I have previously written about how final-year students at the University of Liverpool start to really grasp the concept of judgment when looking at accounting for provisions.
Building on this, the lectures move to the judgments that are applied within the process of consolidated financial statements, beginning with acquisition and continuing throughout the process. For those to whom these lessons are a distant memory, here are some reminders about accounting judgments.
Control judgments
One of the first areas of judgment relates to control. As covered previously, the judgment of control over the joint venture between British retailers M&S and Ocado has led them to account for their 50% share of the joint venture in Ocado completely differently, with significant impacts on the relevant financial statements.
In 2019, the British sports fashion retailer JD Sports acquired footwear retailer Footasylum for £90m. This led to an investigation from the UK regulator, the Competition and Market Authority, during which time JD was not able to integrate Footasylum’s assets into the group or make significant changes to its organisational structure.
Placing a fair value on internally generated assets includes significant judgment and estimation
Despite these restrictions, JD consolidated Footasylum as a subsidiary, stating its belief that it had control. Despite numerous appeals, JD was required to dispose of the Footasylum investment in 2022 at a vastly reduced price of £37.5m. This means that they consolidated a subsidiary for three years that they couldn’t really incorporate into the group.
Valuation judgments
Other judgments upon acquisition relate to the recognition of assets at their fair value, as per IFRS 3, Business Combinations. For intangible assets, applying the principles of IFRS 3 overrides the principles of IAS 38, Intangible Assets. This results in assets that were internally generated in an entity’s individual financial statements being recognised at fair value in the consolidated statement of financial position.
An impact of this can be seen in the recent acquisition of the gaming company Activision Blizzard by Microsoft for US$75.4bn. Activision Blizzard is the producer of successful games such as Call of Duty, World of Warcraft and Candy Crush, and these brands would have been a key reason for the acquisition.
In the Activision Blizzard individual financial statements there were intangible assets valued at US$442m, but when Activision Blizzard was consolidated into Microsoft, the intangible assets were included at their fair value of US$22bn, with goodwill of US$50bn.
The inclusion of these assets at fair value aims to highlight some of the key reasons for the acquisition. Placing a fair value on these internally generated assets includes significant judgment and estimation, which is why it is currently prohibited under IAS 38.
Microsoft has previously increased its profit by billions through a revision of some of its useful lives
As well as highlighting some of the key assets, another aspect of recording the intangible assets at fair value is that it separates them from goodwill. The intangible assets acquired in Activision Blizzard are amortised over their useful lives, whereas the goodwill figure is not amortised but checked annually for indications of impairment.
As the figure of goodwill is the biggest asset in the acquisition, the judgments around annual impairment loom large, but the business combinations exposure draft currently being discussed could not find a way to improve this test.
The useful life of these acquired intangibles is also judgmental. Microsoft has applied an average life of 24 years to the marketing-related assets (giving annual amortisation of US$483m) and four years to the technology-based assets (giving annual amortisation of US$2.4bn). Clearly the 24-year life assigned to the marketing-related assets is hugely judgmental, and this judgment could make a difference of hundreds of millions of dollars. As discussed before, Microsoft has previously increased its profit by billions through a revision of some of its useful lives.
Non-controlling interests
Under IFRS 3, the non-controlling interest can be measured at the proportion of net assets or fair value. The fair value figure is more judgmental, but is still more likely to be a more accurate depiction than simply taking a percentage of the acquired company’s net assets.
Usually the non-controlling interest is recorded in equity, but there are situations where it is recorded as a liability. This is a less common issue, but it is the centre of a significant valuation battle at the moment.
Since 2019, following its acquisition of 21st Century Fox, Disney has owned 67% of Hulu, the cable network, with Comcast owning the other 33%. Disney and Comcast came to a put/call arrangement where either party could require the shares to be transferred to Disney for at least US$8.6bn.
Estimates around the true value of acquired intangibles are incredibly difficult to make
Watch and learn
See Adam Deller’s series of videos explaining the fundamentals of IFRS Accounting Standards
Disney paid that initial amount, stating that its bankers JP Morgan valued Hulu at US$27.5bn and therefore no further consideration would be due above the US$8.6bn floor value. Comcast’s bankers Morgan Stanley valued Hulu at over US$40bn, meaning that Disney is potentially liable to pay a further US$5bn. This has resulted in a third bank being appointed to value Hulu and come up with a final figure, and the figures could have significant impacts on the results of both entities.
The use of fair value accounting does therefore add some value in consolidated financial statements, but it brings its own challenges. It is clearly useful to approximate the fair value of assets, but it may well be that the fair value assigned to intangible assets is no more accurate than assessing whether goodwill is impaired or not.
In a digital society, estimates around the true value of acquired intangibles and even their useful life are incredibly difficult to make and could have large impacts on financial statements.
