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Post deal accounting: impairment test according to IFRS & HGB

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The accounting treatment of a company acquisition (post deal accounting) requires both in-depth knowledge of accounting standards and detailed know-how of business valuation. For accounting purposes it is necessary to distinguish between the accounting treatment in the acquiring company’s separate financial statements prepared according to the German Commercial Code (HGB) and accounting in consolidated financial statements prepared according to HGB or IFRS.

 

When accounting for an acquired and fully-consolidated company for the first time, its net assets are broken down into individual “components” and each acquired asset and assumed liability is revalued at market value as part of the so-called purchase price allocation (“PPA”). If the total assets measured at market value less liabilities are lower than the purchase price, the difference is disclosed as goodwill in the acquiring company’s consolidated financial statements.

 

In the case of consolidated financial statements prepared according to HGB, the resulting goodwill is amortised over the useful life based on the straight-line method. However, if goodwill is accounted for according to International Financial Reporting Standards (IFRS), applicable are the provisions of International Accounting Standard 36 (IAS 36), according to which goodwill must be subject to an impairment test at least once a year. Thus, contrary to the HGB accounting treatment, IFRS stipulate that a write-down must only be made if goodwill has been found to be impaired (“impairment only approach”).

 

Since the introduction of the impairment only approach, it has been observed that German companies listed on stock exchange have made write-downs of goodwill to a small extent only. As a result of further company acquisitions and low impairments, individual companies disclose in the meantime a goodwill value that is higher than the equity value reported according to IFRS. Consequently, if any of those companies impaired their goodwill, this would lead to an excess of liabilities over assets in their consolidated financial statements.

 

Due to the coronavirus pandemic and the related adverse economic effects for individual companies and industries, market observers expected that there would be more goodwill impairments in consolidated financial statements for 2020 (among others, to use the coronavirus pandemic quasi as a pretext to eliminate accounting risks by way of future impairment write-downs). As this “goodwill impairment wave” has not shown up yet and there have been further company acquisitions, the goodwill values are at a historical high according to the latest valuations of goodwill of DAX listed companies.

 

In this context, it is becoming ever more important for shareholders and potential investors to understand what guidelines and selection criteria are used to carry out an impairment test for the purpose of separate and consolidated financial statements. Therefore, in the following we present the general procedures and the differences between the HGB and IFRS impairment testing.
 

IFRS consolidated financial statements – goodwill impairment test according to IAS 36

Definition of valuation object: According to IAS 36, an acquired company should be basically split into the so-called cash-generating units (CGU), that is, the smallest identifiable group of assets that generates cash inflows largely independently [of the cash inflows from other assets or groups of assets]. The definition of CGU is based on business criteria (for example, business lines, regions) rather than on the company’s legal form. This means that an acquired company can be split into several CGUs depending on the CGU definition. Accordingly, the goodwill resulting from the company acquisition is split into CGUs.

 

The impairment test according to IAS 36 is based on a comparison between the carrying amount and the recoverable amount of a CGU. A write-down must be made if the CGU’s recoverable amount is lower than its carrying amount.

 

Definition of carrying amount: Carrying amount comprises total assets less total liabilities of a CGU which are necessary for conducting business operations, excluding items that serve financing purposes (liquid funds, equity, or financial liabilities to e.g. credit institutions). The definition of relevant balance sheet items requires in practice a detailed analysis of the balance sheet, partially at the level of individual accounts or trial balances.

 

Definition of recoverable amount: Recoverable amount is the higher of two values: value in use and fair value less cost of disposal. Value in use is the CGU’s value which can be derived from its continued use. Fair value less cost of disposal is a value that could be generated from the CGU’s fictitious disposal.

 

In practice, both value concepts are regularly based on a discounted cash flow approach. According to this approach, a cash flow before financing (free cash flow to firm) is derived based on an integrated CGU-specific business planning consisting of the income statement and balance sheet, and is discounted at an appropriate discount rate (weighted average cost of capital, WACC) as of the valuation date.   

 

Whereas the value in use as the “value derived from continued use” is generally based on business planning and can therefore include real synergies, the fair value less cost of disposal as a disposal value relies to a larger extent on the market and industry data and does not take into account any real synergies.

 

The discount rate for both value concepts should be derived in accordance with the so-called “market participant view”, according to which all WACC components (in particular, capital structure, beta factor, and cost of debt) are determined based on a group of comparable companies (peer group) rather than on the basis of the CGU's actual financing structure.

 

Therefore, the recoverable amount corresponds to the CGU’s value before taking into account the net financial debt (comparable with an “entity value” used in business valuation) and is thus equivalent to the definition of carrying amount, which also comprises only balance sheet items which do not serve financing purposes.

 

HGB separate financial statements – impairment test according to IDW RS HFA 10

Definition of valuation object: When preparing separate financial statements according to HGB, the impairment test – contrary to the IFRS rules – is to be carried out not at the level of CGUs but at the level of legal entities, which means that individual book values of shareholdings in subsidiaries are tested for impairment. In this process, a company value (“fair value”) is determined for each subsidiary in accordance with IDW RS HFA 10 and is then matched with the book value of the shareholding.

 

An (unscheduled) write-down must be made only if the fair value is lower than the book value of the shareholding.

 

Deriving the fair value: A subsidiary is valued generally using an income or discounted cash flow approach. Assuming the same premises, both approaches lead to the same results, because they share the same investment theory basis (calculation of net present value).

 

Unlike in the procedure under IAS 36, the specific debt structure of the valuation object (at market values) rather than the debt structure of a peer group is applied to determine the cost of capital for the purpose of testing the book value of the shareholding. Additionally, the valuation can take into account synergies between the subsidiary being valued and further subsidiaries or the company preparing the financial statements itself.

 

The company value to be compared with the tested book value of the shareholding is the so-called “equity value”, that is, the company value after taking into account the net financial debt. 

 

Summary

In post deal accounting, a distinction should be generally made between the testing of the book value of the shareholding in separate financial statements according to HGB and the impairment test in consolidated financial statements according to IFRS.

 

Both impairment test concepts are often based on a discounted cash flow approach, but they differ, partly significantly, in terms of design, implementation, and the applicable premises. The following table presents an aggregated overview of the key differences between the two impairment test concepts:  

 

​Item​IFRS consolidated financial statements​HGB separate financial statements

​Valuation object

​CGU​Legal entity
​Test value (“book value”)​Carrying amount​Book value of the shareholding
​Test value (“market value”)​Recoverable amount (~entity value)​Equity value
​Cost of capital​Peer group​Legal entity

 

Due to the described differences, the two tests require in practice two separate valuations for which the accountant often needs to use two different valuation models.

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