Accounting treatment for intangible assets acquired in a business combination under IFRS

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Master’s Thesis Accounting Elina Hämäläinen

Accounting treatment for intangible assets acquired in a business combination under IFRS

Supervisor/Examiner: Satu Pätäri Second Examiner: Pasi Syrjä

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Title: Accounting treatment for intangible assets acquired in a business combination under IFRS

Faculty: LUT, School of Business and Management

Major: Accounting

Year: 2015

Master’s Thesis: Lappeenranta University of Technology 127 pages, 4 figures and 25 tables Examiners: Professor Satu Pätäri

Professor Pasi Syrjä

Keywords: Intangible assets, business combinations, IFRS, goodwill, accounting, media companies

The role of intangible assets and the amount of business combinations have increased significantly during the last decades which has caused the need to reform and harmonise the accounting treatment for acquired intangible assets. The aim of this study is to find out how the new accounting standard for business combinations, IFRS 3, has affected the accounting treatment for identifiable intangible assets and goodwill in the examined media companies between 2005 and 2014. The most significant reforms introduced by IFRS 3 have been goodwill impairment test and the fair value accounting for acquired intangibles. This study is conducted by using a descriptive analysis and the empirical data consists of financial statement information of listed Finnish and international media companies. The main objectives of IFRS 3 have been to reduce the amount of acquisition cost allocated to goodwill and allow companies to recognise new intangible assets separately from goodwill. The results of this study show that the amount of the acquisition cost allocated to goodwill has decreased during the examined period and due to the fair value accounting, business acquisitions have made new intangible assets visible that otherwise would have not met the recognition criteria under IAS 38. The application of IFRS has revealed a big amount of invisible assets in the balance sheets but at the same time this has reduced the comparability between companies.

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Tutkielman nimi: Yritysten yhteenliittymistä nousevien aineettomien hyödykkeiden tilinpäätöskäsittely IFRS –standardien mukaisesti

Tiedekunta: LUT, Kauppakorkeakoulu

Pääaine: Laskentatoimi

Vuosi: 2015

Pro gradu –tutkielma: Lappeenrannan teknillinen yliopisto 127 sivua, 4 kuvaa ja 25 taulukkoa Tarkastajat: Professori Satu Pätäri

Professori Pasi Syrjä

Hakusanat: Aineettomat hyödykkeet, yritysten yhteenliittymät, IFRS, liikearvo, kirjanpito, mediayhtiöt

Aineettomien hyödykkeiden merkitys yritysostoissa on kasvanut merkittävästi samalla, kun pitkään jatkunut keskustelu tilinpäätösten luotettavuuden heikkenemisestä on nostanut esille sen, että yritysten tilinpäätökset eivät riittävissä määrin heijasta aineettomien hyödykkeiden arvoa. Tämän tutkielman tavoitteena on selvittää, kuinka tarkasteltavat mediayhtiöt ovat soveltaneet yritysostoihin liittyvää tilinpäätösstandardia (IFRS 3), jonka päätavoitteena on ollut erityisesti liikearvon käsitteen selkeyttäminen sekä liikearvolle allokoitavan hankintahinnan määrän vähentäminen tunnistamalla aineettomia hyödykkeitä erillään liikearvosta. Samalla standardin tarkoituksena on ollut tuoda uusia aineettomia hyödykkeitä näkyväksi yritysostojen yhteydessä. Käyvän arvon soveltaminen yritysostoissa nouseville aineettomille hyödykkeille on ollut merkittävä uudistus, ja tuonut tavoitteiden mukaisesti näkyväksi uusia aineettomia hyödykkeitä, jotka muutoin olisivat olleet aktivointikelvottomia IAS 38:n mukaisesti. Tämän tutkielman tulokset osoittavat, että liikearvolle allokoitavan hankintahinnan määrä on vähentynyt tarkasteltavissa yrityksissä, mutta samalla ne nostavat esille sen, että yritysten taseet sisältävät näkymätöntä aineetonta omaisuutta, jotka eivät täytä IAS 38:n aktivointiedellytyksiä, ja näin ollen tämä heikentää vertailtavuutta yritysten välillä.

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acknowledgements was: Am I really done? I moved to Lappeenranta about five years ago and at that time I did not know what to expect. These past five years have been amazing and I have met so many new and wonderful people and got unforgettable memories. During these years in Lappeenranta, I have also found my own fields of interests. Writing this thesis has been a long process including both ups and down but now it has finally come to an end.

First, I want to say thank you to my parents, who have been the most important support for me during my whole life and helped me both financially and mentally and encouraged me to do what I want. I also want to say thank you to my lovely friends, Rosa and Laura, because I would not be in this point without your support and our prolonged lunch conversations.

I would like to thank my examiners, Satu and Pasi, for the comments and guidance and help to improve the content of this study. Last, I want to say a special thank you to Juha Nuutinen at Alma Media for all the comments, new development ideas, expertise and the possibility to co-operate with you.

I also want to thank everyone who has stood by me during this process and supported me. I would not be here without all this support. However, now it is time to say goodbye to Lappeenranta, leave a student life behind and move on.

Elina Hämäläinen Helsinki, 17.10.2015

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1.2 Literature review ... 2

1.3 Research questions, objectives and delimitations ... 6

1.4 Research methodology and data ... 8

1.5 Structure of the study ... 9

2 Accounting for intangible assets ... 10

2.1 Background ... 10

2.2 The value relevance of financial statements and intangible assets ... 11

2.3 International Financial Reporting Standards ... 16

2.3.1 Intangible assets ... 17

2.3.2 Recognition criteria of intangible assets ... 20

2.3.3 Initial recognition, measurement subsequent to acquisition and amortisation ... 25

2.3.4 Accounting for business combinations ... 26

2.4 Accounting for intangible assets acquired in a business combination under IFRS 3 ... 29

2.4.1 Accounting treatment for goodwill under IFRS 3 ... 30

2.4.2 Fair value accounting of acquired intangible assets ... 35

2.4.3 Disclosures related to intangible assets and goodwill ... 39

2.5 Theoretical evidence for using IFRS accounting for business combinations ... 41

2.5.1 Accounting conservatism ... 42

2.5.2 The effects of the adoption of IFRS on the value-relevance of intangible assets 43 2.5.3 The value relevance of goodwill impairments and fair values ... 47

3 Accounting treatment for acquired intangible assets in the media companies ... 52

3.1 Research data and description of research process ... 52

3.2 Alma Media ... 55

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3.7 The main findings and discussion ... 92

4 Summary and conclusions ... 100

4.1 Answers to the research questions ... 100

4.2 Contribution of the study ... 103

4.3 Further research and limitations ... 107

References ... 109

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Figure 2. Intangible asset recognition criteria under IAS 38

Figure 3. Alma Media’s goodwill and identifiable intangible assets amounts (million EUR) in the balance sheet between 2005 and 2014

Figure 4. Axel Springer’s shares of the acquisition costs allocated to goodwill between 2006 and 2014

LIST OF TABLES

Table 1. History of IFRS 3

Table 2. The basic information about the examined companies in 2014 Table 3. Alma Media’s balance sheet information

Table 4. Alma Media’s income statement information

Table 5. Impact of business acquisitions on Alma Media’s assets and liabilities

Table 6. Carrying amounts and fair values of acquired assets Table 7. Sanoma’s balance sheet information

Table 8. Sanoma’s income statement information

Table 9. Impact of business acquisitions on Sanoma’s assets and liabilities Table 10. Carrying amounts and fair values of Nowa Era

Table 11. Carrying amounts and fair values of Independent Media Table 12. Schibsted’s balance sheet information

Table 13. Schibsted’s income statement information

Table 14. Impact of business acquisitions on Schibsted’s assets and liabilities Table 15. Specification of acquired intangible assets

Table 16. Modern Times Group’s balance sheet information Table 17. Modern Times Group’s income statement information

Table 18. Impact of business acquisitions on Modern Times Group’s assets and liabilities

Table 19. Carrying amounts and fair values of acquired assets Table 20. Axel Springer’s balance sheet information

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Table 23. Carrying amounts and fair values of acquired assets

Table 24. Summary of the examined companies’ balance sheet information in 2005-2014

Table 25. Summary of the impact of business combinations on the examined companies’ assets and liabilities in 2005-2014, averages

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FASB Financial Accounting Standards Board

GAAP Generally Accepted Accounting Principles

IAS International Accounting Standards

IASB International Accounting Standards Board

IFRIC FRS Interpretation Committee

IFRS International Financial Reporting Standards

SFAS Statement of Financial Accounting Standards

US GAAP United States Generally Accepted Accounting Principles

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1 Introduction

1.1 Background and motivation

An underlying trend in the nature of economic activity has been one of the most significant reasons for the growing importance of intangibles. Resources spent on intangible assets have conventionally been expensed and treated as costs and not as investments. This traditional accounting treatment for intangibles has reduced the value relevance of financial statements as the importance of intangibles has been continuously increasing and advocates of greater intangible asset reporting often argue that financial statements do not reflect the value of intangible assets. Over the last decades there have been needs for accounting reforms and a general view is that the traditional historical cost approach is no longer useful as the economy has shifted from industrial-based to knowledge-based where intangibles play an important role. (Cañibano et al. 2000;; Hoegh-Krohn & Knivsflå 2000)

A study made by OECD (2012) reveals that investments in intangible capital have grown and in many cases, they are even more important than tangible investments. The figure 1. below shows that in many countries intangible investments are as important as tangible and in the USA and UK the total business investments in intangible capital have been even bigger than investments in tangible capital in 2009. As the importance of intangibles has grown there has also been an increased focus on mergers and acquisitions that has caused the need for creating the accounting for intangible assets acquired in a business combination. These transactions can have significant benefits, e.g. increased stakeholder value and market share and cost reductions, for the acquiring company but the related accounting is complex.

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Figure 1. Intangible and tangible business investments in 2009 (OECD 2012)

There are several reasons for the complexity related to intangibles like that the nature of intangible assets, which is less detectable because they are without physical substance. In addition, all the intangibles are not usually recognised in the acquiree’s pre-combination financial statements and fair value determination of intangible assets often requires estimation techniques because of the lack of quoted market prices. This topic is very relevant especially in the media sector due to the digitalisation process and the changes in the customer preferences as they are switching to digital channels and mobile services. Because of this, media companies have been searching for growth though business acquisitions to keep up with the speed of digitalisation and new technology.

1.2 Literature review

There are numerous studies and surveys examining intangible assets’ impacts on the companies’ success and productivity (Kyläheiko et al. 2004; Lönnqvist 2007; Saarnivaara 2007) and many academic studies, e.g. Chen et al. (2005), Huang and Wang (2008) and Shakina and Molodchik (2014) agree that intangibles are the most

0 2 4 6 8 10 12 14 16 18 20

Business Investments in Intangible and Tangible Capital,

2009 (% GDP)

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important strategic resources. The specific nature of intangible resources allows to create a sustainable competitive advantage but, on the other hand, it also complicates their practical usage as well as their theoretical investigation and accounting treatment.

The importance of intangible assets has continuously been growing and researches have been attempting to show that intangible investments do contribute a company’s future performance. Therefore, they should be considered as assets but researchers have still not found a consistent solution for for the accounting treatment for intangible assets. (e.g. Cañibano et al. 2000, Choi et al. 2000, Egginton 1990, Hoegh-Krohn & Knivsflå 2000, Skinner 2008;; Zéghal & Maaloul 2011) Accounting for intangible assets, goodwill and other identifiable intangible assets, has been one of the most complex issues in the harmonisation of accounting standards and different opinions are regarding whether some or all the intangible assets should be capitalised or not and if so, whether they should be amortised or subjected to annual impairment test. (Sahut et al. 2011;; Dahmash et al. 2009;; Hoegh-Krohn & Knivsflå 2000)

Advocates of greater intangible asset reporting frequently criticise that the published financial statements of companies do not reflect the value of intangible assets and thus provide misleading information to the users of the financial statements (Lev & Zarowin 1999;; Aboody & Lev 1998;; Godfrey & Koh, 2001). Older studies by Rubinstein (1973) and Epstein and Turnbull (1980) have already noticed in their studies that the value of an asset is inversely related to the uncertainty of expected future benefits from an asset and this relationship is totally ignored in many balance sheet and income statement measures. When it comes to intangible assets, this is relevant because of the great uncertainty associated with the amount and timing of future economic benefits of intangibles.

The value-relevance and reliability of financial statements and intangible assets have been an extensively discussed topic among academic researchers during the last three decades. A growing number of older empirical studies have documented

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that the value-relevance of financial statements has been decreasing over the past decades as accounting numbers, especially reported earnings, are less able to explain variations in stock prices than before. (e.g. Hayn, 1995;; Lev & Zarowin 1999;; Beaver et al. 1987;; Easton & Harris, 1990) However, despite the fact that earnings have become less value-relevant there is also clear evidence that book values and balance sheet have become more value-relevant as the focus is moving from income statement towards balance sheet (Francis & Schipper 1999, Lev and Zarowin 1999, Collins et al. 1997).

Much of the academic research has focused on the topics related to accounting for goodwill, which is also the largest intangible asset for many firms (Wiese 2005;; Seetharaman et al. 2004;; Henning et al. 2000;; Johnson & Petrone 1998;; Jennings et al. 1996;; Colley & Volkan 1988;; Wines et al. 2007). For example, Jennings et al. (1996) has empirically investigated the relationship between market equity values and purchased goodwill. Their results show that the market values purchased goodwill as an asset. Older studies by Amir et al. (1993), Chauvin and Hirschey (1994) and McCarthy and Schneider (1995) reported a significant positive relationship between goodwill and the market value of a firm. Researchers also disagree about whether goodwill is an asset or not (Johnson & Petrone 1998) and several attempts have been made to define goodwill but it still seems to be unclear (Giuliani & Brännström 2011;; Bloom 2009;; Colley & Volkan 1988;; Henning et al. 2000).

The academic researchers have also been keen on to investigate differences between IFRS and US GAAP (Adams et al. 1999;; Bhimani 2008;; Harris & Muller 1999) The accounting treatment for business combinations is quite similar both under IFRS and US GAAP. The adoption of International Financial Reporting Standards (IFRS) has had major impacts on the recognition and measurement practices for goodwill and other identifiable intangible assets. IFRS 3 Business Combinations have changed the accounting for goodwill as impairment tests are carried out instead of systematic amortisation and fair-value based accounting numbers have been replacing traditional historical cost approach book values. In addition to IFRS 3, IAS 38 which outlines the accounting requirements for intangible

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assets and IAS 36 which ensures that assets are not carried at more than their recoverable amounts. IAS 36 also regulates the impairment of assets. (Hamberg et al. 263;; European Commission 2011;; 2010)

IFRS 3 has originally issued in 2004 by the International Accounting Standard Board (later on the IASB). The standard outlines the accounting when an acquirer obtains a control of a business. Recognition and fair value measurement of all the acquiree’s identifiable intangible assets and liabilities at the acquisition date are among the most relevant elements of the acquisition method under IFRS 3. The development started in the U.S. when the Financial Accounting Standard Board, later on the FASB, issued Statement of Financial Accounting Standards (SFAS) 141 (Business Combinations) and 142 (Goodwill and Other Intangible Assets) in 2001. The IASB also wanted to harmonise accounting standards in Europe, and since 2005 IFRS has been the official accounting principles for all the listed companies in the European Union. (Busacca and Maccarrone 2007, 307;; Hamberg et al. 263-264)

Many studies examining goodwill amortisations under US GAAP and other local accounting standards in Europe and Australia have found that they are not value relevant and they do not convey private information about future cash flows like impairment test does (e.g. Egginton 1990;; Jennings et al. 2001, Churyk & Chewning 2003;; Chen et al. 2004;; Chalmers et al. 2011;; Chalmers et al. 2012). The introductions of IFRS and goodwill impairment regime have also been widely examined topic in recent studies (e.g. Oliveira et al. 2010;; Daske et al. 2008;; Chalmers et al. 2012;; Carlin & Finch 2010;; Comiskey & Mulford 2010;; Wines et al. 2007;; Gjerde et al. 2008). Many studies (e.g. Oliveira et al. 2010;; Daske et al. 2008;; Chalmers et al. 2012) find that markets have reacted positively to the transition of IFRS. One of the biggest changes of IFRS adoption is the annual impairment test for goodwill introduced by IFRS 3 issued in 2004. For example, Chalmers et al. (2012) find that the accounting information under IFRS provides more useful information especially about reported goodwill in Australia because IFRS 3 requires an impairment test for goodwill.

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1.3 Research questions, objectives and delimitations

The global interest in mergers and acquisitions has been growing due to the several significant benefits, e.g. increased market shares and cost reductions, related to them. The same trend can be seen in the media sector while companies have actively been involved in business acquisitions as traditional print and broadcast media companies have been struggling to compete with new online and mobile media companies. Due to the recent digital transformation, which has already been going on several years, traditional media companies has been trying to remain competitive and keep up with the latest technology by acquiring other companies. In this study, intangible assets are the key interest because in the media sector, they form a major part of the assets in the balance sheet due to the nature of the industry.

As mentioned above, the topic of this study is very actual and relevant and this is why the objective of this study is to investigate how IFRS 3 has affected on the accounting treatment for acquired intangible assets. The aim is to find out how the examined companies have applied IFRS 3 in terms of acquired identifiable intangible assets and goodwill comparing to the requirements set by IFRS 3 and other examined companies.

The main research question of this study is:

• How the adoption of IFRS 3 has affected the accounting treatment for identifiable intangible assets and goodwill acquired in a business combination in the examined companies in 2005-2014?

The main research question examines how the examined companies have applied IFRS 3 and how it has affected the accounting treatment for acquired identifiable intangible assets and goodwill. This study investigates, whether there can be found significant changes in the business combination accounting after 2005 when IFRS 3 was introduced. In addition, this study examines, whether it can be found differences in applying IFRS 3 between the examined companies during the

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examined time period. The subjects of this study are Finnish and international media companies which includes both small and big companies.

Sub questions related to the main research question are:

1. How has the value-relevance of financial statements and intangible assets changed along with the introduction of IFRS 3?

2. What are the requirements set by IFRS 3 to the accounting treatment for goodwill and other intangible assets?

3. What are the advantages and challenges of IFRS 3 related to the accounting treatment for goodwill and other intangible assets?

The first sub question concentrates on the value relevance of financial statements and intangible assets and whether the adoption of IFRS 3 has impacted positively on the value relevance of financial statements and intangible assets. The value relevance of goodwill impairments is also investigated as impairment test for goodwill introduced by IFRS 3 is one of the most significant reforms of IFRS accounting. The second sub question examines the requirements set by IFRS related to the accounting treatment for business combinations and goodwill and other intangible assets arising on the acquisitions. The third sub question examines both advantages and challenges of IFRS 3 related to the accounting treatment for goodwill and other identifiable intangibles.

The topic of this study is examined from the perspective of accounting professional and IFRS 3 standard is examined only insofar as it relates to the accounting treatment for goodwill and other intangible assets. In the empirical part, the topic covers only media sector as media companies in Finland and worldwide have actively been involved in business combinations and intangible assets play a major role in the media sector and cover a significant share of assets acquired in business combinations made in the media sector. The examined companies are examined at group level as the key interest is IFRS accounting so the data consists of consolidated financial statements, which are prepared in accordance with IFRS. Therefore, the relevant IFRS standards form a theoretical framework of this study.

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Financial statements of parent companies are prepared according to local accounting standards so they are not included in the observation.

1.4 Research methodology and data

The literature in the theory chapters consists of topics related to International Financial Reporting Standards (IFRS) and International Accounting Standards (IAS) and academic studies and journals and other relevant literature related to the topic. The aim of the theory chapter is to give a deep understanding of the nature of intangible assets, accounting treatment related to intangible assets and business combinations and the historical development of intangible asset accounting. It is also examined how other studies have investigated these topics.

This study is conducted by using a qualitative research methodology. The idea of using qualitative research methodology is to get an in-depth understanding about the research subject. In the empirical part, the gathered quantitative and qualitative data is examined in a descriptive level. The research data consists of annual reports and consolidated financial statements and this study tries to answer the research questions by analysing the collected data.

This study uses financial statements data from the time period of 2005-2014. The data about business combinations and intangible assets is collected from the consolidated annual reports. The examined time period was chosen based on that IFRS 3 was applied first time in 2005, and to get the best result to make conclusions as many fiscal years as possible is included in the investigation. Five companies have been chosen of which two are Finnish listed companies and others are international. The financial statements of all the examined companies from 2005- 2014 are included in this observation. All the selected companies are listed companies and due to this they all apply IFRS and the reporting practices are similar and comparable.

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1.5 Structure of the study

This study consists of four main chapters. The first chapter is the introduction which includes the background and motivation, literature review, research questions, objectives and delimitations, research methodology as well as structure of the study. The second chapter is the theory part. First, it takes a look at the value relevance of financial statements in general and then the value relevance of intangible assets. Second, IFRS are examined and how the accounting for intangible assets and business combinations are treated under these standards. Last, theoretical evidence is presented in favor of using IFRS accounting for acquired intangible assets. The third chapter is the empirical part and analyses Finnish and international media companies on how the IFRS has affected the accounting treatment for acquired intangible assets between 2005 and 2014. The last main chapter includes the summary and conclusions.

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2 Accounting for intangible assets

2.1 Background

Accounting for goodwill and other intangible assets has been one of the biggest problems of financial reporting and extensively discussed topic among researchers (e.g. Canibano et al. 2000, Choi et al. 2000, Egginton 1990, Hoegh-Krohn & Knivsflå 2000, Skinner 2008;; Zéghal & Maaloul 2011). This problem is very relevant because of the changes in the financial environment that has caused the continuously growing importance of intangible assets. Fast changing technology and communication media require more complex resources and tangible assets alone do not guarantee the success and expenses related to intangible assets often create future economic benefits. Traditionally, resources spent on intangible assets have been treated as costs and expensed in the balance sheet instead of seeing them as valuable investments and capitalising in the balance sheet. International mergers and acquisitions and rapidly developed financial markets are one of the key reasons why intangible asset regulation is extremely important (Ji & Lu 2014, 188).

According to Lev (2008, 210) there are two things that have to be done: capitalise intangible investments and improve the standardised disclosures about intangibles. There are three primary issues relating to accounting treatment for intangible assets. First, should intangible assets be recognised (capitalised rather than expensed) in the balance sheet and if they should, should internally generated intangibles be treated differently from purchased intangible assets. Second, should all the capitalised intangible assets be systematically amortised including those with indefinite lives or should they rather be subjected to impairment test and on what basis. Third, should companies be allowed to revalue (upwards) intangible assets to better reflect their fair values and under what circumstances. (Sahut et al. 2011, 270)

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Lev (2001, 16) states that there are two forces that have caused the shift towards intangibles: an increase in global competition and changes in information technology. Accounting academics have advocated recognising intangibles in financial statements and provided much evidence in their studies to show that intangibles are value relevant and they should be recognised in the balance sheet (e.g. Aboody & Lev 1998;; Francis & Schipper, 1999;; Lev and Zarowin, 1999;; Hoegh- Krohn & Knivsflå 2000;; Goodwin and Ahmed, 2006). According to Dahmash et al. (2009) the recent shift from the profit and loss statement towards the balance sheet increases the importance of appropriate recognition of intangible assets.

Skinner (2008) and Zéghal and Maaloul (2011) provide a good summary and a critical evaluation of the arguments that have been advanced in favor of reforming the current accounting and disclosure practices relating to intangible assets. Zéghal and Maaloul (2011) state that because of the inadequate accounting treatment of intangibles, more information about them should be disclosed. Skinner (2008) argue that evidence provided to support accounting reforms related to intangible assets is weak, especially in the case of expanding the existing asset recognition criteria to include intangibles, which are currently excluded from the balance sheet. According to him, accounting regulators can provide guidance but relying on private incentives to encourage the disclosure related to the management and valuation of intangibles is more important. Both of these studies highlight the importance of disclosures. However, even though academic researchers do not agree how intangibles should be treated everyone admits that the value relevance of financial statements have been decreasing and one of the reasons is that the importance of intangible assets have been growing continuously.

2.2 The value relevance of financial statements and intangible assets

The purpose of financial statements is to provide relevant information for users in making economic decisions. Financial statement information has been criticized for failing to reflect changes in the uncertainty of future economic benefits and costs related to different assets and there has been an increasing concern about the decreased value relevance and reliability of financial reporting. Some of the

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concerns expressed about the current reporting model focus on the content of what is reported;; it has been asserted that the current reporting model does not recognize and measure economic assets that create shareholder value. One reason for this might be that either because accounting standards and practices have not changed as business has changed. The other possible reason can be that accounting standards and practices have changed in ways, which does not give value-relevant information. (Choi et al. 2000, 35;; Francis & Schipper, 1999, 323;; Hoegh-Krohn & Knivsflå 2000, 254)

Intangible resources should be recognised in the balance sheet to maximize the informational relevance of financial statements. Information is relevant if it can confirm or change a decision maker’s expectations and the value-relevance of financial statements can be defined as “… ability to confirm or change investors’ expectations of value”. Further, the value-relevance of financial statements can be measured by the response in the market price or volume when accounting information is revealed or by their ability to explain variations in the market price or volume. In addition to these, value-relevance can also be measured by the total return that could be earned from pre-disclosure knowledge of financial statement information. (Hoegh-Krohn & Knivsflå 2000, 255)

Lev and Zarowin (1999) have found a significant increase in the market-to-book ratio of US firms from a level of 0,81 to 1,69 between 1973 and 1992. Basically, this means that almost 40 percent of the company’s market value of is not reflected in the balance sheet. They argue that intangible assets are the reason in the decline because investment in intangible assets has increased significantly over time, and because the current accounting practice for intangibles creates a discrepancy between the valuation implied in firms' earnings and their stock prices.

There are also assumed to be other reasons than immediate expensing of intangibles, such as the increase in percentage of losses and one-time items (Collins et al. 1997) or the increase in returns volatility (Francis & Schipper 1999) in explaining declining earnings value relevance. Collins et al. (1997) conclude that the shift in value-relevance from earnings to book value can be explained by the

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increasing significance of one-time items and the increased frequency of negative earnings but mention also intangible intensity to be one of the reasons. Amir & Lev (1996) find that, on a stand-alone basis, financial information (earnings, book values and cash flows) is mostly irrelevant for the valuation of cellural companies and non- financial (e.g. market penetration) is highly value-relevant. This finding indicates that the traditional focus on financial information and variables may lead to wrong conclusions if there is a big amount of unreported intangibles.

The value-relevance of intangibles has been extensively examined over the last 20 years as intangible assets have been stated to be one major reason for the declined value relevance of financial statements (e.g. Cañibano et al. 2000;; Dahmash et al. 2009;; Godfrey & Koh, 2001;; Wyatt 2008). Capitalising and amortising intangible assets over their useful lives to better match costs with the future benefits is believed to increase the informativeness of financial statements. However, intangibles are difficult to record objectively and the value relevance and reliability of financial statements may be even reduced if reporting entities are given more discretion to recognise doubtful or even imaginary intangible assets. The pressure from financial statement users to recognise more intangible resources as assets will increase as the importance of intangibles increases. (Hoegh-Krohn & Knivsflå 2000)

Hoegh-Krohn and Knivsflå (2000) have examined accounting for intangible assets in Scandinavia, the UK, and the USA. They conclude that in order to improve value relevance of financial statements all types of intangible assets need to be capitalized and subsequently amortised over their useful lives. They also state that some of the previously expensed costs should be reversed and capitalised in the balance sheet, which also will improve the value-relevance. Goodwin and Ahmed (2006) examine the value-relevance of intangibles in Australia between 1975 and 1999 using regression analysis. Even though they do not find clear evidence of the decreased value relevance they, find that the value relevance of earnings in those firms, which capitalise intangibles has increased more than in those firms that do not capitalise intangibles. In general, the results indicate that the value relevance of earnings and book values has increased for those companies, which capitalise intangibles.

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Aboody and Lev (1998) examine software capitalization in 163 companies between 1987-1995 and conclude market values the capitalisation of intangible assets compared with immediate expensing in the income statement. Choi et al. (2000) examine the relationship between the reported value of intangible assets, the associated amortisation expense and firm’s equity market values using a matched pair portfolio and multiple regression analyses. Their results indicate that the financial market positively values reported intangible assets and support the criticism of financial statements’ failure to reflect changes in the levels of uncertainty of different assets. According to them intangible assets should be reported in the balance sheets but they should not be periodically amortised.

Due to the fact that goodwill is the most significant intangible asset, there are number of studies examining the value relevance of reported goodwill in both US and Australia and these studies indicate that capitalisation of goodwill does have value to investors (Churyk 2005;; Godfrey & Koh 2001;; Henning et al. 2000). Godfrey and Koh (2001) investigate the capitalisation of intangible assets in Australia using regression analysis. Their results provide evidence that capitalisation of intangible assets, as a whole, provides information which is relevant for firm valuation. They also find that when examining intangible assets separately, both goodwill and identifiable intangible assets seem to be value relevant. However, one interesting fact is that investors attach more value to the reported goodwill than to other balance sheets items including identifiable intangible assets. These findings indicate that accounting treatment for goodwill has significant economic consequences.

Jennings et al. (1996) has empirically investigated the relationship between market equity values and purchased goodwill in the US during the period of 1982-1988. Their results show that the markets value purchased goodwill as an asset. In addition, they also find little evidence of a systematic relationship between goodwill amortisation and firms’ market values. Consistent with Jennings et al. Churyk (2005) adds that goodwill is not typically overvalued when it is initially recorded and supports that the systematic amortisation is not warranted and does not improve the relevance of reported goodwill.

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Regarding the capitalisation of acquired intangibles in general, Kimbrough (2007) documents that investors find the values of recognised intangibles informative. He finds that investors’ responses to the release of purchase price allocations are increasing in both the percent of total assets that are recognised apart from goodwill and in the percent of intangible assets that are recognised apart from goodwill. This supports the FASB’s objective to maximize the amount of assets recognised apart from goodwill. The evidence provided in this study supports the contention that the disclosure of the decomposition of the purchase price yields information that is relevant to investors in assessing a merger. As the IASB has followed the development of US GAAP this may also mean that purchase price allocation under IFRS provides useful information to investors and other stakeholders.

There is also another important concept which closely relates to the value relevance and should be taken into account: the value reliability. According to Dahmash et al. (2009) the value relevance is conditional on the value reliability. Ji & Lu (2014, 183) agree and state that standard setters, like the IASB, are concerned about the relevance of information about intangible assets because the reliability of such information affects also the value-relevance. The value-relevance and value- reliability of the accounting information about intangibles has to be improved but the accounting regulators may be unable to improve both value relevancy and value reliability simultaneously. Both of them are equally important because unreliable information also reduces the value relevance of information. Wyatt (2008) also argues that even though information about intangible assets is value relevant, these assets may not be reliably measured.

Dahmash et al. (2009) have examined both value relevance and reliability (degree of bias) of identifiable intangible assets and goodwill under Australian GAAP from 1994 to 2003 and find that information about intangible assets is value relevant but also biased. Goodwill tends to be reported conservatively and identifiable intangible assets aggressively. Their results indicate that the transition to IFRSs is about to reduce the level of bias because these standards require goodwill to be tested for impairment instead of systematic amortisation. Dahmash et al. also state that the

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more prudent recognition requirements related to the recognition of identifiable intangible assets reduce these biases. These recognition requirements are examined in the next chapter.

2.3 International Financial Reporting Standards

Since 2005, European listed companies have been obliged to use International Financial Reporting Standards (IFRS) as a regulation environment for consolidated financial statements in an effort to achieve transparency and harmonisation of financial reporting standards and to reinforce the integration of European capital markets. More than 100 countries have adopted IFRS around the world despite it is not mandatory for all of these countries and is rather based on recommendations. (Haaramo 2012, 21) Carmona and Trombetta (2008) have examined the application of IFRS and suggest that the inner flexibility enables the application of IFRS/IAS to countries with diverse accounting traditions and varying institutional conditions. Hence, a distinctive of IFRS standards is that they are principles-based instead of rules-based and do not include specific guidance for every possible situation. (Carmona & Trombetta 2008, 456)

IFRS standards are issued by the IASB. IFRS norms includes Framework, IFRS and IFRIC. Framework includes the general fundamentals of preparation and presentation of financial statements, IFRS includes financial statement standards and IFRIC, IFRS Interpretation Committee, includes interpretation guidelines of these standards. Accrual basis and going concern are the fundamental assumptions of IFRS. Qualitative requirements of financial reporting can be divided into fundamental characteristics and enhancing characteristics. Fundamental characteristics include relevance and faithful representation and enhancing characteristics include comparability, verifiability, timeliness and understandability. (Haaramo 2012, 21, 32;; Troberg 2007, 26) From the perspective of acquired intangible assets, the most relevant standards are IFRS 3, IAS 38 and IAS 36 that are examined more detailed in the upcoming chapters.

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2.3.1 Intangible assets

According to IFRS an intangible asset is “an identifiable non-monetary asset without physical substance”. An asset, in turn, can be defined as a resource that is controlled by the entity as a result of past events (for example, purchase or self- creation) and from which future economic benefits (inflows of cash or other assets) are expected. Accounting for intangible assets is regulated under IAS 38 and this standard identifies three critical attributes of an intangible asset: identifiability, control (power to obtain benefits from the asset) and future economic benefits, which can be, for example, revenues or future cost reductions. (European Commission 2010, 3-5)

One common classification of intangibles mainly developed by accounting standard setters divides them into two categories: internally generated intangibles and externally acquired intangibles. This is also the classification IFRS uses. Both externally and internally generated Intangible assets consist of identifiable intangible assets and unidentified intangible assets, which cannot be identified separately and form goodwill. Intangibles other than goodwill are usually called identifiable intangible assets. Externally acquired intangible assets are purchased via transactions with external parties and at arm’s-length prices. They can be purchased individually or as a part of a business combination. A common externally acquired intangible asset is purchased goodwill arising on a business combination and it represents future economic benefits arising from synergy between identifiable assets or from intangible assets that do not meet the definition of an identifiable intangible asset. (Hoegh-Krohn & Knivsflå 2000, 245) Due to the special nature and the importance of goodwill regarding this study, it is examined more closely.

Goodwill is one of the most complex and controversial intangible assets. The simplest definition of goodwill is to consider it as an acquisition premium, which means that goodwill is the cost above the fair value of firm once all the assets of the firm have been stated at fair value. Much of the research has focused on issues related to accounting for goodwill because it is also the largest intangible asset for most companies. Despite the theoretical definition, goodwill is not clear from the

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empirical perspective because it consists of many different elements and components. Hence, it is important to investigate goodwill from an empirical perspective because goodwill is also an empirical issue. (Choi et al. 2000, 36-37;; Giuliani & Brännström 2011, 162;; Lhaopadchan 2010, 123)

Goodwill is generally considered difficult to interpret, because it consists of many different components and accounting for goodwill has been constituting big challenges to accounting standard setters (Henning et al. 2000;; Powell 2003). According to the IASB goodwill is any excess of the costs of the acquisition over the acquirer’s interests in the fair value of the identifiable assets and liabilities. Johnson and Petrone (1998, 294) find two main perspectives of goodwill that can be observed: a top-down perspective and a bottom-up perspective. From the top-down perspective, goodwill is considered as a residuum of a larger asset after a breaking- down process of this larger asset into goodwill and other identifiable intangibles. From the bottom-up perspective goodwill is viewed in terms of its components which means that goodwill is seen as a sum of unrecognized intangible assets which are potential for identification or a sort of “purchase premium”. According to Giuliani and Brännström (2011, 164) the concept of goodwill under IFRS does not reflect the image of goodwill and one reason for this may be that the theoretical definition of goodwill combines the top-down perspective with the bottom-up perspective.

It has also been under the discussion whether goodwill is an asset or not. For example, Johnson and Petrone (1998) argue that from a top-down perspective goodwill is an asset because it is viewed as a part of larger asset but from the bottom-up perspective it is not as clear whether goodwill is considered as an asset or not. Purchased goodwill is regulated under IFRS 3 and it treats goodwill as an asset with indefinite useful life and defines goodwill as “An asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognised.” (European Commission 2011, 13) The definition of goodwill is an academic problem but from a practical point of view goodwill has also qualitative impacts on financial statements related to how to e.g. value or impair goodwill (Giuliani and Brännström 2011, 162).

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It is good to notice that recognising intangibles as an asset depends on the accounting regulations. Under the definition of an asset made by the IASB some intangibles do not meet the recognition criteria introduced by IAS 38, which is examined more detailed in the next part, so the existence of goodwill depends on that which intangibles can be recognised separately and which should be accounted into goodwill. For example, human capital is a recurrent item in goodwill as it cannot be recognised separately in the balance sheet due to the lack of control over the expected future economic benefits from skilled workforce, so in the case of a business combination it is accounted into goodwill (Eckstein 2004, 154). The possibility to include different intangibles with a wide variety in goodwill makes the definition of goodwill complex but at the same time very relevant for precision and understandability. (Giuliani and Brännström 2011, 163-164)

Previous studies (e.g. Johnson and Petrone 1998) focus on goodwill from the theoretical point of view but the study of Giuliani and Brännström (2011) is taking a more practical perspective. They concentrate on the description of goodwill arising from business combinations in Swedish and Italy and identify three different classes named “Identified goodwill”, “Not specified” and “Residuum”. They examine whether it can be found any consistency in how companies define goodwill in practice in the first year of mandatory application of IFRS 3. The class “identified goodwill” includes the cases in which goodwill is defined in terms of intangibles and/or synergies. The second class covers the cases in which no explanations are found. The third class defines goodwill as a residuum or as a difference between the purchase price and fair value of net assets acquired. The majority of the companies in this study have described goodwill as a residuum and many companies also supplied a description of goodwill required by IFRS 3. In addition, they find that companies adopting a top- down perspective seems to not disclose goodwill. (Giuliani and Brännström 2011, 167-168)

In those cases, where the goodwill is disclosed Giuliani and Brännström (2011, 169 identify three interpretations: “Core goodwill”, “Intangibles” and “Core goodwill and intangibles”. The first one includes all the interpretations of goodwill in terms of

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synergies and benefits. The second class “Intangibles” refers to all the intangibles the company cannot account separately. The third class is the combination of other two classes and includes both synergies and intangibles. Giuliani and Brännström (2011) find that “Core goodwill” is the largest category and “Intangibles” is the smallest. However, they conclude that despite the stimulation of IFRS 3, the top- down approach for goodwill is still predominant and goodwill continues to be seen as a residuum.

2.3.2 Recognition criteria of intangible assets

Intangible resources have some characteristics that are relevant when evaluating whether they should be recognised as assets or not: (1) they have few or no alternative uses because many intangible assets are firm-specific and difficult to utilize for others, (2) problems with or lack of separability because many intangibles only have value together with tangible assets, (3) difficulties to determine whether the asset which was originally recorded is being maintained or whether a new asset is gradually substituting it and (4) greater uncertainty of whether their costs will bring future economic benefits. (Hoegh-Krohn & Knivsflå 2000, 257)

Intangible asset recognition is an important topic because of the nature of intangibles. They are not easy to recognise and verify and that is the reason why they can be used to manage and manipulate accounting numbers and reported earnings. Under IFRS all the intangible expenses should meet the certain criteria to be recognised as assets. The objective of IAS 38 is to prescribe the accounting treatment for intangible assets and according to this standard an intangible asset needs to be recognised if, and only if, it meets the certain criteria. IAS 38 requires an entity to recognise an intangible asset (purchased and self-created) if, and only if “it is probable that he future economic benefits that are attributable to the asset will flow to the entity and the cost of the asset can be measured reliably”. (Hoegh- Krohn & Knivsflå 2000, 249) The recognition criteria are applied both to externally acquired and internally generated intangible assets. IAS 38 is applied to intangible assets acquired in a business combinations occurring on or after 31 March 2004 but it is not applied to purchased goodwill, which is regulated only under IFRS 3.

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According to IAS 38 an intangible asset should be recognised if it is identifiable. An intangible asset is identifiable when it is separable (capable of being separated and sold, transferred, licensed, rented or exchanged either individually or together with a related contract or arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations. (Haaramo 2012, 190-191) However, Intangible assets are difficult to identify and separate from other assets (Violeta & Mariana 2011, 297). Consistent with this Wyatt (2001, 84, 110) notes that the assessment of the existence and identifiability of intangible assets may be really challenging and this is the reason why not all the intangible assets and investments are not recognised in the company’s balance sheet.

An entity has the control over the asset if the entity has to power to obtain future benefits, the entity can restrict others to access to benefit from the profits. Usually, the company obtains a control through legal rights, e.g. copyright. In addition to the control and identifiability, to be able to recognised the asset in the balance sheet, probable future economic benefits, such as revenues or reduced future costs, are expected. According to IAS 38, these future economic benefits must be based on reasonable and supportable assumptions about conditions that will exist over the life of the asset.”. This definition of probable future benefits allows management to use their discretion to determine probability, which has also been criticised due to the possibility for accounting manipulation and opportunistic behavior. (Haaramo 2012, 192-194) Figure 2. presents the recognition criteria under IAS 38.