IFRS has taken a significant step forward with a proposal for disclosure requirements of management key objectives and related targets in strategic business combinations and the extent to which they are subsequently met. The background to this unprecedented disclosure stems from the concern that management may try to conceal failed business combinations. The proposal reflects a clear trend by the IASB to use the management approach to improve the relevance of financial statements. Shaking up traditional accounting and increasing auditor awareness of the business perspective through the management approach is also appropriate in several other accounting topics, such as the selection of accounting policies.
Recently, the IASB published a proposal to amend the disclosure requirements of IFRS 3 regarding business combinations, which has two main components. The first component relates to how assets, including goodwill, are tested for impairment in accordance with IAS 36 and mainly includes removing the current restriction on including improvements, enhancements or restructuring in the calculation of value in use. Undoubtedly, this is a welcome change that broadens the use of economic factors in the preparation of financial statements. However, the real drama lies in the second component regarding new disclosure requirements for strategic business combinations. According to the proposal, an entity will be required to disclose the key objectives of the acquisition, such as increasing revenue, profit, or market share, and the related targets to assess the achievement of those key objectives, such as the rate of increase in revenue, profit, or market share. Additionally, in subsequent years the entity will be required to disclose whether the acquisition-date related targets were met, and consequently whether the key objectives have been achieved. Furthermore, the proposal will require the disclosure of additional information about the expected amounts of synergy resulting from the acquisition, such as revenue growth and cost savings. This proposed requirement could be vastly significant to investors given the increased dominance of business combinations in recent years and the amazing statistic that most business combinations fail due to management’s inherent optimism.
It is important to emphasize that this is not just another proposal to amend a standard. This is, in a way, a revolution taking place in international accounting, especially over the last decade, called the “management approach”. The trend began with the revolutionary IFRS 8, published back in 2006, which first introduced the management approach regarding how to identify operating segments and which items to disclose. IFRS 8 indeed came to the world following a similar American standard, but since then, a clear independent trend can be identified in IFRS of adopting the management approach, which reached the revolutionary requirement in the recently published IFRS 18, to disclose information on non-GAAP data (Management Performance Measures) in an entity’s financial statements. Additional standards published in the last decade that are influenced by management’s business model are IFRS 10 regarding the definition of investment entities and IFRS 9, which bases the classification of financial assets on the business model (within certain limits). In addition to these, for goodwill impairment testing purposes IAS 36 requires goodwill to be allocated to cash-generating units based on how management monitors goodwill for internal purposes.
The main rationale for the unprecedented disclosure requirements in the proposal is investors’ concern that losses from impairment of goodwill are recognised too late, due to management’s interest in concealing failed business combinations. The delay in impairment recognition can sometimes result from distortions that can arise due to the way impairment testing is performed, whereby goodwill is shielded from impairment by assets in the same cash-generating unit that were not recognized, as well as inherent over-optimism in management’s assumptions.
For illustration purposes, assume a company successfully completed an internally generated R&D project, and because the accounting criteria for capitalisation were not met, no intangible asset was recognized in the financial statements. Now, the company acquires a subsidiary and recognizes goodwill. For impairment testing purposes, the goodwill is allocated to a cash-generating unit that also includes the unrecognized intangible asset. In this case, even if the acquisition is an utter failure and does not justify the inflated consideration paid (recognized as goodwill), an impairment loss of the goodwill will not be recognized in the years following the acquisition due to the way value in use of the cash-generating unit is calculated. The value in use relates to the cash-generating unit as a whole, and thus the economic value of the intangible asset that was not recognized in the financial statements provides shielding to the recognized goodwill, which has no economic value.
Beyond the fact that it is appropriate to find a solution to the accounting distortion stemming from the non-recognition of R&D projects as an asset, the rationale of the new disclosure requirements is to convey the message to users in real-time that the business combination has failed. It should be noted that the disclosure requirements of management’s key objectives and related targets, and whether they are met, only relate to strategic business combinations.
Looking to the Future: The Management Approach as a Basis for Choosing Accounting Policies
Although in recent IFRS standards one can see a worrying detachment from US GAAP, the importance of the proposed disclosure requirement cannot be underestimated, and no less important is the direction it can signal for future accounting standards. This is true not only for matters related to presentation and disclosure. Thus, in my opinion, the management approach should be adopted regarding the application of accounting policies in cases where there is an option to choose an accounting policy and there is no preference under IFRS (as exists, for example, regarding the choice of measurement model for investment property). In other words, the adopted accounting policy will be consistent with how this information is reported to decision-makers within the company. The basic assumption should be that management knows better than anyone else what is the most relevant way to measure the company’s performance. For example, regarding the designation of an investment in shares (financial asset) measured at fair value through other comprehensive income or through profit or loss, or alternatively choosing an accounting policy to measure inventory using the average method or the FIFO method. That is, where management internally reports the changes in the fair value of its investment in shares in profit or loss, it will not be able to recognise those changes in other comprehensive income for financial reporting purposes, and vice versa. Similarly, where management calculates its gross profit for internal purposes based on the average method, it will not be able to apply the FIFO method in its financial statements, and vice versa.
One can go a step further with the management approach and establish a requirement that where management measures a certain item for internal purposes based on fair value, then the item will be measured in the financial statements accordingly. Such an item could be, for example, an investment in an associate or joint venture measured in the financial statements using the equity method because the entity is not an investment entity nor a venture capital fund. Just think what a significant improvement in the relevance of financial statements is inherent in such a move. For illustration purposes, in cases where a company has consolidated divisions or activities that it assesses from the perspective of the group’s investment arm at fair value, investors will receive the most relevant information.
In addition to implementing the management approach in recognizing and measuring items in financial statements, it is also worthwhile to adopt a principle whereby disclosure and explanation should be provided for deviations from critical management estimates, such as the rate of allowance for expected credit losses or the growth rate considered in calculating value in use for impairment testing of assets. For example, consider two identical companies in the same industry, calculating the value in use of an identical plant. One management is realistic and calculates a growth rate of 2%, resulting in the recognition of an impairment loss, while the other is optimistic and calculates a growth rate of 5%, not recognising any loss. In this case, how can investors know that the difference in accounting treatment stems not from different facts and circumstances, but rather from a difference in the level of management optimism? My suggestion is to add a disclosure requirement for the actual growth rate in subsequent years, compared to the original growth rate estimated for these years, including an explanation for any gap. Such a disclosure requirement would significantly contribute to the relevance of financial statements, both in terms of the appropriateness of estimates and in providing investors the ability to assess the reliability of the information.
There is no doubt that these steps, as well as the current proposed step regarding disclosure for business combinations, will greatly challenge the audit of financial statements and will require increased auditor awareness of the business model of management. This is a positive change, which will advance the auditing profession to the stage of viewing an entity from a business perspective, especially considering the AI revolution. Accountants should welcome the change, evaluate it from a long-term view and remember that in the end, AI will not be able to replace the business-oriented auditor.
The bottom line – it is in the best interest of the accounting profession as a whole that the proposal for the unprecedented disclosure requirements for business combinations be accepted, even with certain changes, and thus the trend of using the management approach in accounting standards will continue.
(*) Written by Shlomi Shuv, with thanks to Naftali Flaumenhaft for his useful comments