Company Valuation Under IFRS : Interpreting and Forecasting ...

Chapter Seven – An introduction to consolidation
assets. In addition, the rules regarding goodwill amortisation are, as we have seen,
changing. So we need not merely to be able to analyse proposed deals but also to
analyse companies whose accounts reflect a legacy of growth through acquisition.
9.5.1 The accounting change
The change over to IFRS will result in a very simple change to the accounting
treatment of goodwill created on acquisition. It will no longer be subject to
annual amortisation and under normal circumstances will therefore remain
permanently in the balance sheet at historical cost. It will continue to be subject
to impairment tests, and in the event of its value being deemed to be lower than
its book carrying value, the surplus will have to be written off.
9.5.2 What should we do?
From the valuation perspective, the key questions are why or whether we should
have worried about earnings after amortisation, and what balance sheet figure for
goodwill we should be using to determine the company’s profitability.
Our answer to these questions is as follows:
1. Goodwill amortisation was always an irrelevance to valuation, and its
disappearance is to be welcomed.
2. In assessing the operating performance of a company, and in forecasting its
profits, returns on capital excluding goodwill are the key driver, since the
company will not build a pile of goodwill on its new investments (unless it
is a serial acquirer).
3. But it is important that goodwill is justified in the end, otherwise value has
been eroded (this is not a contradiction to the sentence above).
4. For many companies, balance sheets understate economic capital, because
much of what was really an investment is treated as if it were an operating
cost.
9.5.3 Other intangibles do matter
Let us just kill off the last statement first. Imagine that a consumer goods
company had grown entirely organically. All of the cost of building its brand
would have been written off as operating costs. So the balance sheet would be
hugely understated. Now imagine that a competitor, with an identical set of
products, had built its business partly organically and partly by acquisition, which
would imply capitalising those acquired either as intangible assets or as goodwill.
The solution here is to remove the goodwill and to adjust the balance sheets of
both companies to reflect the investments that they have made in building their
brands, including investment made by companies that have been absorbed into
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