlying national performance it is not surprising that some less developed economies with significant assets in ICT knowledge and Internet-related expertise are hoping to leapfrog more developed economies ( Malhotra2000) Intangible assets have two main characteristics- they lack physical existence and they are not financial instruments Intangible assets derive their value from the rights and privileges granted to the company using them (Kieso Weygandt and Warfield570) Intangible assets are further classified as limited life intangibles or indefinite life intangibles Limited life intangibles have a known useful life and indefinite life intangibles are intangibles whose useful life cannot be determined Accounting treatment for the intangibles vary according to their type which we shall look more in detail in the next section When intangibles are purchased from other parties they are most recorded at the 16

cost of purchase or fair market value under most accounting systems This cost includes all the expenses incurred to make the asset ready for use These include its purchase price legal fees and incidental expenses Internally generated intangibles are generally expensed as incurred All the research and development costs that companies have to incur to come up with the asset are expensed in the income statement The six major categories of intangible assets are marketing ndashrelated intangible assets customer-related intangible assets artistic-related intangible assets contract-related intangible assets technology-related intangible assets and goodwill Marketing - related intangibles assets are those assets used in the marketing or promotion of products These include trademark trade names and internet domain names Customer-related intangible assets include assets such as customer contracts customer relationships subscriber lists customer orders and backlogs and core deposits Artistic ndash related intangible assets include ownership rights to plays literary works musical works etc Contract ndashrelated intangible assets include licenses non-competition agreements and various other agreements and contract rights Goodwill is an important component of intangible assets and comes into play during business acquisitions and mergers Goodwill can be internally created or purchased goodwill Accounting treatment for goodwill differs according to its type and the accounting standards followed 17

Goodwill Goodwill is the excess of the purchase price over the fair market value of an asset during a business combination Some of the reasons why a business would be worth more than the sum of the fair values of the accountable and identifiable net assets of that business are- The expertise of the workforce mdash current accounting practices do not normally recognize the value of human resources as an asset on the balance sheet The reputation of the product(s) of the business mdash if the product has a well known name attached to it then sales and profits will be boosted on the basis of reputation alone The general economic environment mdash levels of interest rates and exchange rates and levels of investor confidence generally will clearly have a major influence on the value of businesses and hence on the amount of goodwill attaching to a business( Robins2000) Goodwill is often referred to as the most intangible of all intangible assets The problem of determining the proper cost to allocate to intangible assets in a business combination is complex because of the many different types of intangibles that might be considered It is extremely difficult not only to identify certain types of intangibles but also to assign a value to them in a business combination As a result the approach followed is to record identifiable intangible assets that can be reliably measured Other intangible assets that are difficult to identify or measure are recorded as goodwill (KiesoWeygandt and Warfield 578) 18

IFRS accounting for business combinations The three IFRS standards impacting accounting for intangible assets are IFRS3 Business Combinations IAS36 Impairment of Assets and IAS38 Intangible Assets These three standards are applicable to intangible assets and goodwill acquired on or after 31 March 2004IAS38 prescribes accounting treatment for the recognition of internally generated and acquired intangible assets IAS38 prescribes the rules for impairment testing of assets and goodwill IFRS3 prescribes the overall treatment for accounting for acquired assets and goodwill in a business combination The three standards can be summarized as follows- Acquired intangible assets Business combinations are accounted for using the purchase method ie accounting from the perspective of the acquirer Intangible assets are initially recognized at cost based on the following criteria-

1) They are identifiable

2) The probable future economic benefits created by them will benefit the organization

3) The measurement of their cost is reliable

After their initial recognition intangible assets may be carried at their cost or revalued amount less any accumulated amortization or impairment losses Their revaluation amount is their fair value at the date of revaluation If there is an increase in the amount of carrying value after revaluation is credited to a revaluation surplus account 19

Internally Generated Intangible assets Internally generated goodwill brands mastheads publishing titles customer lists are not recognized as intangible assets Research and development costs are generally expensed They can however be treated as an intangible asset if they meet the following criteria-

bull They are identifiable

bull The probable future economic benefits created by them will benefit the organization

bull The measurement of their cost is reliable

Goodwill Internally generated goodwill is not recognized The only goodwill recognized is as a result of business combinations Goodwill represents the difference between the total purchase consideration and the total of the fair value of all acquired assets and liabilities assumed If the fair value of the assets exceed the purchase consideration then the acquirer must reassess and identify all the assets and immediately after reassessment must recognize the negative goodwill as a profit in the income statement Impairment testing The useful life of the asset is determined If the asset has a finite useful life it should be amortized over its life For assets with indefinite useful life annual impairment testing is required The test involves a comparison of the carrying value of the asset with its 20

estimated recoverable amount The recoverable is defined as the higher of the value less costs to sell and the value in use The in use is generally based on the discounted future cash flows from the asset When the recoverable amount is found to be lower than the carrying value the carrying value is reduced to the recoverable amount with a charge to profits(Caldwell4)

US GAAP accounting for Business Combinations The standards that prescribe treatment for accounting for Business Combinations are SFAS141 Business Combinations and SFAS 142 Goodwill and other intangible assets The treatment can be summarized as follows- Acquired intangible assets Recorded cost 1)Acquired intangibles are recorded at cost and this cost includes the purchase price and all costs incurred to bring the asset to its intended use 2) In cases where the asset is acquired in exchange for stock or other assets the cost of the asset is the fair value of the consideration given or the fair value of the intangible received whichever is more clear 3) In the case of a lsquobasket purchasersquo cost is allocated on the basis of fair market values of assets acquired Amortization Assets with limited useful life are amortized over life of the asset The asset generates cash flows over such a useful life and the amortization method should to a certain extent 21

reflect the pattern in which the asset is used up if that could be determined If the usage pattern cannot be determined then the straight-line method is used Assets with indefinite life are not amortized Internally Generated Intangibles Costs related to internally generated intangibles are expensed as incurred Research and development costs related to intangibles are expensed and appear in the income statement Only direct costs incurred in obtaining intangibles including legal costs are capitalized Goodwill Goodwill recognized is the difference between the purchase consideration and the fair value of assets It appears on the balance sheet Internally generated goodwill is not recognized The impairment rule for goodwill involves two steps First the fair value of the reporting unit should be compared to its carrying amount including goodwill If the fair value of the reporting unit is greater than the carrying amount goodwill is considered not to be impaired and the company does not have to do anything else (Kieso Weygandt and Warfield593) Impairment testing of intangibles Impairment refers to the write-off or reduction in value of the asset that has to be carried out when the carrying amount of a long-lived asset is not recoverable When the carrying value of an intangible is not recoverable impairment is carried Impairment testing for indefinite life intangibles just involves a fair value test For limited life intangibles impairment is based on a recoverability test and a fair value test Goodwill impairments are based on a fair value test 22

Types of intangible asset Impairment test Limited life Recoverability test then fair value test Indefinite life other than goodwill Fair value test Goodwill Fair value test on reporting unit then fair value test on implied goodwill (Kieso Weygandt and Warfield584)

Pre-IFRS UK GAAP accounting for Business Combinations Starting 2005 all the 25 nations in the European Union including the United Kingdom have adopted the IFRS The pre-IFRS UK GAAP is no longer functional The FRS10 Goodwill and Intangible assets used to prescribe the rules for accounting for Intangibles and Goodwill The Deloitte and Touche publication lsquoGAAP 2004rsquo summarizes the key features of this standard as follows-

bull Internally generated goodwill may not be recognized Purchased goodwill is capitalized and classified as an asset

bull Internally developed intangible assets are recognized only if they have a readily ascertainable market value Purchased intangible assets are capitalized Intangible assets acquired as a part of a business combination are recognized only if they are separable and can be measured reliably

bull Goodwill and intangible assets are amortized over their useful economic lives if this is finite or not amortized if this is indefinite Negative goodwill is classified alongside positive goodwill and amortized

23

bull When the period of amortization exceeds 20 years an impairment test is carried out annually In other cases an impairment test at the end of the first full year after acquisition and then if there is an indicator of impairment

COMPARING THE IFRS TO US GAAP AND PRE-IFRS UK GAAP BUSINESS COMBINATIONS IFRS 3 vs UK GAAP The major differences between the IFRS 3 and FRS provisions for accounting for business combinations are as follows- End of merger accounting and pooling of assets An important requirement of the IFRS 3 is that business acquisitions be accounted for using the purchase method from the perspective of the acquirer This nullifies the UK GAAP provision of allowing companies to use merger accounting where they simply pooled together their balance sheet thus not recognizing goodwill The IFRS provision makes it mandatory for companies to recognize goodwill Goodwill no longer amortized Goodwill is no longer amortized but is instead subjected to a stringent annual impairment test In the event that it is impaired an immediate charge will be taken to the profit and loss account so poor performing acquisitions will be highlighted through such a charge sooner rather than later This represents a fundamental shift in the way goodwill 24

is viewed Goodwill is seen no longer a s steadily wasting asset but instead as one that should be expected to maintain its value(Hadjiloucas and Winter2) More Intangible Assets recognized Historically under UK GAAP when a deal was completed acquired intangible assets would generally just be subsumed within a pot marked lsquogoodwillrsquo The major benefit was that by amortizing this goodwill evenly over a period of usually 20 years you could predict with greater accuracy the impact on earnings (Stevenson and Mc Phee 82) However IFRS 3 requires that all identifiable and valuable intangible assets be reported on the balance sheet The acquirer needs to recognize purchased intangibles on the Balance Sheet More Disclosures The IFRS 3 requires that detailed disclosures be made about transactions and the purchase price allocation method utilized Detailed information about impairment testing of assets and goodwill also needs to be disclosed Strict criteria for determining useful life Limited life intangibles can be amortized over their useful life However management now needs to be more stringent about classifying assets as having a definite or indefinite useful life An indefinite life assertion needs to be backed by evidence and analysis supporting that no legal regulatory contractual competitive economic or other factors limit the life of the asset (Hadjiloucas and Winter3) 25

UK GAAP IFRS Merging accounting and pooling of assets used

No merger accounting allowed all combinations accounted for using the purchase method

Goodwill amortized over life of the asset

Goodwill tested for impairment annually

Fewer capitalized intangible assets More intangibles identified and recognized on acquisition

Details of purchase price allocation not essentially required to be disclosed

Details of purchase price allocation need to be disclosed

maximize the value of their investment it is the managerrsquos duty to work in accordance Managers who fail to do so violate the moral property right (Mitchell et al 1997) note that stakeholder theory has managerial importance because it can determine to what and to whom managers need to listen and give attention What do Stakeholders want Different people want different things from their relationships with organizations Stakeholder discussions often focus on allocating some measure of organizational value or outcome (eg who gets how much money from the firm) The question of how the organization creates this value usually gets less attention but it is certainly not less important Not all stakeholders want a voice in organizational decision-making but those who do desire a voice should have it (Philips 2004 2) My literature sources had to be organized into three data sets-IFRS standards US GAAP and pre ndashIFRS UK GAAP My documents for analyzing the IFRS were the web summaries put up on the International Accounting Standards Board site For pre-IFRS UK GAAP I referred primarily to the Deloitte and Touche publication lsquoGAAP 2004rsquo For the US GAAP I referred to the textbook being used right now in UMass Boston for AF310 and AF311 lsquoIntermediate Accountingrsquo by Kieso Weygandt and Warfield The IFRS accounting for intangible assets was the x variable I used to prove my y variables which are increased transparency and better stakeholder management I must mention that this research greatly benefited from the articles posted by Intangibles Business Ltd The research resources I have used are archives real data literature interviews reviews and the research facilities available at UMASS in the Healey library database The databases I have used are Business Source Premier Lexis Nexis Academic 11

Ebrary and the Wall Street Journal for articles Besides these I have also used other UMB resources like the CM faculty the CM Business Center and the advice and guidance of the Accounting and Management Department faculty

METHODOLOGY I have used an analytical as well as a theoretical framework to prove my research objective My research can be divided into three stages Stage one involves analysis involves looking at the standards for intangible assets and goodwill under IFRS UK GAAP and US GAAP and making comparisons This is followed by Stage two- the analysis of the reconciliations of Balance Sheets of a sample of 10 companies and interpret the data to prove the increased transparency under IFRS In Stage three The stakeholder theory which I have explained in detailed in a later section has been to used to prove how this increased transparency has lead to better stakeholder management ie provides managers with a number of alternatives to serve stakeholders in a better manner which would ultimately prove beneficial to business In the end I use the stakeholder theory again to prove the general effectiveness of the IFRS using the information in surveys conducted Empirically my research could be summarized in the following steps- collection of data questioning of the information collected forming conclusions and finally putting together all of my research on paper The diagram on the next page summarizes the structure and organization of my thesis 12

Accounting for intangible assets Sample analysis Using the stakeholder theory

IFRS 3 US GAAP

SFAS 141

SFAS 142

UK GAAP

FRS 10

Comparisons and differences

Analysis of reconciliatory statements of sample of 10 European companies that have transitioned to the IFRS

INCREASED TRANSPARENCY

Interpretation of data on intangible assets and goodwill

IFRS

IFRS 3

Investors

Government

Suppliers Customers Creditors

Society 13

US GAAP

ANALYSIS

STAGE 1 ACCOUNTING FOR INTANGIBLE ASSETS This stage involves a comparison of accounting for intangibles under IFRS US GAAP and UK GAAP

SFAS 141

SFAS 142

UK GAAP

FRS 10

Comparisons

and

differences IFRS 3 14

Introducing concepts Intangible assets Goodwill Intangible assets The Uniform Commercial Code (Section 9-102(a)(42)) defines general intangibles as any personal property other than accounts chattel paper commercial tort claims deposit accounts documents goods instruments investment property letter of credit rights letters of credit money and oil gas or other minerals before extraction The term includes payment intangibles and software In todayrsquos global economy dominated by information and service providers intangible assets constitute a major proportion of total assets Intangible assets command an increasingly large proportion of a companyrsquos value and this value has largely not been recognized In heavily branded consumer businesses such as Coca Cola or Nike brands account to up to 80 of the companyrsquos value In other industries such as pharmaceutical patents and copyrights are more prominent(Thaynes1 ) Thus Microsoftrsquos software Cokersquos secret formula and America Onlinersquos subscription base are the most important assets on their balance sheets Infact the value of tangible assets as a percentage of all assets has been steadily decreasing as shown in the graph below which is provided by the Federal Reserve Board but which is recreated by me for this thesisrsquos purpose The original graph is attached 80 70 60 5055 Years lsquo00 15

While intangibles are potential sources of income their values can erode just as quickly Just before Winstar Communications filed for bankruptcy in 2001 their assets were listed at 5 billion dollars However on liquidation the assets fetched just 42 million dollars due to decline in the value of intangibles Traditional assessment of national economic performance has relied upon understanding the GDP in terms of traditional factors of production ndash land labor and capital Knowledge assets may be distinguished from the traditional factors of production ndash in that they are governed by what has been described as the lsquolaw of increasing returnsrsquo In contrast to the traditional factors of production that were governed by diminishing returns every additional unit of knowledge used effectively results in a marginal increase in performance Success of companies such as Microsoft is often attributed to the fact that every additional unit of information-based product or service would result in an increase in the marginal returns Given the changing dynamics underlying national performance it is not surprising that some less developed economies with significant assets in ICT knowledge and Internet-related expertise are hoping to leapfrog more developed economies ( Malhotra2000) Intangible assets have two main characteristics- they lack physical existence and they are not financial instruments Intangible assets derive their value from the rights and privileges granted to the company using them (Kieso Weygandt and Warfield570) Intangible assets are further classified as limited life intangibles or indefinite life intangibles Limited life intangibles have a known useful life and indefinite life intangibles are intangibles whose useful life cannot be determined Accounting treatment for the intangibles vary according to their type which we shall look more in detail in the next section When intangibles are purchased from other parties they are most recorded at the 16

cost of purchase or fair market value under most accounting systems This cost includes all the expenses incurred to make the asset ready for use These include its purchase price legal fees and incidental expenses Internally generated intangibles are generally expensed as incurred All the research and development costs that companies have to incur to come up with the asset are expensed in the income statement The six major categories of intangible assets are marketing ndashrelated intangible assets customer-related intangible assets artistic-related intangible assets contract-related intangible assets technology-related intangible assets and goodwill Marketing - related intangibles assets are those assets used in the marketing or promotion of products These include trademark trade names and internet domain names Customer-related intangible assets include assets such as customer contracts customer relationships subscriber lists customer orders and backlogs and core deposits Artistic ndash related intangible assets include ownership rights to plays literary works musical works etc Contract ndashrelated intangible assets include licenses non-competition agreements and various other agreements and contract rights Goodwill is an important component of intangible assets and comes into play during business acquisitions and mergers Goodwill can be internally created or purchased goodwill Accounting treatment for goodwill differs according to its type and the accounting standards followed 17

Goodwill Goodwill is the excess of the purchase price over the fair market value of an asset during a business combination Some of the reasons why a business would be worth more than the sum of the fair values of the accountable and identifiable net assets of that business are- The expertise of the workforce mdash current accounting practices do not normally recognize the value of human resources as an asset on the balance sheet The reputation of the product(s) of the business mdash if the product has a well known name attached to it then sales and profits will be boosted on the basis of reputation alone The general economic environment mdash levels of interest rates and exchange rates and levels of investor confidence generally will clearly have a major influence on the value of businesses and hence on the amount of goodwill attaching to a business( Robins2000) Goodwill is often referred to as the most intangible of all intangible assets The problem of determining the proper cost to allocate to intangible assets in a business combination is complex because of the many different types of intangibles that might be considered It is extremely difficult not only to identify certain types of intangibles but also to assign a value to them in a business combination As a result the approach followed is to record identifiable intangible assets that can be reliably measured Other intangible assets that are difficult to identify or measure are recorded as goodwill (KiesoWeygandt and Warfield 578) 18

IFRS accounting for business combinations The three IFRS standards impacting accounting for intangible assets are IFRS3 Business Combinations IAS36 Impairment of Assets and IAS38 Intangible Assets These three standards are applicable to intangible assets and goodwill acquired on or after 31 March 2004IAS38 prescribes accounting treatment for the recognition of internally generated and acquired intangible assets IAS38 prescribes the rules for impairment testing of assets and goodwill IFRS3 prescribes the overall treatment for accounting for acquired assets and goodwill in a business combination The three standards can be summarized as follows- Acquired intangible assets Business combinations are accounted for using the purchase method ie accounting from the perspective of the acquirer Intangible assets are initially recognized at cost based on the following criteria-

1) They are identifiable

2) The probable future economic benefits created by them will benefit the organization

3) The measurement of their cost is reliable

After their initial recognition intangible assets may be carried at their cost or revalued amount less any accumulated amortization or impairment losses Their revaluation amount is their fair value at the date of revaluation If there is an increase in the amount of carrying value after revaluation is credited to a revaluation surplus account 19

Internally Generated Intangible assets Internally generated goodwill brands mastheads publishing titles customer lists are not recognized as intangible assets Research and development costs are generally expensed They can however be treated as an intangible asset if they meet the following criteria-

bull They are identifiable

bull The probable future economic benefits created by them will benefit the organization

bull The measurement of their cost is reliable

Goodwill Internally generated goodwill is not recognized The only goodwill recognized is as a result of business combinations Goodwill represents the difference between the total purchase consideration and the total of the fair value of all acquired assets and liabilities assumed If the fair value of the assets exceed the purchase consideration then the acquirer must reassess and identify all the assets and immediately after reassessment must recognize the negative goodwill as a profit in the income statement Impairment testing The useful life of the asset is determined If the asset has a finite useful life it should be amortized over its life For assets with indefinite useful life annual impairment testing is required The test involves a comparison of the carrying value of the asset with its 20

estimated recoverable amount The recoverable is defined as the higher of the value less costs to sell and the value in use The in use is generally based on the discounted future cash flows from the asset When the recoverable amount is found to be lower than the carrying value the carrying value is reduced to the recoverable amount with a charge to profits(Caldwell4)

US GAAP accounting for Business Combinations The standards that prescribe treatment for accounting for Business Combinations are SFAS141 Business Combinations and SFAS 142 Goodwill and other intangible assets The treatment can be summarized as follows- Acquired intangible assets Recorded cost 1)Acquired intangibles are recorded at cost and this cost includes the purchase price and all costs incurred to bring the asset to its intended use 2) In cases where the asset is acquired in exchange for stock or other assets the cost of the asset is the fair value of the consideration given or the fair value of the intangible received whichever is more clear 3) In the case of a lsquobasket purchasersquo cost is allocated on the basis of fair market values of assets acquired Amortization Assets with limited useful life are amortized over life of the asset The asset generates cash flows over such a useful life and the amortization method should to a certain extent 21

reflect the pattern in which the asset is used up if that could be determined If the usage pattern cannot be determined then the straight-line method is used Assets with indefinite life are not amortized Internally Generated Intangibles Costs related to internally generated intangibles are expensed as incurred Research and development costs related to intangibles are expensed and appear in the income statement Only direct costs incurred in obtaining intangibles including legal costs are capitalized Goodwill Goodwill recognized is the difference between the purchase consideration and the fair value of assets It appears on the balance sheet Internally generated goodwill is not recognized The impairment rule for goodwill involves two steps First the fair value of the reporting unit should be compared to its carrying amount including goodwill If the fair value of the reporting unit is greater than the carrying amount goodwill is considered not to be impaired and the company does not have to do anything else (Kieso Weygandt and Warfield593) Impairment testing of intangibles Impairment refers to the write-off or reduction in value of the asset that has to be carried out when the carrying amount of a long-lived asset is not recoverable When the carrying value of an intangible is not recoverable impairment is carried Impairment testing for indefinite life intangibles just involves a fair value test For limited life intangibles impairment is based on a recoverability test and a fair value test Goodwill impairments are based on a fair value test 22

Types of intangible asset Impairment test Limited life Recoverability test then fair value test Indefinite life other than goodwill Fair value test Goodwill Fair value test on reporting unit then fair value test on implied goodwill (Kieso Weygandt and Warfield584)

Pre-IFRS UK GAAP accounting for Business Combinations Starting 2005 all the 25 nations in the European Union including the United Kingdom have adopted the IFRS The pre-IFRS UK GAAP is no longer functional The FRS10 Goodwill and Intangible assets used to prescribe the rules for accounting for Intangibles and Goodwill The Deloitte and Touche publication lsquoGAAP 2004rsquo summarizes the key features of this standard as follows-

bull Internally generated goodwill may not be recognized Purchased goodwill is capitalized and classified as an asset

bull Internally developed intangible assets are recognized only if they have a readily ascertainable market value Purchased intangible assets are capitalized Intangible assets acquired as a part of a business combination are recognized only if they are separable and can be measured reliably

bull Goodwill and intangible assets are amortized over their useful economic lives if this is finite or not amortized if this is indefinite Negative goodwill is classified alongside positive goodwill and amortized

23

bull When the period of amortization exceeds 20 years an impairment test is carried out annually In other cases an impairment test at the end of the first full year after acquisition and then if there is an indicator of impairment

COMPARING THE IFRS TO US GAAP AND PRE-IFRS UK GAAP BUSINESS COMBINATIONS IFRS 3 vs UK GAAP The major differences between the IFRS 3 and FRS provisions for accounting for business combinations are as follows- End of merger accounting and pooling of assets An important requirement of the IFRS 3 is that business acquisitions be accounted for using the purchase method from the perspective of the acquirer This nullifies the UK GAAP provision of allowing companies to use merger accounting where they simply pooled together their balance sheet thus not recognizing goodwill The IFRS provision makes it mandatory for companies to recognize goodwill Goodwill no longer amortized Goodwill is no longer amortized but is instead subjected to a stringent annual impairment test In the event that it is impaired an immediate charge will be taken to the profit and loss account so poor performing acquisitions will be highlighted through such a charge sooner rather than later This represents a fundamental shift in the way goodwill 24

is viewed Goodwill is seen no longer a s steadily wasting asset but instead as one that should be expected to maintain its value(Hadjiloucas and Winter2) More Intangible Assets recognized Historically under UK GAAP when a deal was completed acquired intangible assets would generally just be subsumed within a pot marked lsquogoodwillrsquo The major benefit was that by amortizing this goodwill evenly over a period of usually 20 years you could predict with greater accuracy the impact on earnings (Stevenson and Mc Phee 82) However IFRS 3 requires that all identifiable and valuable intangible assets be reported on the balance sheet The acquirer needs to recognize purchased intangibles on the Balance Sheet More Disclosures The IFRS 3 requires that detailed disclosures be made about transactions and the purchase price allocation method utilized Detailed information about impairment testing of assets and goodwill also needs to be disclosed Strict criteria for determining useful life Limited life intangibles can be amortized over their useful life However management now needs to be more stringent about classifying assets as having a definite or indefinite useful life An indefinite life assertion needs to be backed by evidence and analysis supporting that no legal regulatory contractual competitive economic or other factors limit the life of the asset (Hadjiloucas and Winter3) 25

UK GAAP IFRS Merging accounting and pooling of assets used

No merger accounting allowed all combinations accounted for using the purchase method

Goodwill amortized over life of the asset

Goodwill tested for impairment annually

Fewer capitalized intangible assets More intangibles identified and recognized on acquisition

Details of purchase price allocation not essentially required to be disclosed

Details of purchase price allocation need to be disclosed

Ebrary and the Wall Street Journal for articles Besides these I have also used other UMB resources like the CM faculty the CM Business Center and the advice and guidance of the Accounting and Management Department faculty

METHODOLOGY I have used an analytical as well as a theoretical framework to prove my research objective My research can be divided into three stages Stage one involves analysis involves looking at the standards for intangible assets and goodwill under IFRS UK GAAP and US GAAP and making comparisons This is followed by Stage two- the analysis of the reconciliations of Balance Sheets of a sample of 10 companies and interpret the data to prove the increased transparency under IFRS In Stage three The stakeholder theory which I have explained in detailed in a later section has been to used to prove how this increased transparency has lead to better stakeholder management ie provides managers with a number of alternatives to serve stakeholders in a better manner which would ultimately prove beneficial to business In the end I use the stakeholder theory again to prove the general effectiveness of the IFRS using the information in surveys conducted Empirically my research could be summarized in the following steps- collection of data questioning of the information collected forming conclusions and finally putting together all of my research on paper The diagram on the next page summarizes the structure and organization of my thesis 12

Accounting for intangible assets Sample analysis Using the stakeholder theory

IFRS 3 US GAAP

SFAS 141

SFAS 142

UK GAAP

FRS 10

Comparisons and differences

Analysis of reconciliatory statements of sample of 10 European companies that have transitioned to the IFRS

INCREASED TRANSPARENCY

Interpretation of data on intangible assets and goodwill

IFRS

IFRS 3

Investors

Government

Suppliers Customers Creditors

Society 13

US GAAP

ANALYSIS

STAGE 1 ACCOUNTING FOR INTANGIBLE ASSETS This stage involves a comparison of accounting for intangibles under IFRS US GAAP and UK GAAP

SFAS 141

SFAS 142

UK GAAP

FRS 10

Comparisons

and

differences IFRS 3 14

Introducing concepts Intangible assets Goodwill Intangible assets The Uniform Commercial Code (Section 9-102(a)(42)) defines general intangibles as any personal property other than accounts chattel paper commercial tort claims deposit accounts documents goods instruments investment property letter of credit rights letters of credit money and oil gas or other minerals before extraction The term includes payment intangibles and software In todayrsquos global economy dominated by information and service providers intangible assets constitute a major proportion of total assets Intangible assets command an increasingly large proportion of a companyrsquos value and this value has largely not been recognized In heavily branded consumer businesses such as Coca Cola or Nike brands account to up to 80 of the companyrsquos value In other industries such as pharmaceutical patents and copyrights are more prominent(Thaynes1 ) Thus Microsoftrsquos software Cokersquos secret formula and America Onlinersquos subscription base are the most important assets on their balance sheets Infact the value of tangible assets as a percentage of all assets has been steadily decreasing as shown in the graph below which is provided by the Federal Reserve Board but which is recreated by me for this thesisrsquos purpose The original graph is attached 80 70 60 5055 Years lsquo00 15

While intangibles are potential sources of income their values can erode just as quickly Just before Winstar Communications filed for bankruptcy in 2001 their assets were listed at 5 billion dollars However on liquidation the assets fetched just 42 million dollars due to decline in the value of intangibles Traditional assessment of national economic performance has relied upon understanding the GDP in terms of traditional factors of production ndash land labor and capital Knowledge assets may be distinguished from the traditional factors of production ndash in that they are governed by what has been described as the lsquolaw of increasing returnsrsquo In contrast to the traditional factors of production that were governed by diminishing returns every additional unit of knowledge used effectively results in a marginal increase in performance Success of companies such as Microsoft is often attributed to the fact that every additional unit of information-based product or service would result in an increase in the marginal returns Given the changing dynamics underlying national performance it is not surprising that some less developed economies with significant assets in ICT knowledge and Internet-related expertise are hoping to leapfrog more developed economies ( Malhotra2000) Intangible assets have two main characteristics- they lack physical existence and they are not financial instruments Intangible assets derive their value from the rights and privileges granted to the company using them (Kieso Weygandt and Warfield570) Intangible assets are further classified as limited life intangibles or indefinite life intangibles Limited life intangibles have a known useful life and indefinite life intangibles are intangibles whose useful life cannot be determined Accounting treatment for the intangibles vary according to their type which we shall look more in detail in the next section When intangibles are purchased from other parties they are most recorded at the 16

cost of purchase or fair market value under most accounting systems This cost includes all the expenses incurred to make the asset ready for use These include its purchase price legal fees and incidental expenses Internally generated intangibles are generally expensed as incurred All the research and development costs that companies have to incur to come up with the asset are expensed in the income statement The six major categories of intangible assets are marketing ndashrelated intangible assets customer-related intangible assets artistic-related intangible assets contract-related intangible assets technology-related intangible assets and goodwill Marketing - related intangibles assets are those assets used in the marketing or promotion of products These include trademark trade names and internet domain names Customer-related intangible assets include assets such as customer contracts customer relationships subscriber lists customer orders and backlogs and core deposits Artistic ndash related intangible assets include ownership rights to plays literary works musical works etc Contract ndashrelated intangible assets include licenses non-competition agreements and various other agreements and contract rights Goodwill is an important component of intangible assets and comes into play during business acquisitions and mergers Goodwill can be internally created or purchased goodwill Accounting treatment for goodwill differs according to its type and the accounting standards followed 17

Goodwill Goodwill is the excess of the purchase price over the fair market value of an asset during a business combination Some of the reasons why a business would be worth more than the sum of the fair values of the accountable and identifiable net assets of that business are- The expertise of the workforce mdash current accounting practices do not normally recognize the value of human resources as an asset on the balance sheet The reputation of the product(s) of the business mdash if the product has a well known name attached to it then sales and profits will be boosted on the basis of reputation alone The general economic environment mdash levels of interest rates and exchange rates and levels of investor confidence generally will clearly have a major influence on the value of businesses and hence on the amount of goodwill attaching to a business( Robins2000) Goodwill is often referred to as the most intangible of all intangible assets The problem of determining the proper cost to allocate to intangible assets in a business combination is complex because of the many different types of intangibles that might be considered It is extremely difficult not only to identify certain types of intangibles but also to assign a value to them in a business combination As a result the approach followed is to record identifiable intangible assets that can be reliably measured Other intangible assets that are difficult to identify or measure are recorded as goodwill (KiesoWeygandt and Warfield 578) 18

IFRS accounting for business combinations The three IFRS standards impacting accounting for intangible assets are IFRS3 Business Combinations IAS36 Impairment of Assets and IAS38 Intangible Assets These three standards are applicable to intangible assets and goodwill acquired on or after 31 March 2004IAS38 prescribes accounting treatment for the recognition of internally generated and acquired intangible assets IAS38 prescribes the rules for impairment testing of assets and goodwill IFRS3 prescribes the overall treatment for accounting for acquired assets and goodwill in a business combination The three standards can be summarized as follows- Acquired intangible assets Business combinations are accounted for using the purchase method ie accounting from the perspective of the acquirer Intangible assets are initially recognized at cost based on the following criteria-

1) They are identifiable

2) The probable future economic benefits created by them will benefit the organization

3) The measurement of their cost is reliable

After their initial recognition intangible assets may be carried at their cost or revalued amount less any accumulated amortization or impairment losses Their revaluation amount is their fair value at the date of revaluation If there is an increase in the amount of carrying value after revaluation is credited to a revaluation surplus account 19

Internally Generated Intangible assets Internally generated goodwill brands mastheads publishing titles customer lists are not recognized as intangible assets Research and development costs are generally expensed They can however be treated as an intangible asset if they meet the following criteria-

bull They are identifiable

bull The probable future economic benefits created by them will benefit the organization

bull The measurement of their cost is reliable

Goodwill Internally generated goodwill is not recognized The only goodwill recognized is as a result of business combinations Goodwill represents the difference between the total purchase consideration and the total of the fair value of all acquired assets and liabilities assumed If the fair value of the assets exceed the purchase consideration then the acquirer must reassess and identify all the assets and immediately after reassessment must recognize the negative goodwill as a profit in the income statement Impairment testing The useful life of the asset is determined If the asset has a finite useful life it should be amortized over its life For assets with indefinite useful life annual impairment testing is required The test involves a comparison of the carrying value of the asset with its 20

estimated recoverable amount The recoverable is defined as the higher of the value less costs to sell and the value in use The in use is generally based on the discounted future cash flows from the asset When the recoverable amount is found to be lower than the carrying value the carrying value is reduced to the recoverable amount with a charge to profits(Caldwell4)

US GAAP accounting for Business Combinations The standards that prescribe treatment for accounting for Business Combinations are SFAS141 Business Combinations and SFAS 142 Goodwill and other intangible assets The treatment can be summarized as follows- Acquired intangible assets Recorded cost 1)Acquired intangibles are recorded at cost and this cost includes the purchase price and all costs incurred to bring the asset to its intended use 2) In cases where the asset is acquired in exchange for stock or other assets the cost of the asset is the fair value of the consideration given or the fair value of the intangible received whichever is more clear 3) In the case of a lsquobasket purchasersquo cost is allocated on the basis of fair market values of assets acquired Amortization Assets with limited useful life are amortized over life of the asset The asset generates cash flows over such a useful life and the amortization method should to a certain extent 21

reflect the pattern in which the asset is used up if that could be determined If the usage pattern cannot be determined then the straight-line method is used Assets with indefinite life are not amortized Internally Generated Intangibles Costs related to internally generated intangibles are expensed as incurred Research and development costs related to intangibles are expensed and appear in the income statement Only direct costs incurred in obtaining intangibles including legal costs are capitalized Goodwill Goodwill recognized is the difference between the purchase consideration and the fair value of assets It appears on the balance sheet Internally generated goodwill is not recognized The impairment rule for goodwill involves two steps First the fair value of the reporting unit should be compared to its carrying amount including goodwill If the fair value of the reporting unit is greater than the carrying amount goodwill is considered not to be impaired and the company does not have to do anything else (Kieso Weygandt and Warfield593) Impairment testing of intangibles Impairment refers to the write-off or reduction in value of the asset that has to be carried out when the carrying amount of a long-lived asset is not recoverable When the carrying value of an intangible is not recoverable impairment is carried Impairment testing for indefinite life intangibles just involves a fair value test For limited life intangibles impairment is based on a recoverability test and a fair value test Goodwill impairments are based on a fair value test 22

Types of intangible asset Impairment test Limited life Recoverability test then fair value test Indefinite life other than goodwill Fair value test Goodwill Fair value test on reporting unit then fair value test on implied goodwill (Kieso Weygandt and Warfield584)

Pre-IFRS UK GAAP accounting for Business Combinations Starting 2005 all the 25 nations in the European Union including the United Kingdom have adopted the IFRS The pre-IFRS UK GAAP is no longer functional The FRS10 Goodwill and Intangible assets used to prescribe the rules for accounting for Intangibles and Goodwill The Deloitte and Touche publication lsquoGAAP 2004rsquo summarizes the key features of this standard as follows-

bull Internally generated goodwill may not be recognized Purchased goodwill is capitalized and classified as an asset

bull Internally developed intangible assets are recognized only if they have a readily ascertainable market value Purchased intangible assets are capitalized Intangible assets acquired as a part of a business combination are recognized only if they are separable and can be measured reliably

bull Goodwill and intangible assets are amortized over their useful economic lives if this is finite or not amortized if this is indefinite Negative goodwill is classified alongside positive goodwill and amortized

23

bull When the period of amortization exceeds 20 years an impairment test is carried out annually In other cases an impairment test at the end of the first full year after acquisition and then if there is an indicator of impairment

COMPARING THE IFRS TO US GAAP AND PRE-IFRS UK GAAP BUSINESS COMBINATIONS IFRS 3 vs UK GAAP The major differences between the IFRS 3 and FRS provisions for accounting for business combinations are as follows- End of merger accounting and pooling of assets An important requirement of the IFRS 3 is that business acquisitions be accounted for using the purchase method from the perspective of the acquirer This nullifies the UK GAAP provision of allowing companies to use merger accounting where they simply pooled together their balance sheet thus not recognizing goodwill The IFRS provision makes it mandatory for companies to recognize goodwill Goodwill no longer amortized Goodwill is no longer amortized but is instead subjected to a stringent annual impairment test In the event that it is impaired an immediate charge will be taken to the profit and loss account so poor performing acquisitions will be highlighted through such a charge sooner rather than later This represents a fundamental shift in the way goodwill 24

is viewed Goodwill is seen no longer a s steadily wasting asset but instead as one that should be expected to maintain its value(Hadjiloucas and Winter2) More Intangible Assets recognized Historically under UK GAAP when a deal was completed acquired intangible assets would generally just be subsumed within a pot marked lsquogoodwillrsquo The major benefit was that by amortizing this goodwill evenly over a period of usually 20 years you could predict with greater accuracy the impact on earnings (Stevenson and Mc Phee 82) However IFRS 3 requires that all identifiable and valuable intangible assets be reported on the balance sheet The acquirer needs to recognize purchased intangibles on the Balance Sheet More Disclosures The IFRS 3 requires that detailed disclosures be made about transactions and the purchase price allocation method utilized Detailed information about impairment testing of assets and goodwill also needs to be disclosed Strict criteria for determining useful life Limited life intangibles can be amortized over their useful life However management now needs to be more stringent about classifying assets as having a definite or indefinite useful life An indefinite life assertion needs to be backed by evidence and analysis supporting that no legal regulatory contractual competitive economic or other factors limit the life of the asset (Hadjiloucas and Winter3) 25

UK GAAP IFRS Merging accounting and pooling of assets used

No merger accounting allowed all combinations accounted for using the purchase method

Goodwill amortized over life of the asset

Goodwill tested for impairment annually

Fewer capitalized intangible assets More intangibles identified and recognized on acquisition

Details of purchase price allocation not essentially required to be disclosed

Details of purchase price allocation need to be disclosed

Accounting for intangible assets Sample analysis Using the stakeholder theory

IFRS 3 US GAAP

SFAS 141

SFAS 142

UK GAAP

FRS 10

Comparisons and differences

Analysis of reconciliatory statements of sample of 10 European companies that have transitioned to the IFRS

INCREASED TRANSPARENCY

Interpretation of data on intangible assets and goodwill

IFRS

IFRS 3

Investors

Government

Suppliers Customers Creditors

Society 13

US GAAP

ANALYSIS

STAGE 1 ACCOUNTING FOR INTANGIBLE ASSETS This stage involves a comparison of accounting for intangibles under IFRS US GAAP and UK GAAP

SFAS 141

SFAS 142

UK GAAP

FRS 10

Comparisons

and

differences IFRS 3 14

Introducing concepts Intangible assets Goodwill Intangible assets The Uniform Commercial Code (Section 9-102(a)(42)) defines general intangibles as any personal property other than accounts chattel paper commercial tort claims deposit accounts documents goods instruments investment property letter of credit rights letters of credit money and oil gas or other minerals before extraction The term includes payment intangibles and software In todayrsquos global economy dominated by information and service providers intangible assets constitute a major proportion of total assets Intangible assets command an increasingly large proportion of a companyrsquos value and this value has largely not been recognized In heavily branded consumer businesses such as Coca Cola or Nike brands account to up to 80 of the companyrsquos value In other industries such as pharmaceutical patents and copyrights are more prominent(Thaynes1 ) Thus Microsoftrsquos software Cokersquos secret formula and America Onlinersquos subscription base are the most important assets on their balance sheets Infact the value of tangible assets as a percentage of all assets has been steadily decreasing as shown in the graph below which is provided by the Federal Reserve Board but which is recreated by me for this thesisrsquos purpose The original graph is attached 80 70 60 5055 Years lsquo00 15

While intangibles are potential sources of income their values can erode just as quickly Just before Winstar Communications filed for bankruptcy in 2001 their assets were listed at 5 billion dollars However on liquidation the assets fetched just 42 million dollars due to decline in the value of intangibles Traditional assessment of national economic performance has relied upon understanding the GDP in terms of traditional factors of production ndash land labor and capital Knowledge assets may be distinguished from the traditional factors of production ndash in that they are governed by what has been described as the lsquolaw of increasing returnsrsquo In contrast to the traditional factors of production that were governed by diminishing returns every additional unit of knowledge used effectively results in a marginal increase in performance Success of companies such as Microsoft is often attributed to the fact that every additional unit of information-based product or service would result in an increase in the marginal returns Given the changing dynamics underlying national performance it is not surprising that some less developed economies with significant assets in ICT knowledge and Internet-related expertise are hoping to leapfrog more developed economies ( Malhotra2000) Intangible assets have two main characteristics- they lack physical existence and they are not financial instruments Intangible assets derive their value from the rights and privileges granted to the company using them (Kieso Weygandt and Warfield570) Intangible assets are further classified as limited life intangibles or indefinite life intangibles Limited life intangibles have a known useful life and indefinite life intangibles are intangibles whose useful life cannot be determined Accounting treatment for the intangibles vary according to their type which we shall look more in detail in the next section When intangibles are purchased from other parties they are most recorded at the 16

cost of purchase or fair market value under most accounting systems This cost includes all the expenses incurred to make the asset ready for use These include its purchase price legal fees and incidental expenses Internally generated intangibles are generally expensed as incurred All the research and development costs that companies have to incur to come up with the asset are expensed in the income statement The six major categories of intangible assets are marketing ndashrelated intangible assets customer-related intangible assets artistic-related intangible assets contract-related intangible assets technology-related intangible assets and goodwill Marketing - related intangibles assets are those assets used in the marketing or promotion of products These include trademark trade names and internet domain names Customer-related intangible assets include assets such as customer contracts customer relationships subscriber lists customer orders and backlogs and core deposits Artistic ndash related intangible assets include ownership rights to plays literary works musical works etc Contract ndashrelated intangible assets include licenses non-competition agreements and various other agreements and contract rights Goodwill is an important component of intangible assets and comes into play during business acquisitions and mergers Goodwill can be internally created or purchased goodwill Accounting treatment for goodwill differs according to its type and the accounting standards followed 17

Goodwill Goodwill is the excess of the purchase price over the fair market value of an asset during a business combination Some of the reasons why a business would be worth more than the sum of the fair values of the accountable and identifiable net assets of that business are- The expertise of the workforce mdash current accounting practices do not normally recognize the value of human resources as an asset on the balance sheet The reputation of the product(s) of the business mdash if the product has a well known name attached to it then sales and profits will be boosted on the basis of reputation alone The general economic environment mdash levels of interest rates and exchange rates and levels of investor confidence generally will clearly have a major influence on the value of businesses and hence on the amount of goodwill attaching to a business( Robins2000) Goodwill is often referred to as the most intangible of all intangible assets The problem of determining the proper cost to allocate to intangible assets in a business combination is complex because of the many different types of intangibles that might be considered It is extremely difficult not only to identify certain types of intangibles but also to assign a value to them in a business combination As a result the approach followed is to record identifiable intangible assets that can be reliably measured Other intangible assets that are difficult to identify or measure are recorded as goodwill (KiesoWeygandt and Warfield 578) 18

IFRS accounting for business combinations The three IFRS standards impacting accounting for intangible assets are IFRS3 Business Combinations IAS36 Impairment of Assets and IAS38 Intangible Assets These three standards are applicable to intangible assets and goodwill acquired on or after 31 March 2004IAS38 prescribes accounting treatment for the recognition of internally generated and acquired intangible assets IAS38 prescribes the rules for impairment testing of assets and goodwill IFRS3 prescribes the overall treatment for accounting for acquired assets and goodwill in a business combination The three standards can be summarized as follows- Acquired intangible assets Business combinations are accounted for using the purchase method ie accounting from the perspective of the acquirer Intangible assets are initially recognized at cost based on the following criteria-

1) They are identifiable

2) The probable future economic benefits created by them will benefit the organization

3) The measurement of their cost is reliable

After their initial recognition intangible assets may be carried at their cost or revalued amount less any accumulated amortization or impairment losses Their revaluation amount is their fair value at the date of revaluation If there is an increase in the amount of carrying value after revaluation is credited to a revaluation surplus account 19

Internally Generated Intangible assets Internally generated goodwill brands mastheads publishing titles customer lists are not recognized as intangible assets Research and development costs are generally expensed They can however be treated as an intangible asset if they meet the following criteria-

bull They are identifiable

bull The probable future economic benefits created by them will benefit the organization

bull The measurement of their cost is reliable

Goodwill Internally generated goodwill is not recognized The only goodwill recognized is as a result of business combinations Goodwill represents the difference between the total purchase consideration and the total of the fair value of all acquired assets and liabilities assumed If the fair value of the assets exceed the purchase consideration then the acquirer must reassess and identify all the assets and immediately after reassessment must recognize the negative goodwill as a profit in the income statement Impairment testing The useful life of the asset is determined If the asset has a finite useful life it should be amortized over its life For assets with indefinite useful life annual impairment testing is required The test involves a comparison of the carrying value of the asset with its 20

estimated recoverable amount The recoverable is defined as the higher of the value less costs to sell and the value in use The in use is generally based on the discounted future cash flows from the asset When the recoverable amount is found to be lower than the carrying value the carrying value is reduced to the recoverable amount with a charge to profits(Caldwell4)

US GAAP accounting for Business Combinations The standards that prescribe treatment for accounting for Business Combinations are SFAS141 Business Combinations and SFAS 142 Goodwill and other intangible assets The treatment can be summarized as follows- Acquired intangible assets Recorded cost 1)Acquired intangibles are recorded at cost and this cost includes the purchase price and all costs incurred to bring the asset to its intended use 2) In cases where the asset is acquired in exchange for stock or other assets the cost of the asset is the fair value of the consideration given or the fair value of the intangible received whichever is more clear 3) In the case of a lsquobasket purchasersquo cost is allocated on the basis of fair market values of assets acquired Amortization Assets with limited useful life are amortized over life of the asset The asset generates cash flows over such a useful life and the amortization method should to a certain extent 21

reflect the pattern in which the asset is used up if that could be determined If the usage pattern cannot be determined then the straight-line method is used Assets with indefinite life are not amortized Internally Generated Intangibles Costs related to internally generated intangibles are expensed as incurred Research and development costs related to intangibles are expensed and appear in the income statement Only direct costs incurred in obtaining intangibles including legal costs are capitalized Goodwill Goodwill recognized is the difference between the purchase consideration and the fair value of assets It appears on the balance sheet Internally generated goodwill is not recognized The impairment rule for goodwill involves two steps First the fair value of the reporting unit should be compared to its carrying amount including goodwill If the fair value of the reporting unit is greater than the carrying amount goodwill is considered not to be impaired and the company does not have to do anything else (Kieso Weygandt and Warfield593) Impairment testing of intangibles Impairment refers to the write-off or reduction in value of the asset that has to be carried out when the carrying amount of a long-lived asset is not recoverable When the carrying value of an intangible is not recoverable impairment is carried Impairment testing for indefinite life intangibles just involves a fair value test For limited life intangibles impairment is based on a recoverability test and a fair value test Goodwill impairments are based on a fair value test 22

Types of intangible asset Impairment test Limited life Recoverability test then fair value test Indefinite life other than goodwill Fair value test Goodwill Fair value test on reporting unit then fair value test on implied goodwill (Kieso Weygandt and Warfield584)

Pre-IFRS UK GAAP accounting for Business Combinations Starting 2005 all the 25 nations in the European Union including the United Kingdom have adopted the IFRS The pre-IFRS UK GAAP is no longer functional The FRS10 Goodwill and Intangible assets used to prescribe the rules for accounting for Intangibles and Goodwill The Deloitte and Touche publication lsquoGAAP 2004rsquo summarizes the key features of this standard as follows-

bull Internally generated goodwill may not be recognized Purchased goodwill is capitalized and classified as an asset

bull Internally developed intangible assets are recognized only if they have a readily ascertainable market value Purchased intangible assets are capitalized Intangible assets acquired as a part of a business combination are recognized only if they are separable and can be measured reliably

bull Goodwill and intangible assets are amortized over their useful economic lives if this is finite or not amortized if this is indefinite Negative goodwill is classified alongside positive goodwill and amortized

23

bull When the period of amortization exceeds 20 years an impairment test is carried out annually In other cases an impairment test at the end of the first full year after acquisition and then if there is an indicator of impairment

COMPARING THE IFRS TO US GAAP AND PRE-IFRS UK GAAP BUSINESS COMBINATIONS IFRS 3 vs UK GAAP The major differences between the IFRS 3 and FRS provisions for accounting for business combinations are as follows- End of merger accounting and pooling of assets An important requirement of the IFRS 3 is that business acquisitions be accounted for using the purchase method from the perspective of the acquirer This nullifies the UK GAAP provision of allowing companies to use merger accounting where they simply pooled together their balance sheet thus not recognizing goodwill The IFRS provision makes it mandatory for companies to recognize goodwill Goodwill no longer amortized Goodwill is no longer amortized but is instead subjected to a stringent annual impairment test In the event that it is impaired an immediate charge will be taken to the profit and loss account so poor performing acquisitions will be highlighted through such a charge sooner rather than later This represents a fundamental shift in the way goodwill 24

is viewed Goodwill is seen no longer a s steadily wasting asset but instead as one that should be expected to maintain its value(Hadjiloucas and Winter2) More Intangible Assets recognized Historically under UK GAAP when a deal was completed acquired intangible assets would generally just be subsumed within a pot marked lsquogoodwillrsquo The major benefit was that by amortizing this goodwill evenly over a period of usually 20 years you could predict with greater accuracy the impact on earnings (Stevenson and Mc Phee 82) However IFRS 3 requires that all identifiable and valuable intangible assets be reported on the balance sheet The acquirer needs to recognize purchased intangibles on the Balance Sheet More Disclosures The IFRS 3 requires that detailed disclosures be made about transactions and the purchase price allocation method utilized Detailed information about impairment testing of assets and goodwill also needs to be disclosed Strict criteria for determining useful life Limited life intangibles can be amortized over their useful life However management now needs to be more stringent about classifying assets as having a definite or indefinite useful life An indefinite life assertion needs to be backed by evidence and analysis supporting that no legal regulatory contractual competitive economic or other factors limit the life of the asset (Hadjiloucas and Winter3) 25

UK GAAP IFRS Merging accounting and pooling of assets used

No merger accounting allowed all combinations accounted for using the purchase method

Goodwill amortized over life of the asset

Goodwill tested for impairment annually

Fewer capitalized intangible assets More intangibles identified and recognized on acquisition

Details of purchase price allocation not essentially required to be disclosed

Details of purchase price allocation need to be disclosed

US GAAP

ANALYSIS

STAGE 1 ACCOUNTING FOR INTANGIBLE ASSETS This stage involves a comparison of accounting for intangibles under IFRS US GAAP and UK GAAP

SFAS 141

SFAS 142

UK GAAP

FRS 10

Comparisons

and

differences IFRS 3 14

Introducing concepts Intangible assets Goodwill Intangible assets The Uniform Commercial Code (Section 9-102(a)(42)) defines general intangibles as any personal property other than accounts chattel paper commercial tort claims deposit accounts documents goods instruments investment property letter of credit rights letters of credit money and oil gas or other minerals before extraction The term includes payment intangibles and software In todayrsquos global economy dominated by information and service providers intangible assets constitute a major proportion of total assets Intangible assets command an increasingly large proportion of a companyrsquos value and this value has largely not been recognized In heavily branded consumer businesses such as Coca Cola or Nike brands account to up to 80 of the companyrsquos value In other industries such as pharmaceutical patents and copyrights are more prominent(Thaynes1 ) Thus Microsoftrsquos software Cokersquos secret formula and America Onlinersquos subscription base are the most important assets on their balance sheets Infact the value of tangible assets as a percentage of all assets has been steadily decreasing as shown in the graph below which is provided by the Federal Reserve Board but which is recreated by me for this thesisrsquos purpose The original graph is attached 80 70 60 5055 Years lsquo00 15

While intangibles are potential sources of income their values can erode just as quickly Just before Winstar Communications filed for bankruptcy in 2001 their assets were listed at 5 billion dollars However on liquidation the assets fetched just 42 million dollars due to decline in the value of intangibles Traditional assessment of national economic performance has relied upon understanding the GDP in terms of traditional factors of production ndash land labor and capital Knowledge assets may be distinguished from the traditional factors of production ndash in that they are governed by what has been described as the lsquolaw of increasing returnsrsquo In contrast to the traditional factors of production that were governed by diminishing returns every additional unit of knowledge used effectively results in a marginal increase in performance Success of companies such as Microsoft is often attributed to the fact that every additional unit of information-based product or service would result in an increase in the marginal returns Given the changing dynamics underlying national performance it is not surprising that some less developed economies with significant assets in ICT knowledge and Internet-related expertise are hoping to leapfrog more developed economies ( Malhotra2000) Intangible assets have two main characteristics- they lack physical existence and they are not financial instruments Intangible assets derive their value from the rights and privileges granted to the company using them (Kieso Weygandt and Warfield570) Intangible assets are further classified as limited life intangibles or indefinite life intangibles Limited life intangibles have a known useful life and indefinite life intangibles are intangibles whose useful life cannot be determined Accounting treatment for the intangibles vary according to their type which we shall look more in detail in the next section When intangibles are purchased from other parties they are most recorded at the 16

cost of purchase or fair market value under most accounting systems This cost includes all the expenses incurred to make the asset ready for use These include its purchase price legal fees and incidental expenses Internally generated intangibles are generally expensed as incurred All the research and development costs that companies have to incur to come up with the asset are expensed in the income statement The six major categories of intangible assets are marketing ndashrelated intangible assets customer-related intangible assets artistic-related intangible assets contract-related intangible assets technology-related intangible assets and goodwill Marketing - related intangibles assets are those assets used in the marketing or promotion of products These include trademark trade names and internet domain names Customer-related intangible assets include assets such as customer contracts customer relationships subscriber lists customer orders and backlogs and core deposits Artistic ndash related intangible assets include ownership rights to plays literary works musical works etc Contract ndashrelated intangible assets include licenses non-competition agreements and various other agreements and contract rights Goodwill is an important component of intangible assets and comes into play during business acquisitions and mergers Goodwill can be internally created or purchased goodwill Accounting treatment for goodwill differs according to its type and the accounting standards followed 17

Goodwill Goodwill is the excess of the purchase price over the fair market value of an asset during a business combination Some of the reasons why a business would be worth more than the sum of the fair values of the accountable and identifiable net assets of that business are- The expertise of the workforce mdash current accounting practices do not normally recognize the value of human resources as an asset on the balance sheet The reputation of the product(s) of the business mdash if the product has a well known name attached to it then sales and profits will be boosted on the basis of reputation alone The general economic environment mdash levels of interest rates and exchange rates and levels of investor confidence generally will clearly have a major influence on the value of businesses and hence on the amount of goodwill attaching to a business( Robins2000) Goodwill is often referred to as the most intangible of all intangible assets The problem of determining the proper cost to allocate to intangible assets in a business combination is complex because of the many different types of intangibles that might be considered It is extremely difficult not only to identify certain types of intangibles but also to assign a value to them in a business combination As a result the approach followed is to record identifiable intangible assets that can be reliably measured Other intangible assets that are difficult to identify or measure are recorded as goodwill (KiesoWeygandt and Warfield 578) 18

IFRS accounting for business combinations The three IFRS standards impacting accounting for intangible assets are IFRS3 Business Combinations IAS36 Impairment of Assets and IAS38 Intangible Assets These three standards are applicable to intangible assets and goodwill acquired on or after 31 March 2004IAS38 prescribes accounting treatment for the recognition of internally generated and acquired intangible assets IAS38 prescribes the rules for impairment testing of assets and goodwill IFRS3 prescribes the overall treatment for accounting for acquired assets and goodwill in a business combination The three standards can be summarized as follows- Acquired intangible assets Business combinations are accounted for using the purchase method ie accounting from the perspective of the acquirer Intangible assets are initially recognized at cost based on the following criteria-

1) They are identifiable

2) The probable future economic benefits created by them will benefit the organization

3) The measurement of their cost is reliable

After their initial recognition intangible assets may be carried at their cost or revalued amount less any accumulated amortization or impairment losses Their revaluation amount is their fair value at the date of revaluation If there is an increase in the amount of carrying value after revaluation is credited to a revaluation surplus account 19

Internally Generated Intangible assets Internally generated goodwill brands mastheads publishing titles customer lists are not recognized as intangible assets Research and development costs are generally expensed They can however be treated as an intangible asset if they meet the following criteria-

bull They are identifiable

bull The probable future economic benefits created by them will benefit the organization

bull The measurement of their cost is reliable

Goodwill Internally generated goodwill is not recognized The only goodwill recognized is as a result of business combinations Goodwill represents the difference between the total purchase consideration and the total of the fair value of all acquired assets and liabilities assumed If the fair value of the assets exceed the purchase consideration then the acquirer must reassess and identify all the assets and immediately after reassessment must recognize the negative goodwill as a profit in the income statement Impairment testing The useful life of the asset is determined If the asset has a finite useful life it should be amortized over its life For assets with indefinite useful life annual impairment testing is required The test involves a comparison of the carrying value of the asset with its 20

estimated recoverable amount The recoverable is defined as the higher of the value less costs to sell and the value in use The in use is generally based on the discounted future cash flows from the asset When the recoverable amount is found to be lower than the carrying value the carrying value is reduced to the recoverable amount with a charge to profits(Caldwell4)

US GAAP accounting for Business Combinations The standards that prescribe treatment for accounting for Business Combinations are SFAS141 Business Combinations and SFAS 142 Goodwill and other intangible assets The treatment can be summarized as follows- Acquired intangible assets Recorded cost 1)Acquired intangibles are recorded at cost and this cost includes the purchase price and all costs incurred to bring the asset to its intended use 2) In cases where the asset is acquired in exchange for stock or other assets the cost of the asset is the fair value of the consideration given or the fair value of the intangible received whichever is more clear 3) In the case of a lsquobasket purchasersquo cost is allocated on the basis of fair market values of assets acquired Amortization Assets with limited useful life are amortized over life of the asset The asset generates cash flows over such a useful life and the amortization method should to a certain extent 21

reflect the pattern in which the asset is used up if that could be determined If the usage pattern cannot be determined then the straight-line method is used Assets with indefinite life are not amortized Internally Generated Intangibles Costs related to internally generated intangibles are expensed as incurred Research and development costs related to intangibles are expensed and appear in the income statement Only direct costs incurred in obtaining intangibles including legal costs are capitalized Goodwill Goodwill recognized is the difference between the purchase consideration and the fair value of assets It appears on the balance sheet Internally generated goodwill is not recognized The impairment rule for goodwill involves two steps First the fair value of the reporting unit should be compared to its carrying amount including goodwill If the fair value of the reporting unit is greater than the carrying amount goodwill is considered not to be impaired and the company does not have to do anything else (Kieso Weygandt and Warfield593) Impairment testing of intangibles Impairment refers to the write-off or reduction in value of the asset that has to be carried out when the carrying amount of a long-lived asset is not recoverable When the carrying value of an intangible is not recoverable impairment is carried Impairment testing for indefinite life intangibles just involves a fair value test For limited life intangibles impairment is based on a recoverability test and a fair value test Goodwill impairments are based on a fair value test 22

Types of intangible asset Impairment test Limited life Recoverability test then fair value test Indefinite life other than goodwill Fair value test Goodwill Fair value test on reporting unit then fair value test on implied goodwill (Kieso Weygandt and Warfield584)

Pre-IFRS UK GAAP accounting for Business Combinations Starting 2005 all the 25 nations in the European Union including the United Kingdom have adopted the IFRS The pre-IFRS UK GAAP is no longer functional The FRS10 Goodwill and Intangible assets used to prescribe the rules for accounting for Intangibles and Goodwill The Deloitte and Touche publication lsquoGAAP 2004rsquo summarizes the key features of this standard as follows-

bull Internally generated goodwill may not be recognized Purchased goodwill is capitalized and classified as an asset

bull Internally developed intangible assets are recognized only if they have a readily ascertainable market value Purchased intangible assets are capitalized Intangible assets acquired as a part of a business combination are recognized only if they are separable and can be measured reliably

bull Goodwill and intangible assets are amortized over their useful economic lives if this is finite or not amortized if this is indefinite Negative goodwill is classified alongside positive goodwill and amortized

23

bull When the period of amortization exceeds 20 years an impairment test is carried out annually In other cases an impairment test at the end of the first full year after acquisition and then if there is an indicator of impairment

COMPARING THE IFRS TO US GAAP AND PRE-IFRS UK GAAP BUSINESS COMBINATIONS IFRS 3 vs UK GAAP The major differences between the IFRS 3 and FRS provisions for accounting for business combinations are as follows- End of merger accounting and pooling of assets An important requirement of the IFRS 3 is that business acquisitions be accounted for using the purchase method from the perspective of the acquirer This nullifies the UK GAAP provision of allowing companies to use merger accounting where they simply pooled together their balance sheet thus not recognizing goodwill The IFRS provision makes it mandatory for companies to recognize goodwill Goodwill no longer amortized Goodwill is no longer amortized but is instead subjected to a stringent annual impairment test In the event that it is impaired an immediate charge will be taken to the profit and loss account so poor performing acquisitions will be highlighted through such a charge sooner rather than later This represents a fundamental shift in the way goodwill 24

is viewed Goodwill is seen no longer a s steadily wasting asset but instead as one that should be expected to maintain its value(Hadjiloucas and Winter2) More Intangible Assets recognized Historically under UK GAAP when a deal was completed acquired intangible assets would generally just be subsumed within a pot marked lsquogoodwillrsquo The major benefit was that by amortizing this goodwill evenly over a period of usually 20 years you could predict with greater accuracy the impact on earnings (Stevenson and Mc Phee 82) However IFRS 3 requires that all identifiable and valuable intangible assets be reported on the balance sheet The acquirer needs to recognize purchased intangibles on the Balance Sheet More Disclosures The IFRS 3 requires that detailed disclosures be made about transactions and the purchase price allocation method utilized Detailed information about impairment testing of assets and goodwill also needs to be disclosed Strict criteria for determining useful life Limited life intangibles can be amortized over their useful life However management now needs to be more stringent about classifying assets as having a definite or indefinite useful life An indefinite life assertion needs to be backed by evidence and analysis supporting that no legal regulatory contractual competitive economic or other factors limit the life of the asset (Hadjiloucas and Winter3) 25

UK GAAP IFRS Merging accounting and pooling of assets used

No merger accounting allowed all combinations accounted for using the purchase method

Goodwill amortized over life of the asset

Goodwill tested for impairment annually

Fewer capitalized intangible assets More intangibles identified and recognized on acquisition

Details of purchase price allocation not essentially required to be disclosed

Details of purchase price allocation need to be disclosed

Introducing concepts Intangible assets Goodwill Intangible assets The Uniform Commercial Code (Section 9-102(a)(42)) defines general intangibles as any personal property other than accounts chattel paper commercial tort claims deposit accounts documents goods instruments investment property letter of credit rights letters of credit money and oil gas or other minerals before extraction The term includes payment intangibles and software In todayrsquos global economy dominated by information and service providers intangible assets constitute a major proportion of total assets Intangible assets command an increasingly large proportion of a companyrsquos value and this value has largely not been recognized In heavily branded consumer businesses such as Coca Cola or Nike brands account to up to 80 of the companyrsquos value In other industries such as pharmaceutical patents and copyrights are more prominent(Thaynes1 ) Thus Microsoftrsquos software Cokersquos secret formula and America Onlinersquos subscription base are the most important assets on their balance sheets Infact the value of tangible assets as a percentage of all assets has been steadily decreasing as shown in the graph below which is provided by the Federal Reserve Board but which is recreated by me for this thesisrsquos purpose The original graph is attached 80 70 60 5055 Years lsquo00 15

While intangibles are potential sources of income their values can erode just as quickly Just before Winstar Communications filed for bankruptcy in 2001 their assets were listed at 5 billion dollars However on liquidation the assets fetched just 42 million dollars due to decline in the value of intangibles Traditional assessment of national economic performance has relied upon understanding the GDP in terms of traditional factors of production ndash land labor and capital Knowledge assets may be distinguished from the traditional factors of production ndash in that they are governed by what has been described as the lsquolaw of increasing returnsrsquo In contrast to the traditional factors of production that were governed by diminishing returns every additional unit of knowledge used effectively results in a marginal increase in performance Success of companies such as Microsoft is often attributed to the fact that every additional unit of information-based product or service would result in an increase in the marginal returns Given the changing dynamics underlying national performance it is not surprising that some less developed economies with significant assets in ICT knowledge and Internet-related expertise are hoping to leapfrog more developed economies ( Malhotra2000) Intangible assets have two main characteristics- they lack physical existence and they are not financial instruments Intangible assets derive their value from the rights and privileges granted to the company using them (Kieso Weygandt and Warfield570) Intangible assets are further classified as limited life intangibles or indefinite life intangibles Limited life intangibles have a known useful life and indefinite life intangibles are intangibles whose useful life cannot be determined Accounting treatment for the intangibles vary according to their type which we shall look more in detail in the next section When intangibles are purchased from other parties they are most recorded at the 16

cost of purchase or fair market value under most accounting systems This cost includes all the expenses incurred to make the asset ready for use These include its purchase price legal fees and incidental expenses Internally generated intangibles are generally expensed as incurred All the research and development costs that companies have to incur to come up with the asset are expensed in the income statement The six major categories of intangible assets are marketing ndashrelated intangible assets customer-related intangible assets artistic-related intangible assets contract-related intangible assets technology-related intangible assets and goodwill Marketing - related intangibles assets are those assets used in the marketing or promotion of products These include trademark trade names and internet domain names Customer-related intangible assets include assets such as customer contracts customer relationships subscriber lists customer orders and backlogs and core deposits Artistic ndash related intangible assets include ownership rights to plays literary works musical works etc Contract ndashrelated intangible assets include licenses non-competition agreements and various other agreements and contract rights Goodwill is an important component of intangible assets and comes into play during business acquisitions and mergers Goodwill can be internally created or purchased goodwill Accounting treatment for goodwill differs according to its type and the accounting standards followed 17

Goodwill Goodwill is the excess of the purchase price over the fair market value of an asset during a business combination Some of the reasons why a business would be worth more than the sum of the fair values of the accountable and identifiable net assets of that business are- The expertise of the workforce mdash current accounting practices do not normally recognize the value of human resources as an asset on the balance sheet The reputation of the product(s) of the business mdash if the product has a well known name attached to it then sales and profits will be boosted on the basis of reputation alone The general economic environment mdash levels of interest rates and exchange rates and levels of investor confidence generally will clearly have a major influence on the value of businesses and hence on the amount of goodwill attaching to a business( Robins2000) Goodwill is often referred to as the most intangible of all intangible assets The problem of determining the proper cost to allocate to intangible assets in a business combination is complex because of the many different types of intangibles that might be considered It is extremely difficult not only to identify certain types of intangibles but also to assign a value to them in a business combination As a result the approach followed is to record identifiable intangible assets that can be reliably measured Other intangible assets that are difficult to identify or measure are recorded as goodwill (KiesoWeygandt and Warfield 578) 18

IFRS accounting for business combinations The three IFRS standards impacting accounting for intangible assets are IFRS3 Business Combinations IAS36 Impairment of Assets and IAS38 Intangible Assets These three standards are applicable to intangible assets and goodwill acquired on or after 31 March 2004IAS38 prescribes accounting treatment for the recognition of internally generated and acquired intangible assets IAS38 prescribes the rules for impairment testing of assets and goodwill IFRS3 prescribes the overall treatment for accounting for acquired assets and goodwill in a business combination The three standards can be summarized as follows- Acquired intangible assets Business combinations are accounted for using the purchase method ie accounting from the perspective of the acquirer Intangible assets are initially recognized at cost based on the following criteria-

1) They are identifiable

2) The probable future economic benefits created by them will benefit the organization

3) The measurement of their cost is reliable

After their initial recognition intangible assets may be carried at their cost or revalued amount less any accumulated amortization or impairment losses Their revaluation amount is their fair value at the date of revaluation If there is an increase in the amount of carrying value after revaluation is credited to a revaluation surplus account 19

Internally Generated Intangible assets Internally generated goodwill brands mastheads publishing titles customer lists are not recognized as intangible assets Research and development costs are generally expensed They can however be treated as an intangible asset if they meet the following criteria-

bull They are identifiable

bull The probable future economic benefits created by them will benefit the organization

bull The measurement of their cost is reliable

Goodwill Internally generated goodwill is not recognized The only goodwill recognized is as a result of business combinations Goodwill represents the difference between the total purchase consideration and the total of the fair value of all acquired assets and liabilities assumed If the fair value of the assets exceed the purchase consideration then the acquirer must reassess and identify all the assets and immediately after reassessment must recognize the negative goodwill as a profit in the income statement Impairment testing The useful life of the asset is determined If the asset has a finite useful life it should be amortized over its life For assets with indefinite useful life annual impairment testing is required The test involves a comparison of the carrying value of the asset with its 20

estimated recoverable amount The recoverable is defined as the higher of the value less costs to sell and the value in use The in use is generally based on the discounted future cash flows from the asset When the recoverable amount is found to be lower than the carrying value the carrying value is reduced to the recoverable amount with a charge to profits(Caldwell4)

US GAAP accounting for Business Combinations The standards that prescribe treatment for accounting for Business Combinations are SFAS141 Business Combinations and SFAS 142 Goodwill and other intangible assets The treatment can be summarized as follows- Acquired intangible assets Recorded cost 1)Acquired intangibles are recorded at cost and this cost includes the purchase price and all costs incurred to bring the asset to its intended use 2) In cases where the asset is acquired in exchange for stock or other assets the cost of the asset is the fair value of the consideration given or the fair value of the intangible received whichever is more clear 3) In the case of a lsquobasket purchasersquo cost is allocated on the basis of fair market values of assets acquired Amortization Assets with limited useful life are amortized over life of the asset The asset generates cash flows over such a useful life and the amortization method should to a certain extent 21

reflect the pattern in which the asset is used up if that could be determined If the usage pattern cannot be determined then the straight-line method is used Assets with indefinite life are not amortized Internally Generated Intangibles Costs related to internally generated intangibles are expensed as incurred Research and development costs related to intangibles are expensed and appear in the income statement Only direct costs incurred in obtaining intangibles including legal costs are capitalized Goodwill Goodwill recognized is the difference between the purchase consideration and the fair value of assets It appears on the balance sheet Internally generated goodwill is not recognized The impairment rule for goodwill involves two steps First the fair value of the reporting unit should be compared to its carrying amount including goodwill If the fair value of the reporting unit is greater than the carrying amount goodwill is considered not to be impaired and the company does not have to do anything else (Kieso Weygandt and Warfield593) Impairment testing of intangibles Impairment refers to the write-off or reduction in value of the asset that has to be carried out when the carrying amount of a long-lived asset is not recoverable When the carrying value of an intangible is not recoverable impairment is carried Impairment testing for indefinite life intangibles just involves a fair value test For limited life intangibles impairment is based on a recoverability test and a fair value test Goodwill impairments are based on a fair value test 22

Types of intangible asset Impairment test Limited life Recoverability test then fair value test Indefinite life other than goodwill Fair value test Goodwill Fair value test on reporting unit then fair value test on implied goodwill (Kieso Weygandt and Warfield584)

Pre-IFRS UK GAAP accounting for Business Combinations Starting 2005 all the 25 nations in the European Union including the United Kingdom have adopted the IFRS The pre-IFRS UK GAAP is no longer functional The FRS10 Goodwill and Intangible assets used to prescribe the rules for accounting for Intangibles and Goodwill The Deloitte and Touche publication lsquoGAAP 2004rsquo summarizes the key features of this standard as follows-

bull Internally generated goodwill may not be recognized Purchased goodwill is capitalized and classified as an asset

bull Internally developed intangible assets are recognized only if they have a readily ascertainable market value Purchased intangible assets are capitalized Intangible assets acquired as a part of a business combination are recognized only if they are separable and can be measured reliably

bull Goodwill and intangible assets are amortized over their useful economic lives if this is finite or not amortized if this is indefinite Negative goodwill is classified alongside positive goodwill and amortized

23

bull When the period of amortization exceeds 20 years an impairment test is carried out annually In other cases an impairment test at the end of the first full year after acquisition and then if there is an indicator of impairment

COMPARING THE IFRS TO US GAAP AND PRE-IFRS UK GAAP BUSINESS COMBINATIONS IFRS 3 vs UK GAAP The major differences between the IFRS 3 and FRS provisions for accounting for business combinations are as follows- End of merger accounting and pooling of assets An important requirement of the IFRS 3 is that business acquisitions be accounted for using the purchase method from the perspective of the acquirer This nullifies the UK GAAP provision of allowing companies to use merger accounting where they simply pooled together their balance sheet thus not recognizing goodwill The IFRS provision makes it mandatory for companies to recognize goodwill Goodwill no longer amortized Goodwill is no longer amortized but is instead subjected to a stringent annual impairment test In the event that it is impaired an immediate charge will be taken to the profit and loss account so poor performing acquisitions will be highlighted through such a charge sooner rather than later This represents a fundamental shift in the way goodwill 24

is viewed Goodwill is seen no longer a s steadily wasting asset but instead as one that should be expected to maintain its value(Hadjiloucas and Winter2) More Intangible Assets recognized Historically under UK GAAP when a deal was completed acquired intangible assets would generally just be subsumed within a pot marked lsquogoodwillrsquo The major benefit was that by amortizing this goodwill evenly over a period of usually 20 years you could predict with greater accuracy the impact on earnings (Stevenson and Mc Phee 82) However IFRS 3 requires that all identifiable and valuable intangible assets be reported on the balance sheet The acquirer needs to recognize purchased intangibles on the Balance Sheet More Disclosures The IFRS 3 requires that detailed disclosures be made about transactions and the purchase price allocation method utilized Detailed information about impairment testing of assets and goodwill also needs to be disclosed Strict criteria for determining useful life Limited life intangibles can be amortized over their useful life However management now needs to be more stringent about classifying assets as having a definite or indefinite useful life An indefinite life assertion needs to be backed by evidence and analysis supporting that no legal regulatory contractual competitive economic or other factors limit the life of the asset (Hadjiloucas and Winter3) 25

UK GAAP IFRS Merging accounting and pooling of assets used

No merger accounting allowed all combinations accounted for using the purchase method

Goodwill amortized over life of the asset

Goodwill tested for impairment annually

Fewer capitalized intangible assets More intangibles identified and recognized on acquisition

Details of purchase price allocation not essentially required to be disclosed

Details of purchase price allocation need to be disclosed

While intangibles are potential sources of income their values can erode just as quickly Just before Winstar Communications filed for bankruptcy in 2001 their assets were listed at 5 billion dollars However on liquidation the assets fetched just 42 million dollars due to decline in the value of intangibles Traditional assessment of national economic performance has relied upon understanding the GDP in terms of traditional factors of production ndash land labor and capital Knowledge assets may be distinguished from the traditional factors of production ndash in that they are governed by what has been described as the lsquolaw of increasing returnsrsquo In contrast to the traditional factors of production that were governed by diminishing returns every additional unit of knowledge used effectively results in a marginal increase in performance Success of companies such as Microsoft is often attributed to the fact that every additional unit of information-based product or service would result in an increase in the marginal returns Given the changing dynamics underlying national performance it is not surprising that some less developed economies with significant assets in ICT knowledge and Internet-related expertise are hoping to leapfrog more developed economies ( Malhotra2000) Intangible assets have two main characteristics- they lack physical existence and they are not financial instruments Intangible assets derive their value from the rights and privileges granted to the company using them (Kieso Weygandt and Warfield570) Intangible assets are further classified as limited life intangibles or indefinite life intangibles Limited life intangibles have a known useful life and indefinite life intangibles are intangibles whose useful life cannot be determined Accounting treatment for the intangibles vary according to their type which we shall look more in detail in the next section When intangibles are purchased from other parties they are most recorded at the 16

cost of purchase or fair market value under most accounting systems This cost includes all the expenses incurred to make the asset ready for use These include its purchase price legal fees and incidental expenses Internally generated intangibles are generally expensed as incurred All the research and development costs that companies have to incur to come up with the asset are expensed in the income statement The six major categories of intangible assets are marketing ndashrelated intangible assets customer-related intangible assets artistic-related intangible assets contract-related intangible assets technology-related intangible assets and goodwill Marketing - related intangibles assets are those assets used in the marketing or promotion of products These include trademark trade names and internet domain names Customer-related intangible assets include assets such as customer contracts customer relationships subscriber lists customer orders and backlogs and core deposits Artistic ndash related intangible assets include ownership rights to plays literary works musical works etc Contract ndashrelated intangible assets include licenses non-competition agreements and various other agreements and contract rights Goodwill is an important component of intangible assets and comes into play during business acquisitions and mergers Goodwill can be internally created or purchased goodwill Accounting treatment for goodwill differs according to its type and the accounting standards followed 17

Goodwill Goodwill is the excess of the purchase price over the fair market value of an asset during a business combination Some of the reasons why a business would be worth more than the sum of the fair values of the accountable and identifiable net assets of that business are- The expertise of the workforce mdash current accounting practices do not normally recognize the value of human resources as an asset on the balance sheet The reputation of the product(s) of the business mdash if the product has a well known name attached to it then sales and profits will be boosted on the basis of reputation alone The general economic environment mdash levels of interest rates and exchange rates and levels of investor confidence generally will clearly have a major influence on the value of businesses and hence on the amount of goodwill attaching to a business( Robins2000) Goodwill is often referred to as the most intangible of all intangible assets The problem of determining the proper cost to allocate to intangible assets in a business combination is complex because of the many different types of intangibles that might be considered It is extremely difficult not only to identify certain types of intangibles but also to assign a value to them in a business combination As a result the approach followed is to record identifiable intangible assets that can be reliably measured Other intangible assets that are difficult to identify or measure are recorded as goodwill (KiesoWeygandt and Warfield 578) 18

IFRS accounting for business combinations The three IFRS standards impacting accounting for intangible assets are IFRS3 Business Combinations IAS36 Impairment of Assets and IAS38 Intangible Assets These three standards are applicable to intangible assets and goodwill acquired on or after 31 March 2004IAS38 prescribes accounting treatment for the recognition of internally generated and acquired intangible assets IAS38 prescribes the rules for impairment testing of assets and goodwill IFRS3 prescribes the overall treatment for accounting for acquired assets and goodwill in a business combination The three standards can be summarized as follows- Acquired intangible assets Business combinations are accounted for using the purchase method ie accounting from the perspective of the acquirer Intangible assets are initially recognized at cost based on the following criteria-

1) They are identifiable

2) The probable future economic benefits created by them will benefit the organization

3) The measurement of their cost is reliable

After their initial recognition intangible assets may be carried at their cost or revalued amount less any accumulated amortization or impairment losses Their revaluation amount is their fair value at the date of revaluation If there is an increase in the amount of carrying value after revaluation is credited to a revaluation surplus account 19

Internally Generated Intangible assets Internally generated goodwill brands mastheads publishing titles customer lists are not recognized as intangible assets Research and development costs are generally expensed They can however be treated as an intangible asset if they meet the following criteria-

bull They are identifiable

bull The probable future economic benefits created by them will benefit the organization

bull The measurement of their cost is reliable

Goodwill Internally generated goodwill is not recognized The only goodwill recognized is as a result of business combinations Goodwill represents the difference between the total purchase consideration and the total of the fair value of all acquired assets and liabilities assumed If the fair value of the assets exceed the purchase consideration then the acquirer must reassess and identify all the assets and immediately after reassessment must recognize the negative goodwill as a profit in the income statement Impairment testing The useful life of the asset is determined If the asset has a finite useful life it should be amortized over its life For assets with indefinite useful life annual impairment testing is required The test involves a comparison of the carrying value of the asset with its 20

estimated recoverable amount The recoverable is defined as the higher of the value less costs to sell and the value in use The in use is generally based on the discounted future cash flows from the asset When the recoverable amount is found to be lower than the carrying value the carrying value is reduced to the recoverable amount with a charge to profits(Caldwell4)

US GAAP accounting for Business Combinations The standards that prescribe treatment for accounting for Business Combinations are SFAS141 Business Combinations and SFAS 142 Goodwill and other intangible assets The treatment can be summarized as follows- Acquired intangible assets Recorded cost 1)Acquired intangibles are recorded at cost and this cost includes the purchase price and all costs incurred to bring the asset to its intended use 2) In cases where the asset is acquired in exchange for stock or other assets the cost of the asset is the fair value of the consideration given or the fair value of the intangible received whichever is more clear 3) In the case of a lsquobasket purchasersquo cost is allocated on the basis of fair market values of assets acquired Amortization Assets with limited useful life are amortized over life of the asset The asset generates cash flows over such a useful life and the amortization method should to a certain extent 21

reflect the pattern in which the asset is used up if that could be determined If the usage pattern cannot be determined then the straight-line method is used Assets with indefinite life are not amortized Internally Generated Intangibles Costs related to internally generated intangibles are expensed as incurred Research and development costs related to intangibles are expensed and appear in the income statement Only direct costs incurred in obtaining intangibles including legal costs are capitalized Goodwill Goodwill recognized is the difference between the purchase consideration and the fair value of assets It appears on the balance sheet Internally generated goodwill is not recognized The impairment rule for goodwill involves two steps First the fair value of the reporting unit should be compared to its carrying amount including goodwill If the fair value of the reporting unit is greater than the carrying amount goodwill is considered not to be impaired and the company does not have to do anything else (Kieso Weygandt and Warfield593) Impairment testing of intangibles Impairment refers to the write-off or reduction in value of the asset that has to be carried out when the carrying amount of a long-lived asset is not recoverable When the carrying value of an intangible is not recoverable impairment is carried Impairment testing for indefinite life intangibles just involves a fair value test For limited life intangibles impairment is based on a recoverability test and a fair value test Goodwill impairments are based on a fair value test 22

Types of intangible asset Impairment test Limited life Recoverability test then fair value test Indefinite life other than goodwill Fair value test Goodwill Fair value test on reporting unit then fair value test on implied goodwill (Kieso Weygandt and Warfield584)

Pre-IFRS UK GAAP accounting for Business Combinations Starting 2005 all the 25 nations in the European Union including the United Kingdom have adopted the IFRS The pre-IFRS UK GAAP is no longer functional The FRS10 Goodwill and Intangible assets used to prescribe the rules for accounting for Intangibles and Goodwill The Deloitte and Touche publication lsquoGAAP 2004rsquo summarizes the key features of this standard as follows-

bull Internally generated goodwill may not be recognized Purchased goodwill is capitalized and classified as an asset

bull Internally developed intangible assets are recognized only if they have a readily ascertainable market value Purchased intangible assets are capitalized Intangible assets acquired as a part of a business combination are recognized only if they are separable and can be measured reliably

bull Goodwill and intangible assets are amortized over their useful economic lives if this is finite or not amortized if this is indefinite Negative goodwill is classified alongside positive goodwill and amortized

23

bull When the period of amortization exceeds 20 years an impairment test is carried out annually In other cases an impairment test at the end of the first full year after acquisition and then if there is an indicator of impairment

COMPARING THE IFRS TO US GAAP AND PRE-IFRS UK GAAP BUSINESS COMBINATIONS IFRS 3 vs UK GAAP The major differences between the IFRS 3 and FRS provisions for accounting for business combinations are as follows- End of merger accounting and pooling of assets An important requirement of the IFRS 3 is that business acquisitions be accounted for using the purchase method from the perspective of the acquirer This nullifies the UK GAAP provision of allowing companies to use merger accounting where they simply pooled together their balance sheet thus not recognizing goodwill The IFRS provision makes it mandatory for companies to recognize goodwill Goodwill no longer amortized Goodwill is no longer amortized but is instead subjected to a stringent annual impairment test In the event that it is impaired an immediate charge will be taken to the profit and loss account so poor performing acquisitions will be highlighted through such a charge sooner rather than later This represents a fundamental shift in the way goodwill 24

is viewed Goodwill is seen no longer a s steadily wasting asset but instead as one that should be expected to maintain its value(Hadjiloucas and Winter2) More Intangible Assets recognized Historically under UK GAAP when a deal was completed acquired intangible assets would generally just be subsumed within a pot marked lsquogoodwillrsquo The major benefit was that by amortizing this goodwill evenly over a period of usually 20 years you could predict with greater accuracy the impact on earnings (Stevenson and Mc Phee 82) However IFRS 3 requires that all identifiable and valuable intangible assets be reported on the balance sheet The acquirer needs to recognize purchased intangibles on the Balance Sheet More Disclosures The IFRS 3 requires that detailed disclosures be made about transactions and the purchase price allocation method utilized Detailed information about impairment testing of assets and goodwill also needs to be disclosed Strict criteria for determining useful life Limited life intangibles can be amortized over their useful life However management now needs to be more stringent about classifying assets as having a definite or indefinite useful life An indefinite life assertion needs to be backed by evidence and analysis supporting that no legal regulatory contractual competitive economic or other factors limit the life of the asset (Hadjiloucas and Winter3) 25

UK GAAP IFRS Merging accounting and pooling of assets used

No merger accounting allowed all combinations accounted for using the purchase method

Goodwill amortized over life of the asset

Goodwill tested for impairment annually

Fewer capitalized intangible assets More intangibles identified and recognized on acquisition

Details of purchase price allocation not essentially required to be disclosed

Details of purchase price allocation need to be disclosed

cost of purchase or fair market value under most accounting systems This cost includes all the expenses incurred to make the asset ready for use These include its purchase price legal fees and incidental expenses Internally generated intangibles are generally expensed as incurred All the research and development costs that companies have to incur to come up with the asset are expensed in the income statement The six major categories of intangible assets are marketing ndashrelated intangible assets customer-related intangible assets artistic-related intangible assets contract-related intangible assets technology-related intangible assets and goodwill Marketing - related intangibles assets are those assets used in the marketing or promotion of products These include trademark trade names and internet domain names Customer-related intangible assets include assets such as customer contracts customer relationships subscriber lists customer orders and backlogs and core deposits Artistic ndash related intangible assets include ownership rights to plays literary works musical works etc Contract ndashrelated intangible assets include licenses non-competition agreements and various other agreements and contract rights Goodwill is an important component of intangible assets and comes into play during business acquisitions and mergers Goodwill can be internally created or purchased goodwill Accounting treatment for goodwill differs according to its type and the accounting standards followed 17

Goodwill Goodwill is the excess of the purchase price over the fair market value of an asset during a business combination Some of the reasons why a business would be worth more than the sum of the fair values of the accountable and identifiable net assets of that business are- The expertise of the workforce mdash current accounting practices do not normally recognize the value of human resources as an asset on the balance sheet The reputation of the product(s) of the business mdash if the product has a well known name attached to it then sales and profits will be boosted on the basis of reputation alone The general economic environment mdash levels of interest rates and exchange rates and levels of investor confidence generally will clearly have a major influence on the value of businesses and hence on the amount of goodwill attaching to a business( Robins2000) Goodwill is often referred to as the most intangible of all intangible assets The problem of determining the proper cost to allocate to intangible assets in a business combination is complex because of the many different types of intangibles that might be considered It is extremely difficult not only to identify certain types of intangibles but also to assign a value to them in a business combination As a result the approach followed is to record identifiable intangible assets that can be reliably measured Other intangible assets that are difficult to identify or measure are recorded as goodwill (KiesoWeygandt and Warfield 578) 18

IFRS accounting for business combinations The three IFRS standards impacting accounting for intangible assets are IFRS3 Business Combinations IAS36 Impairment of Assets and IAS38 Intangible Assets These three standards are applicable to intangible assets and goodwill acquired on or after 31 March 2004IAS38 prescribes accounting treatment for the recognition of internally generated and acquired intangible assets IAS38 prescribes the rules for impairment testing of assets and goodwill IFRS3 prescribes the overall treatment for accounting for acquired assets and goodwill in a business combination The three standards can be summarized as follows- Acquired intangible assets Business combinations are accounted for using the purchase method ie accounting from the perspective of the acquirer Intangible assets are initially recognized at cost based on the following criteria-

1) They are identifiable

2) The probable future economic benefits created by them will benefit the organization

3) The measurement of their cost is reliable

After their initial recognition intangible assets may be carried at their cost or revalued amount less any accumulated amortization or impairment losses Their revaluation amount is their fair value at the date of revaluation If there is an increase in the amount of carrying value after revaluation is credited to a revaluation surplus account 19

Internally Generated Intangible assets Internally generated goodwill brands mastheads publishing titles customer lists are not recognized as intangible assets Research and development costs are generally expensed They can however be treated as an intangible asset if they meet the following criteria-

bull They are identifiable

bull The probable future economic benefits created by them will benefit the organization

bull The measurement of their cost is reliable

Goodwill Internally generated goodwill is not recognized The only goodwill recognized is as a result of business combinations Goodwill represents the difference between the total purchase consideration and the total of the fair value of all acquired assets and liabilities assumed If the fair value of the assets exceed the purchase consideration then the acquirer must reassess and identify all the assets and immediately after reassessment must recognize the negative goodwill as a profit in the income statement Impairment testing The useful life of the asset is determined If the asset has a finite useful life it should be amortized over its life For assets with indefinite useful life annual impairment testing is required The test involves a comparison of the carrying value of the asset with its 20

estimated recoverable amount The recoverable is defined as the higher of the value less costs to sell and the value in use The in use is generally based on the discounted future cash flows from the asset When the recoverable amount is found to be lower than the carrying value the carrying value is reduced to the recoverable amount with a charge to profits(Caldwell4)

US GAAP accounting for Business Combinations The standards that prescribe treatment for accounting for Business Combinations are SFAS141 Business Combinations and SFAS 142 Goodwill and other intangible assets The treatment can be summarized as follows- Acquired intangible assets Recorded cost 1)Acquired intangibles are recorded at cost and this cost includes the purchase price and all costs incurred to bring the asset to its intended use 2) In cases where the asset is acquired in exchange for stock or other assets the cost of the asset is the fair value of the consideration given or the fair value of the intangible received whichever is more clear 3) In the case of a lsquobasket purchasersquo cost is allocated on the basis of fair market values of assets acquired Amortization Assets with limited useful life are amortized over life of the asset The asset generates cash flows over such a useful life and the amortization method should to a certain extent 21

reflect the pattern in which the asset is used up if that could be determined If the usage pattern cannot be determined then the straight-line method is used Assets with indefinite life are not amortized Internally Generated Intangibles Costs related to internally generated intangibles are expensed as incurred Research and development costs related to intangibles are expensed and appear in the income statement Only direct costs incurred in obtaining intangibles including legal costs are capitalized Goodwill Goodwill recognized is the difference between the purchase consideration and the fair value of assets It appears on the balance sheet Internally generated goodwill is not recognized The impairment rule for goodwill involves two steps First the fair value of the reporting unit should be compared to its carrying amount including goodwill If the fair value of the reporting unit is greater than the carrying amount goodwill is considered not to be impaired and the company does not have to do anything else (Kieso Weygandt and Warfield593) Impairment testing of intangibles Impairment refers to the write-off or reduction in value of the asset that has to be carried out when the carrying amount of a long-lived asset is not recoverable When the carrying value of an intangible is not recoverable impairment is carried Impairment testing for indefinite life intangibles just involves a fair value test For limited life intangibles impairment is based on a recoverability test and a fair value test Goodwill impairments are based on a fair value test 22

Types of intangible asset Impairment test Limited life Recoverability test then fair value test Indefinite life other than goodwill Fair value test Goodwill Fair value test on reporting unit then fair value test on implied goodwill (Kieso Weygandt and Warfield584)

Pre-IFRS UK GAAP accounting for Business Combinations Starting 2005 all the 25 nations in the European Union including the United Kingdom have adopted the IFRS The pre-IFRS UK GAAP is no longer functional The FRS10 Goodwill and Intangible assets used to prescribe the rules for accounting for Intangibles and Goodwill The Deloitte and Touche publication lsquoGAAP 2004rsquo summarizes the key features of this standard as follows-

bull Internally generated goodwill may not be recognized Purchased goodwill is capitalized and classified as an asset

bull Internally developed intangible assets are recognized only if they have a readily ascertainable market value Purchased intangible assets are capitalized Intangible assets acquired as a part of a business combination are recognized only if they are separable and can be measured reliably

bull Goodwill and intangible assets are amortized over their useful economic lives if this is finite or not amortized if this is indefinite Negative goodwill is classified alongside positive goodwill and amortized

23

bull When the period of amortization exceeds 20 years an impairment test is carried out annually In other cases an impairment test at the end of the first full year after acquisition and then if there is an indicator of impairment

COMPARING THE IFRS TO US GAAP AND PRE-IFRS UK GAAP BUSINESS COMBINATIONS IFRS 3 vs UK GAAP The major differences between the IFRS 3 and FRS provisions for accounting for business combinations are as follows- End of merger accounting and pooling of assets An important requirement of the IFRS 3 is that business acquisitions be accounted for using the purchase method from the perspective of the acquirer This nullifies the UK GAAP provision of allowing companies to use merger accounting where they simply pooled together their balance sheet thus not recognizing goodwill The IFRS provision makes it mandatory for companies to recognize goodwill Goodwill no longer amortized Goodwill is no longer amortized but is instead subjected to a stringent annual impairment test In the event that it is impaired an immediate charge will be taken to the profit and loss account so poor performing acquisitions will be highlighted through such a charge sooner rather than later This represents a fundamental shift in the way goodwill 24

is viewed Goodwill is seen no longer a s steadily wasting asset but instead as one that should be expected to maintain its value(Hadjiloucas and Winter2) More Intangible Assets recognized Historically under UK GAAP when a deal was completed acquired intangible assets would generally just be subsumed within a pot marked lsquogoodwillrsquo The major benefit was that by amortizing this goodwill evenly over a period of usually 20 years you could predict with greater accuracy the impact on earnings (Stevenson and Mc Phee 82) However IFRS 3 requires that all identifiable and valuable intangible assets be reported on the balance sheet The acquirer needs to recognize purchased intangibles on the Balance Sheet More Disclosures The IFRS 3 requires that detailed disclosures be made about transactions and the purchase price allocation method utilized Detailed information about impairment testing of assets and goodwill also needs to be disclosed Strict criteria for determining useful life Limited life intangibles can be amortized over their useful life However management now needs to be more stringent about classifying assets as having a definite or indefinite useful life An indefinite life assertion needs to be backed by evidence and analysis supporting that no legal regulatory contractual competitive economic or other factors limit the life of the asset (Hadjiloucas and Winter3) 25

UK GAAP IFRS Merging accounting and pooling of assets used

No merger accounting allowed all combinations accounted for using the purchase method

Goodwill amortized over life of the asset

Goodwill tested for impairment annually

Fewer capitalized intangible assets More intangibles identified and recognized on acquisition

Details of purchase price allocation not essentially required to be disclosed

Details of purchase price allocation need to be disclosed

Goodwill Goodwill is the excess of the purchase price over the fair market value of an asset during a business combination Some of the reasons why a business would be worth more than the sum of the fair values of the accountable and identifiable net assets of that business are- The expertise of the workforce mdash current accounting practices do not normally recognize the value of human resources as an asset on the balance sheet The reputation of the product(s) of the business mdash if the product has a well known name attached to it then sales and profits will be boosted on the basis of reputation alone The general economic environment mdash levels of interest rates and exchange rates and levels of investor confidence generally will clearly have a major influence on the value of businesses and hence on the amount of goodwill attaching to a business( Robins2000) Goodwill is often referred to as the most intangible of all intangible assets The problem of determining the proper cost to allocate to intangible assets in a business combination is complex because of the many different types of intangibles that might be considered It is extremely difficult not only to identify certain types of intangibles but also to assign a value to them in a business combination As a result the approach followed is to record identifiable intangible assets that can be reliably measured Other intangible assets that are difficult to identify or measure are recorded as goodwill (KiesoWeygandt and Warfield 578) 18

IFRS accounting for business combinations The three IFRS standards impacting accounting for intangible assets are IFRS3 Business Combinations IAS36 Impairment of Assets and IAS38 Intangible Assets These three standards are applicable to intangible assets and goodwill acquired on or after 31 March 2004IAS38 prescribes accounting treatment for the recognition of internally generated and acquired intangible assets IAS38 prescribes the rules for impairment testing of assets and goodwill IFRS3 prescribes the overall treatment for accounting for acquired assets and goodwill in a business combination The three standards can be summarized as follows- Acquired intangible assets Business combinations are accounted for using the purchase method ie accounting from the perspective of the acquirer Intangible assets are initially recognized at cost based on the following criteria-

1) They are identifiable

2) The probable future economic benefits created by them will benefit the organization

3) The measurement of their cost is reliable

After their initial recognition intangible assets may be carried at their cost or revalued amount less any accumulated amortization or impairment losses Their revaluation amount is their fair value at the date of revaluation If there is an increase in the amount of carrying value after revaluation is credited to a revaluation surplus account 19

Internally Generated Intangible assets Internally generated goodwill brands mastheads publishing titles customer lists are not recognized as intangible assets Research and development costs are generally expensed They can however be treated as an intangible asset if they meet the following criteria-

bull They are identifiable

bull The probable future economic benefits created by them will benefit the organization

bull The measurement of their cost is reliable

Goodwill Internally generated goodwill is not recognized The only goodwill recognized is as a result of business combinations Goodwill represents the difference between the total purchase consideration and the total of the fair value of all acquired assets and liabilities assumed If the fair value of the assets exceed the purchase consideration then the acquirer must reassess and identify all the assets and immediately after reassessment must recognize the negative goodwill as a profit in the income statement Impairment testing The useful life of the asset is determined If the asset has a finite useful life it should be amortized over its life For assets with indefinite useful life annual impairment testing is required The test involves a comparison of the carrying value of the asset with its 20

estimated recoverable amount The recoverable is defined as the higher of the value less costs to sell and the value in use The in use is generally based on the discounted future cash flows from the asset When the recoverable amount is found to be lower than the carrying value the carrying value is reduced to the recoverable amount with a charge to profits(Caldwell4)

US GAAP accounting for Business Combinations The standards that prescribe treatment for accounting for Business Combinations are SFAS141 Business Combinations and SFAS 142 Goodwill and other intangible assets The treatment can be summarized as follows- Acquired intangible assets Recorded cost 1)Acquired intangibles are recorded at cost and this cost includes the purchase price and all costs incurred to bring the asset to its intended use 2) In cases where the asset is acquired in exchange for stock or other assets the cost of the asset is the fair value of the consideration given or the fair value of the intangible received whichever is more clear 3) In the case of a lsquobasket purchasersquo cost is allocated on the basis of fair market values of assets acquired Amortization Assets with limited useful life are amortized over life of the asset The asset generates cash flows over such a useful life and the amortization method should to a certain extent 21

reflect the pattern in which the asset is used up if that could be determined If the usage pattern cannot be determined then the straight-line method is used Assets with indefinite life are not amortized Internally Generated Intangibles Costs related to internally generated intangibles are expensed as incurred Research and development costs related to intangibles are expensed and appear in the income statement Only direct costs incurred in obtaining intangibles including legal costs are capitalized Goodwill Goodwill recognized is the difference between the purchase consideration and the fair value of assets It appears on the balance sheet Internally generated goodwill is not recognized The impairment rule for goodwill involves two steps First the fair value of the reporting unit should be compared to its carrying amount including goodwill If the fair value of the reporting unit is greater than the carrying amount goodwill is considered not to be impaired and the company does not have to do anything else (Kieso Weygandt and Warfield593) Impairment testing of intangibles Impairment refers to the write-off or reduction in value of the asset that has to be carried out when the carrying amount of a long-lived asset is not recoverable When the carrying value of an intangible is not recoverable impairment is carried Impairment testing for indefinite life intangibles just involves a fair value test For limited life intangibles impairment is based on a recoverability test and a fair value test Goodwill impairments are based on a fair value test 22

Types of intangible asset Impairment test Limited life Recoverability test then fair value test Indefinite life other than goodwill Fair value test Goodwill Fair value test on reporting unit then fair value test on implied goodwill (Kieso Weygandt and Warfield584)

Pre-IFRS UK GAAP accounting for Business Combinations Starting 2005 all the 25 nations in the European Union including the United Kingdom have adopted the IFRS The pre-IFRS UK GAAP is no longer functional The FRS10 Goodwill and Intangible assets used to prescribe the rules for accounting for Intangibles and Goodwill The Deloitte and Touche publication lsquoGAAP 2004rsquo summarizes the key features of this standard as follows-

bull Internally generated goodwill may not be recognized Purchased goodwill is capitalized and classified as an asset

bull Internally developed intangible assets are recognized only if they have a readily ascertainable market value Purchased intangible assets are capitalized Intangible assets acquired as a part of a business combination are recognized only if they are separable and can be measured reliably

bull Goodwill and intangible assets are amortized over their useful economic lives if this is finite or not amortized if this is indefinite Negative goodwill is classified alongside positive goodwill and amortized

23

bull When the period of amortization exceeds 20 years an impairment test is carried out annually In other cases an impairment test at the end of the first full year after acquisition and then if there is an indicator of impairment

COMPARING THE IFRS TO US GAAP AND PRE-IFRS UK GAAP BUSINESS COMBINATIONS IFRS 3 vs UK GAAP The major differences between the IFRS 3 and FRS provisions for accounting for business combinations are as follows- End of merger accounting and pooling of assets An important requirement of the IFRS 3 is that business acquisitions be accounted for using the purchase method from the perspective of the acquirer This nullifies the UK GAAP provision of allowing companies to use merger accounting where they simply pooled together their balance sheet thus not recognizing goodwill The IFRS provision makes it mandatory for companies to recognize goodwill Goodwill no longer amortized Goodwill is no longer amortized but is instead subjected to a stringent annual impairment test In the event that it is impaired an immediate charge will be taken to the profit and loss account so poor performing acquisitions will be highlighted through such a charge sooner rather than later This represents a fundamental shift in the way goodwill 24

is viewed Goodwill is seen no longer a s steadily wasting asset but instead as one that should be expected to maintain its value(Hadjiloucas and Winter2) More Intangible Assets recognized Historically under UK GAAP when a deal was completed acquired intangible assets would generally just be subsumed within a pot marked lsquogoodwillrsquo The major benefit was that by amortizing this goodwill evenly over a period of usually 20 years you could predict with greater accuracy the impact on earnings (Stevenson and Mc Phee 82) However IFRS 3 requires that all identifiable and valuable intangible assets be reported on the balance sheet The acquirer needs to recognize purchased intangibles on the Balance Sheet More Disclosures The IFRS 3 requires that detailed disclosures be made about transactions and the purchase price allocation method utilized Detailed information about impairment testing of assets and goodwill also needs to be disclosed Strict criteria for determining useful life Limited life intangibles can be amortized over their useful life However management now needs to be more stringent about classifying assets as having a definite or indefinite useful life An indefinite life assertion needs to be backed by evidence and analysis supporting that no legal regulatory contractual competitive economic or other factors limit the life of the asset (Hadjiloucas and Winter3) 25

UK GAAP IFRS Merging accounting and pooling of assets used

No merger accounting allowed all combinations accounted for using the purchase method

Goodwill amortized over life of the asset

Goodwill tested for impairment annually

Fewer capitalized intangible assets More intangibles identified and recognized on acquisition

Details of purchase price allocation not essentially required to be disclosed

Details of purchase price allocation need to be disclosed

IFRS accounting for business combinations The three IFRS standards impacting accounting for intangible assets are IFRS3 Business Combinations IAS36 Impairment of Assets and IAS38 Intangible Assets These three standards are applicable to intangible assets and goodwill acquired on or after 31 March 2004IAS38 prescribes accounting treatment for the recognition of internally generated and acquired intangible assets IAS38 prescribes the rules for impairment testing of assets and goodwill IFRS3 prescribes the overall treatment for accounting for acquired assets and goodwill in a business combination The three standards can be summarized as follows- Acquired intangible assets Business combinations are accounted for using the purchase method ie accounting from the perspective of the acquirer Intangible assets are initially recognized at cost based on the following criteria-

1) They are identifiable

2) The probable future economic benefits created by them will benefit the organization

3) The measurement of their cost is reliable

After their initial recognition intangible assets may be carried at their cost or revalued amount less any accumulated amortization or impairment losses Their revaluation amount is their fair value at the date of revaluation If there is an increase in the amount of carrying value after revaluation is credited to a revaluation surplus account 19

Internally Generated Intangible assets Internally generated goodwill brands mastheads publishing titles customer lists are not recognized as intangible assets Research and development costs are generally expensed They can however be treated as an intangible asset if they meet the following criteria-

bull They are identifiable

bull The probable future economic benefits created by them will benefit the organization

bull The measurement of their cost is reliable

Goodwill Internally generated goodwill is not recognized The only goodwill recognized is as a result of business combinations Goodwill represents the difference between the total purchase consideration and the total of the fair value of all acquired assets and liabilities assumed If the fair value of the assets exceed the purchase consideration then the acquirer must reassess and identify all the assets and immediately after reassessment must recognize the negative goodwill as a profit in the income statement Impairment testing The useful life of the asset is determined If the asset has a finite useful life it should be amortized over its life For assets with indefinite useful life annual impairment testing is required The test involves a comparison of the carrying value of the asset with its 20

estimated recoverable amount The recoverable is defined as the higher of the value less costs to sell and the value in use The in use is generally based on the discounted future cash flows from the asset When the recoverable amount is found to be lower than the carrying value the carrying value is reduced to the recoverable amount with a charge to profits(Caldwell4)

US GAAP accounting for Business Combinations The standards that prescribe treatment for accounting for Business Combinations are SFAS141 Business Combinations and SFAS 142 Goodwill and other intangible assets The treatment can be summarized as follows- Acquired intangible assets Recorded cost 1)Acquired intangibles are recorded at cost and this cost includes the purchase price and all costs incurred to bring the asset to its intended use 2) In cases where the asset is acquired in exchange for stock or other assets the cost of the asset is the fair value of the consideration given or the fair value of the intangible received whichever is more clear 3) In the case of a lsquobasket purchasersquo cost is allocated on the basis of fair market values of assets acquired Amortization Assets with limited useful life are amortized over life of the asset The asset generates cash flows over such a useful life and the amortization method should to a certain extent 21

reflect the pattern in which the asset is used up if that could be determined If the usage pattern cannot be determined then the straight-line method is used Assets with indefinite life are not amortized Internally Generated Intangibles Costs related to internally generated intangibles are expensed as incurred Research and development costs related to intangibles are expensed and appear in the income statement Only direct costs incurred in obtaining intangibles including legal costs are capitalized Goodwill Goodwill recognized is the difference between the purchase consideration and the fair value of assets It appears on the balance sheet Internally generated goodwill is not recognized The impairment rule for goodwill involves two steps First the fair value of the reporting unit should be compared to its carrying amount including goodwill If the fair value of the reporting unit is greater than the carrying amount goodwill is considered not to be impaired and the company does not have to do anything else (Kieso Weygandt and Warfield593) Impairment testing of intangibles Impairment refers to the write-off or reduction in value of the asset that has to be carried out when the carrying amount of a long-lived asset is not recoverable When the carrying value of an intangible is not recoverable impairment is carried Impairment testing for indefinite life intangibles just involves a fair value test For limited life intangibles impairment is based on a recoverability test and a fair value test Goodwill impairments are based on a fair value test 22

Types of intangible asset Impairment test Limited life Recoverability test then fair value test Indefinite life other than goodwill Fair value test Goodwill Fair value test on reporting unit then fair value test on implied goodwill (Kieso Weygandt and Warfield584)

Pre-IFRS UK GAAP accounting for Business Combinations Starting 2005 all the 25 nations in the European Union including the United Kingdom have adopted the IFRS The pre-IFRS UK GAAP is no longer functional The FRS10 Goodwill and Intangible assets used to prescribe the rules for accounting for Intangibles and Goodwill The Deloitte and Touche publication lsquoGAAP 2004rsquo summarizes the key features of this standard as follows-

bull Internally generated goodwill may not be recognized Purchased goodwill is capitalized and classified as an asset

bull Internally developed intangible assets are recognized only if they have a readily ascertainable market value Purchased intangible assets are capitalized Intangible assets acquired as a part of a business combination are recognized only if they are separable and can be measured reliably

bull Goodwill and intangible assets are amortized over their useful economic lives if this is finite or not amortized if this is indefinite Negative goodwill is classified alongside positive goodwill and amortized

23

bull When the period of amortization exceeds 20 years an impairment test is carried out annually In other cases an impairment test at the end of the first full year after acquisition and then if there is an indicator of impairment

COMPARING THE IFRS TO US GAAP AND PRE-IFRS UK GAAP BUSINESS COMBINATIONS IFRS 3 vs UK GAAP The major differences between the IFRS 3 and FRS provisions for accounting for business combinations are as follows- End of merger accounting and pooling of assets An important requirement of the IFRS 3 is that business acquisitions be accounted for using the purchase method from the perspective of the acquirer This nullifies the UK GAAP provision of allowing companies to use merger accounting where they simply pooled together their balance sheet thus not recognizing goodwill The IFRS provision makes it mandatory for companies to recognize goodwill Goodwill no longer amortized Goodwill is no longer amortized but is instead subjected to a stringent annual impairment test In the event that it is impaired an immediate charge will be taken to the profit and loss account so poor performing acquisitions will be highlighted through such a charge sooner rather than later This represents a fundamental shift in the way goodwill 24

is viewed Goodwill is seen no longer a s steadily wasting asset but instead as one that should be expected to maintain its value(Hadjiloucas and Winter2) More Intangible Assets recognized Historically under UK GAAP when a deal was completed acquired intangible assets would generally just be subsumed within a pot marked lsquogoodwillrsquo The major benefit was that by amortizing this goodwill evenly over a period of usually 20 years you could predict with greater accuracy the impact on earnings (Stevenson and Mc Phee 82) However IFRS 3 requires that all identifiable and valuable intangible assets be reported on the balance sheet The acquirer needs to recognize purchased intangibles on the Balance Sheet More Disclosures The IFRS 3 requires that detailed disclosures be made about transactions and the purchase price allocation method utilized Detailed information about impairment testing of assets and goodwill also needs to be disclosed Strict criteria for determining useful life Limited life intangibles can be amortized over their useful life However management now needs to be more stringent about classifying assets as having a definite or indefinite useful life An indefinite life assertion needs to be backed by evidence and analysis supporting that no legal regulatory contractual competitive economic or other factors limit the life of the asset (Hadjiloucas and Winter3) 25

UK GAAP IFRS Merging accounting and pooling of assets used

No merger accounting allowed all combinations accounted for using the purchase method

Goodwill amortized over life of the asset

Goodwill tested for impairment annually

Fewer capitalized intangible assets More intangibles identified and recognized on acquisition

Details of purchase price allocation not essentially required to be disclosed

Details of purchase price allocation need to be disclosed

Internally Generated Intangible assets Internally generated goodwill brands mastheads publishing titles customer lists are not recognized as intangible assets Research and development costs are generally expensed They can however be treated as an intangible asset if they meet the following criteria-

bull They are identifiable

bull The probable future economic benefits created by them will benefit the organization

bull The measurement of their cost is reliable

Goodwill Internally generated goodwill is not recognized The only goodwill recognized is as a result of business combinations Goodwill represents the difference between the total purchase consideration and the total of the fair value of all acquired assets and liabilities assumed If the fair value of the assets exceed the purchase consideration then the acquirer must reassess and identify all the assets and immediately after reassessment must recognize the negative goodwill as a profit in the income statement Impairment testing The useful life of the asset is determined If the asset has a finite useful life it should be amortized over its life For assets with indefinite useful life annual impairment testing is required The test involves a comparison of the carrying value of the asset with its 20

estimated recoverable amount The recoverable is defined as the higher of the value less costs to sell and the value in use The in use is generally based on the discounted future cash flows from the asset When the recoverable amount is found to be lower than the carrying value the carrying value is reduced to the recoverable amount with a charge to profits(Caldwell4)

US GAAP accounting for Business Combinations The standards that prescribe treatment for accounting for Business Combinations are SFAS141 Business Combinations and SFAS 142 Goodwill and other intangible assets The treatment can be summarized as follows- Acquired intangible assets Recorded cost 1)Acquired intangibles are recorded at cost and this cost includes the purchase price and all costs incurred to bring the asset to its intended use 2) In cases where the asset is acquired in exchange for stock or other assets the cost of the asset is the fair value of the consideration given or the fair value of the intangible received whichever is more clear 3) In the case of a lsquobasket purchasersquo cost is allocated on the basis of fair market values of assets acquired Amortization Assets with limited useful life are amortized over life of the asset The asset generates cash flows over such a useful life and the amortization method should to a certain extent 21

reflect the pattern in which the asset is used up if that could be determined If the usage pattern cannot be determined then the straight-line method is used Assets with indefinite life are not amortized Internally Generated Intangibles Costs related to internally generated intangibles are expensed as incurred Research and development costs related to intangibles are expensed and appear in the income statement Only direct costs incurred in obtaining intangibles including legal costs are capitalized Goodwill Goodwill recognized is the difference between the purchase consideration and the fair value of assets It appears on the balance sheet Internally generated goodwill is not recognized The impairment rule for goodwill involves two steps First the fair value of the reporting unit should be compared to its carrying amount including goodwill If the fair value of the reporting unit is greater than the carrying amount goodwill is considered not to be impaired and the company does not have to do anything else (Kieso Weygandt and Warfield593) Impairment testing of intangibles Impairment refers to the write-off or reduction in value of the asset that has to be carried out when the carrying amount of a long-lived asset is not recoverable When the carrying value of an intangible is not recoverable impairment is carried Impairment testing for indefinite life intangibles just involves a fair value test For limited life intangibles impairment is based on a recoverability test and a fair value test Goodwill impairments are based on a fair value test 22

Types of intangible asset Impairment test Limited life Recoverability test then fair value test Indefinite life other than goodwill Fair value test Goodwill Fair value test on reporting unit then fair value test on implied goodwill (Kieso Weygandt and Warfield584)

Pre-IFRS UK GAAP accounting for Business Combinations Starting 2005 all the 25 nations in the European Union including the United Kingdom have adopted the IFRS The pre-IFRS UK GAAP is no longer functional The FRS10 Goodwill and Intangible assets used to prescribe the rules for accounting for Intangibles and Goodwill The Deloitte and Touche publication lsquoGAAP 2004rsquo summarizes the key features of this standard as follows-

bull Internally generated goodwill may not be recognized Purchased goodwill is capitalized and classified as an asset

bull Internally developed intangible assets are recognized only if they have a readily ascertainable market value Purchased intangible assets are capitalized Intangible assets acquired as a part of a business combination are recognized only if they are separable and can be measured reliably

bull Goodwill and intangible assets are amortized over their useful economic lives if this is finite or not amortized if this is indefinite Negative goodwill is classified alongside positive goodwill and amortized

23

bull When the period of amortization exceeds 20 years an impairment test is carried out annually In other cases an impairment test at the end of the first full year after acquisition and then if there is an indicator of impairment

COMPARING THE IFRS TO US GAAP AND PRE-IFRS UK GAAP BUSINESS COMBINATIONS IFRS 3 vs UK GAAP The major differences between the IFRS 3 and FRS provisions for accounting for business combinations are as follows- End of merger accounting and pooling of assets An important requirement of the IFRS 3 is that business acquisitions be accounted for using the purchase method from the perspective of the acquirer This nullifies the UK GAAP provision of allowing companies to use merger accounting where they simply pooled together their balance sheet thus not recognizing goodwill The IFRS provision makes it mandatory for companies to recognize goodwill Goodwill no longer amortized Goodwill is no longer amortized but is instead subjected to a stringent annual impairment test In the event that it is impaired an immediate charge will be taken to the profit and loss account so poor performing acquisitions will be highlighted through such a charge sooner rather than later This represents a fundamental shift in the way goodwill 24

is viewed Goodwill is seen no longer a s steadily wasting asset but instead as one that should be expected to maintain its value(Hadjiloucas and Winter2) More Intangible Assets recognized Historically under UK GAAP when a deal was completed acquired intangible assets would generally just be subsumed within a pot marked lsquogoodwillrsquo The major benefit was that by amortizing this goodwill evenly over a period of usually 20 years you could predict with greater accuracy the impact on earnings (Stevenson and Mc Phee 82) However IFRS 3 requires that all identifiable and valuable intangible assets be reported on the balance sheet The acquirer needs to recognize purchased intangibles on the Balance Sheet More Disclosures The IFRS 3 requires that detailed disclosures be made about transactions and the purchase price allocation method utilized Detailed information about impairment testing of assets and goodwill also needs to be disclosed Strict criteria for determining useful life Limited life intangibles can be amortized over their useful life However management now needs to be more stringent about classifying assets as having a definite or indefinite useful life An indefinite life assertion needs to be backed by evidence and analysis supporting that no legal regulatory contractual competitive economic or other factors limit the life of the asset (Hadjiloucas and Winter3) 25

UK GAAP IFRS Merging accounting and pooling of assets used

No merger accounting allowed all combinations accounted for using the purchase method

Goodwill amortized over life of the asset

Goodwill tested for impairment annually

Fewer capitalized intangible assets More intangibles identified and recognized on acquisition

Details of purchase price allocation not essentially required to be disclosed

Details of purchase price allocation need to be disclosed

estimated recoverable amount The recoverable is defined as the higher of the value less costs to sell and the value in use The in use is generally based on the discounted future cash flows from the asset When the recoverable amount is found to be lower than the carrying value the carrying value is reduced to the recoverable amount with a charge to profits(Caldwell4)

US GAAP accounting for Business Combinations The standards that prescribe treatment for accounting for Business Combinations are SFAS141 Business Combinations and SFAS 142 Goodwill and other intangible assets The treatment can be summarized as follows- Acquired intangible assets Recorded cost 1)Acquired intangibles are recorded at cost and this cost includes the purchase price and all costs incurred to bring the asset to its intended use 2) In cases where the asset is acquired in exchange for stock or other assets the cost of the asset is the fair value of the consideration given or the fair value of the intangible received whichever is more clear 3) In the case of a lsquobasket purchasersquo cost is allocated on the basis of fair market values of assets acquired Amortization Assets with limited useful life are amortized over life of the asset The asset generates cash flows over such a useful life and the amortization method should to a certain extent 21

reflect the pattern in which the asset is used up if that could be determined If the usage pattern cannot be determined then the straight-line method is used Assets with indefinite life are not amortized Internally Generated Intangibles Costs related to internally generated intangibles are expensed as incurred Research and development costs related to intangibles are expensed and appear in the income statement Only direct costs incurred in obtaining intangibles including legal costs are capitalized Goodwill Goodwill recognized is the difference between the purchase consideration and the fair value of assets It appears on the balance sheet Internally generated goodwill is not recognized The impairment rule for goodwill involves two steps First the fair value of the reporting unit should be compared to its carrying amount including goodwill If the fair value of the reporting unit is greater than the carrying amount goodwill is considered not to be impaired and the company does not have to do anything else (Kieso Weygandt and Warfield593) Impairment testing of intangibles Impairment refers to the write-off or reduction in value of the asset that has to be carried out when the carrying amount of a long-lived asset is not recoverable When the carrying value of an intangible is not recoverable impairment is carried Impairment testing for indefinite life intangibles just involves a fair value test For limited life intangibles impairment is based on a recoverability test and a fair value test Goodwill impairments are based on a fair value test 22

Types of intangible asset Impairment test Limited life Recoverability test then fair value test Indefinite life other than goodwill Fair value test Goodwill Fair value test on reporting unit then fair value test on implied goodwill (Kieso Weygandt and Warfield584)

Pre-IFRS UK GAAP accounting for Business Combinations Starting 2005 all the 25 nations in the European Union including the United Kingdom have adopted the IFRS The pre-IFRS UK GAAP is no longer functional The FRS10 Goodwill and Intangible assets used to prescribe the rules for accounting for Intangibles and Goodwill The Deloitte and Touche publication lsquoGAAP 2004rsquo summarizes the key features of this standard as follows-

bull Internally generated goodwill may not be recognized Purchased goodwill is capitalized and classified as an asset

bull Internally developed intangible assets are recognized only if they have a readily ascertainable market value Purchased intangible assets are capitalized Intangible assets acquired as a part of a business combination are recognized only if they are separable and can be measured reliably

bull Goodwill and intangible assets are amortized over their useful economic lives if this is finite or not amortized if this is indefinite Negative goodwill is classified alongside positive goodwill and amortized

23

bull When the period of amortization exceeds 20 years an impairment test is carried out annually In other cases an impairment test at the end of the first full year after acquisition and then if there is an indicator of impairment

COMPARING THE IFRS TO US GAAP AND PRE-IFRS UK GAAP BUSINESS COMBINATIONS IFRS 3 vs UK GAAP The major differences between the IFRS 3 and FRS provisions for accounting for business combinations are as follows- End of merger accounting and pooling of assets An important requirement of the IFRS 3 is that business acquisitions be accounted for using the purchase method from the perspective of the acquirer This nullifies the UK GAAP provision of allowing companies to use merger accounting where they simply pooled together their balance sheet thus not recognizing goodwill The IFRS provision makes it mandatory for companies to recognize goodwill Goodwill no longer amortized Goodwill is no longer amortized but is instead subjected to a stringent annual impairment test In the event that it is impaired an immediate charge will be taken to the profit and loss account so poor performing acquisitions will be highlighted through such a charge sooner rather than later This represents a fundamental shift in the way goodwill 24

is viewed Goodwill is seen no longer a s steadily wasting asset but instead as one that should be expected to maintain its value(Hadjiloucas and Winter2) More Intangible Assets recognized Historically under UK GAAP when a deal was completed acquired intangible assets would generally just be subsumed within a pot marked lsquogoodwillrsquo The major benefit was that by amortizing this goodwill evenly over a period of usually 20 years you could predict with greater accuracy the impact on earnings (Stevenson and Mc Phee 82) However IFRS 3 requires that all identifiable and valuable intangible assets be reported on the balance sheet The acquirer needs to recognize purchased intangibles on the Balance Sheet More Disclosures The IFRS 3 requires that detailed disclosures be made about transactions and the purchase price allocation method utilized Detailed information about impairment testing of assets and goodwill also needs to be disclosed Strict criteria for determining useful life Limited life intangibles can be amortized over their useful life However management now needs to be more stringent about classifying assets as having a definite or indefinite useful life An indefinite life assertion needs to be backed by evidence and analysis supporting that no legal regulatory contractual competitive economic or other factors limit the life of the asset (Hadjiloucas and Winter3) 25

UK GAAP IFRS Merging accounting and pooling of assets used

No merger accounting allowed all combinations accounted for using the purchase method

Goodwill amortized over life of the asset

Goodwill tested for impairment annually

Fewer capitalized intangible assets More intangibles identified and recognized on acquisition

Details of purchase price allocation not essentially required to be disclosed

Details of purchase price allocation need to be disclosed

reflect the pattern in which the asset is used up if that could be determined If the usage pattern cannot be determined then the straight-line method is used Assets with indefinite life are not amortized Internally Generated Intangibles Costs related to internally generated intangibles are expensed as incurred Research and development costs related to intangibles are expensed and appear in the income statement Only direct costs incurred in obtaining intangibles including legal costs are capitalized Goodwill Goodwill recognized is the difference between the purchase consideration and the fair value of assets It appears on the balance sheet Internally generated goodwill is not recognized The impairment rule for goodwill involves two steps First the fair value of the reporting unit should be compared to its carrying amount including goodwill If the fair value of the reporting unit is greater than the carrying amount goodwill is considered not to be impaired and the company does not have to do anything else (Kieso Weygandt and Warfield593) Impairment testing of intangibles Impairment refers to the write-off or reduction in value of the asset that has to be carried out when the carrying amount of a long-lived asset is not recoverable When the carrying value of an intangible is not recoverable impairment is carried Impairment testing for indefinite life intangibles just involves a fair value test For limited life intangibles impairment is based on a recoverability test and a fair value test Goodwill impairments are based on a fair value test 22

Types of intangible asset Impairment test Limited life Recoverability test then fair value test Indefinite life other than goodwill Fair value test Goodwill Fair value test on reporting unit then fair value test on implied goodwill (Kieso Weygandt and Warfield584)

Pre-IFRS UK GAAP accounting for Business Combinations Starting 2005 all the 25 nations in the European Union including the United Kingdom have adopted the IFRS The pre-IFRS UK GAAP is no longer functional The FRS10 Goodwill and Intangible assets used to prescribe the rules for accounting for Intangibles and Goodwill The Deloitte and Touche publication lsquoGAAP 2004rsquo summarizes the key features of this standard as follows-

bull Internally generated goodwill may not be recognized Purchased goodwill is capitalized and classified as an asset

bull Internally developed intangible assets are recognized only if they have a readily ascertainable market value Purchased intangible assets are capitalized Intangible assets acquired as a part of a business combination are recognized only if they are separable and can be measured reliably

bull Goodwill and intangible assets are amortized over their useful economic lives if this is finite or not amortized if this is indefinite Negative goodwill is classified alongside positive goodwill and amortized

23

bull When the period of amortization exceeds 20 years an impairment test is carried out annually In other cases an impairment test at the end of the first full year after acquisition and then if there is an indicator of impairment

COMPARING THE IFRS TO US GAAP AND PRE-IFRS UK GAAP BUSINESS COMBINATIONS IFRS 3 vs UK GAAP The major differences between the IFRS 3 and FRS provisions for accounting for business combinations are as follows- End of merger accounting and pooling of assets An important requirement of the IFRS 3 is that business acquisitions be accounted for using the purchase method from the perspective of the acquirer This nullifies the UK GAAP provision of allowing companies to use merger accounting where they simply pooled together their balance sheet thus not recognizing goodwill The IFRS provision makes it mandatory for companies to recognize goodwill Goodwill no longer amortized Goodwill is no longer amortized but is instead subjected to a stringent annual impairment test In the event that it is impaired an immediate charge will be taken to the profit and loss account so poor performing acquisitions will be highlighted through such a charge sooner rather than later This represents a fundamental shift in the way goodwill 24

is viewed Goodwill is seen no longer a s steadily wasting asset but instead as one that should be expected to maintain its value(Hadjiloucas and Winter2) More Intangible Assets recognized Historically under UK GAAP when a deal was completed acquired intangible assets would generally just be subsumed within a pot marked lsquogoodwillrsquo The major benefit was that by amortizing this goodwill evenly over a period of usually 20 years you could predict with greater accuracy the impact on earnings (Stevenson and Mc Phee 82) However IFRS 3 requires that all identifiable and valuable intangible assets be reported on the balance sheet The acquirer needs to recognize purchased intangibles on the Balance Sheet More Disclosures The IFRS 3 requires that detailed disclosures be made about transactions and the purchase price allocation method utilized Detailed information about impairment testing of assets and goodwill also needs to be disclosed Strict criteria for determining useful life Limited life intangibles can be amortized over their useful life However management now needs to be more stringent about classifying assets as having a definite or indefinite useful life An indefinite life assertion needs to be backed by evidence and analysis supporting that no legal regulatory contractual competitive economic or other factors limit the life of the asset (Hadjiloucas and Winter3) 25

UK GAAP IFRS Merging accounting and pooling of assets used

No merger accounting allowed all combinations accounted for using the purchase method

Goodwill amortized over life of the asset

Goodwill tested for impairment annually

Fewer capitalized intangible assets More intangibles identified and recognized on acquisition

Details of purchase price allocation not essentially required to be disclosed

Details of purchase price allocation need to be disclosed

Types of intangible asset Impairment test Limited life Recoverability test then fair value test Indefinite life other than goodwill Fair value test Goodwill Fair value test on reporting unit then fair value test on implied goodwill (Kieso Weygandt and Warfield584)

Pre-IFRS UK GAAP accounting for Business Combinations Starting 2005 all the 25 nations in the European Union including the United Kingdom have adopted the IFRS The pre-IFRS UK GAAP is no longer functional The FRS10 Goodwill and Intangible assets used to prescribe the rules for accounting for Intangibles and Goodwill The Deloitte and Touche publication lsquoGAAP 2004rsquo summarizes the key features of this standard as follows-

bull Internally generated goodwill may not be recognized Purchased goodwill is capitalized and classified as an asset

bull Internally developed intangible assets are recognized only if they have a readily ascertainable market value Purchased intangible assets are capitalized Intangible assets acquired as a part of a business combination are recognized only if they are separable and can be measured reliably

bull Goodwill and intangible assets are amortized over their useful economic lives if this is finite or not amortized if this is indefinite Negative goodwill is classified alongside positive goodwill and amortized

23

bull When the period of amortization exceeds 20 years an impairment test is carried out annually In other cases an impairment test at the end of the first full year after acquisition and then if there is an indicator of impairment

COMPARING THE IFRS TO US GAAP AND PRE-IFRS UK GAAP BUSINESS COMBINATIONS IFRS 3 vs UK GAAP The major differences between the IFRS 3 and FRS provisions for accounting for business combinations are as follows- End of merger accounting and pooling of assets An important requirement of the IFRS 3 is that business acquisitions be accounted for using the purchase method from the perspective of the acquirer This nullifies the UK GAAP provision of allowing companies to use merger accounting where they simply pooled together their balance sheet thus not recognizing goodwill The IFRS provision makes it mandatory for companies to recognize goodwill Goodwill no longer amortized Goodwill is no longer amortized but is instead subjected to a stringent annual impairment test In the event that it is impaired an immediate charge will be taken to the profit and loss account so poor performing acquisitions will be highlighted through such a charge sooner rather than later This represents a fundamental shift in the way goodwill 24

is viewed Goodwill is seen no longer a s steadily wasting asset but instead as one that should be expected to maintain its value(Hadjiloucas and Winter2) More Intangible Assets recognized Historically under UK GAAP when a deal was completed acquired intangible assets would generally just be subsumed within a pot marked lsquogoodwillrsquo The major benefit was that by amortizing this goodwill evenly over a period of usually 20 years you could predict with greater accuracy the impact on earnings (Stevenson and Mc Phee 82) However IFRS 3 requires that all identifiable and valuable intangible assets be reported on the balance sheet The acquirer needs to recognize purchased intangibles on the Balance Sheet More Disclosures The IFRS 3 requires that detailed disclosures be made about transactions and the purchase price allocation method utilized Detailed information about impairment testing of assets and goodwill also needs to be disclosed Strict criteria for determining useful life Limited life intangibles can be amortized over their useful life However management now needs to be more stringent about classifying assets as having a definite or indefinite useful life An indefinite life assertion needs to be backed by evidence and analysis supporting that no legal regulatory contractual competitive economic or other factors limit the life of the asset (Hadjiloucas and Winter3) 25

UK GAAP IFRS Merging accounting and pooling of assets used

No merger accounting allowed all combinations accounted for using the purchase method

Goodwill amortized over life of the asset

Goodwill tested for impairment annually

Fewer capitalized intangible assets More intangibles identified and recognized on acquisition

Details of purchase price allocation not essentially required to be disclosed

Details of purchase price allocation need to be disclosed

bull When the period of amortization exceeds 20 years an impairment test is carried out annually In other cases an impairment test at the end of the first full year after acquisition and then if there is an indicator of impairment

COMPARING THE IFRS TO US GAAP AND PRE-IFRS UK GAAP BUSINESS COMBINATIONS IFRS 3 vs UK GAAP The major differences between the IFRS 3 and FRS provisions for accounting for business combinations are as follows- End of merger accounting and pooling of assets An important requirement of the IFRS 3 is that business acquisitions be accounted for using the purchase method from the perspective of the acquirer This nullifies the UK GAAP provision of allowing companies to use merger accounting where they simply pooled together their balance sheet thus not recognizing goodwill The IFRS provision makes it mandatory for companies to recognize goodwill Goodwill no longer amortized Goodwill is no longer amortized but is instead subjected to a stringent annual impairment test In the event that it is impaired an immediate charge will be taken to the profit and loss account so poor performing acquisitions will be highlighted through such a charge sooner rather than later This represents a fundamental shift in the way goodwill 24

is viewed Goodwill is seen no longer a s steadily wasting asset but instead as one that should be expected to maintain its value(Hadjiloucas and Winter2) More Intangible Assets recognized Historically under UK GAAP when a deal was completed acquired intangible assets would generally just be subsumed within a pot marked lsquogoodwillrsquo The major benefit was that by amortizing this goodwill evenly over a period of usually 20 years you could predict with greater accuracy the impact on earnings (Stevenson and Mc Phee 82) However IFRS 3 requires that all identifiable and valuable intangible assets be reported on the balance sheet The acquirer needs to recognize purchased intangibles on the Balance Sheet More Disclosures The IFRS 3 requires that detailed disclosures be made about transactions and the purchase price allocation method utilized Detailed information about impairment testing of assets and goodwill also needs to be disclosed Strict criteria for determining useful life Limited life intangibles can be amortized over their useful life However management now needs to be more stringent about classifying assets as having a definite or indefinite useful life An indefinite life assertion needs to be backed by evidence and analysis supporting that no legal regulatory contractual competitive economic or other factors limit the life of the asset (Hadjiloucas and Winter3) 25

UK GAAP IFRS Merging accounting and pooling of assets used

No merger accounting allowed all combinations accounted for using the purchase method

Goodwill amortized over life of the asset

Goodwill tested for impairment annually

Fewer capitalized intangible assets More intangibles identified and recognized on acquisition

Details of purchase price allocation not essentially required to be disclosed

Details of purchase price allocation need to be disclosed

is viewed Goodwill is seen no longer a s steadily wasting asset but instead as one that should be expected to maintain its value(Hadjiloucas and Winter2) More Intangible Assets recognized Historically under UK GAAP when a deal was completed acquired intangible assets would generally just be subsumed within a pot marked lsquogoodwillrsquo The major benefit was that by amortizing this goodwill evenly over a period of usually 20 years you could predict with greater accuracy the impact on earnings (Stevenson and Mc Phee 82) However IFRS 3 requires that all identifiable and valuable intangible assets be reported on the balance sheet The acquirer needs to recognize purchased intangibles on the Balance Sheet More Disclosures The IFRS 3 requires that detailed disclosures be made about transactions and the purchase price allocation method utilized Detailed information about impairment testing of assets and goodwill also needs to be disclosed Strict criteria for determining useful life Limited life intangibles can be amortized over their useful life However management now needs to be more stringent about classifying assets as having a definite or indefinite useful life An indefinite life assertion needs to be backed by evidence and analysis supporting that no legal regulatory contractual competitive economic or other factors limit the life of the asset (Hadjiloucas and Winter3) 25

UK GAAP IFRS Merging accounting and pooling of assets used

No merger accounting allowed all combinations accounted for using the purchase method

Goodwill amortized over life of the asset

Goodwill tested for impairment annually

Fewer capitalized intangible assets More intangibles identified and recognized on acquisition

Details of purchase price allocation not essentially required to be disclosed

Details of purchase price allocation need to be disclosed

UK GAAP IFRS Merging accounting and pooling of assets used

No merger accounting allowed all combinations accounted for using the purchase method

Goodwill amortized over life of the asset

Goodwill tested for impairment annually

Fewer capitalized intangible assets More intangibles identified and recognized on acquisition

Details of purchase price allocation not essentially required to be disclosed

Details of purchase price allocation need to be disclosed