In a recent post, I argued that goodwill arising from a business combination was just a random number; therefore, any attempt to measure impairment amounted to nothing more than a costly charade. By coincidence, I recently had an inquiry from a client about the accounting for goodwill at foreign subsidiaries per FAS 52. Thinking about it for my client also reminded me of yet another sordid tale of accounting convergence for its own sake.
The General Problem of Goodwill Arising from Foreign Subs under FAS 52
By way of background, FAS 52 requires that assets of a foreign subsidiary with carrying amounts based on historic costs (e.g., plant and equipment) be translated into the reporting currency (e.g., dollars) at the exchange rate existing on the balance sheet date (e.g., the 'current rate). As I have noted in an earlier post, multiplying historic costs by current exchange rates is the equivalent of multiplying apples and rocks — with the inevitable result being a random number.
What about goodwill arising from the acquisition of a foreign subsidiary? As I am about to show, the choices arising out of a slavish application of the general approach of FAS 52 is so absurd that the FASB buried its own decision deep in an Appendix. Be that as it may, the specific question is whether goodwill should be measured in dollars, or measured in the currency that is used to measure all of the other assets and liabilities of the subsidiary and translated into dollars. The implications are the following:
- If the foreign currency is the answer, then goodwill will be translated to dollars at each balance sheet using the current exchange rate. Exchange rate movements will affect the carrying amount of goodwill expressed in dollars, which will in turn affect consolidated shareholders' equity through other comprehensive income (the so-called 'translation adjustment').
- If goodwill is measured in dollars from the outset it will remain at a constant dollar amount over time, unless it becomes impaired per the FAS 142 charade.
From an investor's viewpoint, which treatment of goodwill is preferable? Measuring in a foreign currency and translating with current exchange rates (the first choice, above) adds another information-less element to goodwill measurement, confounding even further any potential to glean something relevant out of the translation adjustment. Therefore, measurement in dollars (the second choice) would be the lesser of two evils.
Which answer did the FASB pick? Hint: look for the answer that creates a consistent set of rules, irrespective of whether the rules themselves make any sense. Yep, FAS 52, para. 101 requires goodwill measurement in the foreign currency. The only conceivable reason must be that it is consistent with the treatment of other historic-cost-based assets of the foreign subsidiary.
That brings me to the question my client asked, which goes something like this:
The functional currency of Company A is the U.S. dollar. Company A acquires 100% of the outstanding shares of Company B, for which the dollar is also its functional currency. However, Company B has two foreign subsidiaries, C and D, whose functional currencies are their respective local currencies. Given the requirement of paragraph 101 of FAS 52, must a portion of the goodwill recognized from A's purchase of B be attributed to C and D?
It would seem that the fact pattern described above is not uncommon. Yet, I could not find even a glimmer of insight in the official GAAP literature that would acknowledge that the problem even exists. So this is how my own thinking goes:
- Given that the only purpose of paragraph 101 would appear to be consistent with the accounting for other assets, one would think that a reasonable allocation of goodwill would be intended. Take the extreme example where the U.S. operations of the acquired company might be insignificant: failure to allocate goodwill among the subsidiaries would result in a significant inconsistency, and perhaps even, an opportunity for manipulation.
FAS 142, charade that it is, does require a rigorous apportionment of goodwill among reporting units for the purposes of determining whether goodwill is impaired. A reasonable approach to allocating goodwill to foreign subsidiaries might be similar to the reporting unit approach of FAS 142.
However, to my surprise, the few inquiries I have made of practitioners with experience in the area are unanimous in the view that, in practice, goodwill would not allocated below the intermediate parent — in this case, Company B. Why might practitioners take that view? Because no rule prevents them from doing otherwise; and because it benefits them to reduce the volatility caused by translating goodwill from a foreign currency to the reporting currency. In fairness, and as I have noted above, even though what appears to be broad practice may result in inconsistencies, it is arguably better accounting — or rather less bad — than results from a rote extrapolation of the extant rules (which is the most I can say of my own reasoning).
The International Convergence Connection
As I have pointed out elsewhere (interest cost capitalization), some changes to IFRS are made for the sake of convergence, with well-reasoned standards thrown on the junk heap for the sake of convergence with U.S. GAAP and the prospect of IASB financial reporting hegemony. The goodwill provisions of IAS 21, the IFRS counterpart to FAS 52, is another case in point. At one time, IAS 21 allowed either of the approaches we have discussed for goodwill measurement. But as part of an omnibus project to eliminate alternatives in numerous standards (brought on by the 2005 adoption of IFRS by the EU), the IASB eliminated the option to measure goodwill in the reporting currency, making it the same as FAS 52. Again, the only conceivable motivation appears to be convergence for convergence's sake.
I imagine that the progenitors of the original IAS 21 were thinking that at least part of goodwill arises from synergies between a parent that 'thinks' in its reporting currency and a subsidiary that 'thinks' in a foreign currency. Thus, the source of the goodwill is not strictly foreign or domestic; so, who is to say in which currency goodwill should be measured? Evidently a race for convergence trumps reason and reasonableness.