Accounting rules around merger and acquisition (M&A)
activity are ‘poorly applied’ by businesses, resulting in costly and difficult
accounting for such deals and confusion for investors, according to the
Financial Reporting Council (FRC). The findings come as M&A activity is
expected to increase in 2010 after a barren two years.
The FRC recently undertook a study of accounting for acquisitions looking at
whether there is a need for improvement. Ian Wright, its director of corporate
reporting, believes there is. “A step change is needed in the quality of the
information about M&A transactions given in annual reports and accounts,” he
Traditionally, companies give an account of their most significant M&A
activity in the front of their annual reports to help investors and other annual
report users to understand the impact of such transactions.
Impact of acquisitions
However, under the Companies Act 2006, directors of publicly-quoted companies
now have to report explicitly on the main factors likely to affect the company’s
future development, such as the impact of major acquisitions.
The FRC found that almost all the companies “explained well the rationale for
their material acquisitions during the period and set out” in their business
reviews, detailing potential future benefits that they expected to arise from M
&A transactions, including revenue synergies expected from cross-selling
products, access to forward order books and improved distribution networks,
strengthened market positions including the acquisition of brand names,
achieving critical mass in particular locations and cost savings from
elimination of duplication.
International financial reporting standards (IFRS) prohibit the recording of
most internally developed intangible resources. However, IFRS 3 Business
Combinations, which was published in 2004 and came into effect for listed
companies in 2005, contains specific accounting requirements to be applied to
all business combinations.
However, it now seems that many UK companies are still unfamiliar with the
The most significant difference between IFRS 3 2004 and previous UK financial
reporting requirements is that all business combinations, whether mergers or
acquisitions, must be accounted for as acquisitions. Changes to the definition
of an intangible asset also mean that more of them – such as brands, trademarks,
customer and supplier contracts, licences and intellectual property – are likely
to have to be recorded separately from goodwill under IFRS.
During 2008 and early 2009, the FRC conducted a series of interviews with
investors and company finance teams to understand the factors that make the
preparation and use of corporate reports complex. One element of the feedback
received was that companies find M&A accounting costly and difficult to
perform. Moreover, investors said they did not find the resulting information
In the sample of 20 acquisitions carried out during 2008 that the FRC
reviewed (before the current version of IFRS 3 Business Combinations came into
effect, as noted by accounting standards chief Sir David Tweedie in an early
January 2010 letter to the Financial Times), the aggregate value of
intangible assets and goodwill recorded ranged from 30% to 180% of the purchase
price for the transactions selected.
David Tweedie’s letter to the Financial Times, in response to an
article the newspaper ran about the FRC report, said: “The revised standard
addresses many of the application challenges referred to by the FRC study.
Indeed, page 11 of the FRC report acknowledges this, stating that the revised
standard ‘should lead to a step-change in the recording of intangible assets in
future audited accounts’.”
Aggregation of intangible assets
The FRC says that companies seem to find it difficult to establish meaningful
groups of intangible assets to aggregate as classes in the audited accounts,
sometimes simply recognising a category of intangible assets by labelling them
as ‘other’ – while it found three companies had combined a range of intangibles
in this category, from combined purchased and acquired patents, licences and
trademarks, software rights and licences, and order backlog.
“This level of aggregation does not satisfy the requirement that any grouping
of reported assets should be ‘of a similar nature and use in an entity’s
operations’,” the FRC says. “Greater care is needed to ensure compliance with
the disclosure requirements in a meaningful manner.”
The significance of the aggregate values of intangible assets and goodwill
found should lead the companies – and their external auditors – to take
particular care to ensure that the business review is comprehensive and that the
IFRS reporting requirements for acquisitions were met in full.
Indeed, the FRC found that, overall, the results of its study were
disappointing in terms of the understanding and execution of these standards. In
some cases, says the regulator, it was difficult to identify the required
accounts disclosures, while in other cases the information provided in the
business review and the audited accounts was either insufficient or
Nearly all the companies included in the study gave a logical and seemingly
comprehensive account of the reasons and expected benefits of the acquisitions
in their business reviews.
However, the regulator says, “A coherent and consistent link between the
information in the business review and the intangible assets was recorded for
only four of the examined transactions.
“None of the descriptions of the factors giving rise to goodwill in the
audited accounts were informative. This was because more than half the companies
either failed to provide any description of goodwill or provided an analysis
that was ‘non-descript’.
It added that seven of the companies “failed to comply with the IFRS
requirement to identify separately the different classes of intangible asset
arising from each material transaction. Instead, they identified the classes of
intangible asset only in aggregate for all acquisitions during the year. This
restricted the ability of the reader of the accounts to understand which classes
and amounts of intangible assets arose from individually material acquisitions.”
The FRC also says it found that companies have failed to address key specific
requirements under the IFRS accounting rules. For example, IFRS 3.66 2004
requires disclosure in the audited accounts of “information that enables users…
to evaluate the nature and financial effect of business combinations”. But from
the disclosures provided in the audited accounts, there was little evidence that
any of the companies had addressed the requirements.
IFRS 3.67 (f) 2004 requires companies to disclose separately each material
class of asset that they have acquired in each material business combination.
The practical effect of this requirement is that companies need to describe the
nature of the individual intangibles they have grouped.
The results suggest that companies find it difficult to establish meaningful
groups of intangible assets to aggregate as classes in the audited accounts and
also that greater care is needed to ensure compliance with the disclosure
requirements in a meaningful manner. While such assets were identified for 15 of
the 20 transactions, only one acquirer had identified the distinct nature of
different types of customer related intangible assets and reported more than one
class of them.
IFRS 3.67(h) 2004 requires disclosure, for each material acquisition, of the
factors that contribute to goodwill, including a description of each intangible
asset that is not recorded separately.
However, the FRC found that none of the descriptions were generally
informative and that six of the companies failed to provide this required
Meanwhile, work goes on in this field, following the International Accounting
Standards Board’s May 2009 exposure draft on fair value measurement. This is
expected to be finalised during 2010.
The International Valuation Standards Council has issued an exposure draft
around determining the fair value of intangible assets for IFRS reporting,
expected to be finalised early this year.
“This additional guidance should facilitate more reliable valuations of
intangible assets in respect of future acquisitions,” says the FRC.
The Council adds that it will conduct further interviews with investors and
other stakeholders in 18 months’ time to assess whether such reporting has
improved. The regulator has also said it will work with companies to better
understand whether the costs of compliance and the complexity of performing the
asset valuations are increasing or reducing.
To read the FRC study, Accounting for Acquisitions, click
To read the FRC’s discussion paper, Louder than Words, regarding investor fe
edback on M&A accounting, click