Before IFRS 3 was introduced, entities were allowed to amortize goodwill. However, after it was introduced back in 2004-2005, amortization of goodwill was strictly prohibited and entities were required to follow impairment regime. As a result, entities are required to test purchased goodwill for impairment loss on annual basis. Getting deeper in accounting history, we can see that US GAAPs back in 2001 abandoned amortization of goodwill in favour of impairment of goodwill approach.
IAS 38 defines amortisation and impairment loss as follows:
Amortisation is the systematic allocation of the depreciable amount of an intangible asset over its useful life.
Impairment loss is the amount by which the carrying amount of an asset or a cash-generating unit exceeds its recoverable amount.
Another important term to be defined before we discuss the question in hand is goodwill.
Goodwill is an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognised.
In other words goodwill is an unidentifiable or inseparable asset. An asset is said to be identifiable when it can be separated from an entity and can be sold or exchanged without selling the whole entity. For example Plant and Machinery of an entity can be sold without selling the business. But it’s repute cannot be separated and sold individually and when the entity as a whole is sold, its repute gets transferred to new buyer with the entity.
But why impairment approach is preferred over amortisation approach.
Following are some of major reasons:
Amortisation is a systematic allocation of value of asset over its useful life. It is extremely difficult to assign any life span to goodwill. Therefore no such method is yet devised which can amortise infinite life assets. Morover, IAS 38 states very clearly in respect of intangible assets with indefinite life that they should be tested for impairment loss on periodic basis instead of amortisation.
Technically speaking, the rate at which asset is amortized is required to be in line with the rate at which benefits are rendered by the same intangible asset. Speaking of goodwill, it is really hard to value the benefits goodwill generates over a period of time. And due to this amortisation charge cannot be linked to the economic benefits rendered in particular accounting period.
Therefore, impairment is more suited so that goodwill is reduced only when it is needed instead of consistent reduction in an asset with no logical reasoning behind it. Because impairment is based on reasons or in terms of IAS 38 indicators. So whenever goodwill is impaired, users will be given with supportive information and reasons instead of baseless annual amortisation. This becomes even more important in case of large business acquisitions or mergers with significant amount of goodwill involved. In other words, following the impairment approach, accounting is more timely and thus more relevant.
Another thing to understand is that amortisation of goodwill is different from amortization or depreciation of identifiable assets in many different aspects.
Although depreciation or amortisation expenses are not real expenses and thus for some distort the financial performance figures of the entity but still these charges provide some useful information to the users as they need to know when outflow will occur to replace the asset and secondly how much profits of the entity are diluted because of such notional expenses. But goodwill is not replaced. Therefore, any amortisation charge in respect of goodwill does not make any sense.
Another reason on similar basis as above is that investors like to know how much money was actually invested towards goodwill at acquisition. Any annual amortisation will distort this figure and with the passage of time we will completely loose the track of original goodwill. However, this can be avoided by accumulating amortisation charge in a separate account just like accumulated depreciation to preserve the goodwill amount. But again, as said above, amortisation charge in the income statement is not providing any useful information to the users. So abandoning amortisation method in favour of impairment appears to provide better reporting basis.
Yet another reason from investor’s perspective is that if entities are allowed to amortise goodwill then they may follow different approaches to amortise or simply different rates of amortisation which may cause financial statements of an entity to be incomparable with competitor’s financial statements.
Critics however claims that impairment model opens the door to subjective accounting and thus financial reporting may be degraded for that reason because impairment involves judgement and estimation of effects of indicators.
In the end we can see that choosing between amortisation and impairment is just like choosing between two evils and then getting settled with lesser evil or at least what according to majority is less evil.