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Chapter One: Introduction CHAPTER ONE: INTRODUCTION CHAPTER ONE: INTRODUCTION 1.1 Introduction Goodwill and the standards that regulate its measurement and reporting are commonly regarded as some of the most controversial aspects of financial reporting. One reason for this has been the diversity of practice in relation to goodwill accounting and reporting, both within and across jurisdictions. Today, goodwill has increased in importance the world over; the asset composition of companies has changed in the last few decades, and goodwill constitutes a significant proportion of assets for numerous companies (Jensen & Ruback, 1983; Chen et al., 2004). This is due to an increase in the number and value of mergers and acquisitions, which in Malaysia has doubled since 2006 (PWC-Alert, 2007). As a consequence, and because it has a greater impact on financial statements, there has been an increasing need for a more relevant approach for addressing goodwill that reflects the value of the firm. The introduction of the International Financial Reporting Standards (IFRS) in many countries around the world is one of the most significant regulatory changes in accounting history. The IFRS is aimed at increasing the quality and consistency of reporting standards. They are increasingly being viewed as a set of high-quality accounting standards that ideally would apply equally to financial reporting by public companies worldwide. The potential benefits from the use of one common set of accounting standards include increased comparability of financial statements and improved transparency that leads to more efficient investment decisions and restoring investor confidence in publicly traded companies (Hodgdon et al., 2009). 1 CHAPTER ONE: INTRODUCTION Malaysia adopted the IFRS regime in 2006, and from 1 January of that year Malaysian companies were required to implement all the Financial Reporting Standards (FRS1) issued by the Malaysian Accounting Standards Board (MASB) in the preparation and presentation of financial statements. Goodwill impairment testing is now prescribed in Malaysia’s FRS 136 – Impairment of Assets (FRS 136), and the new accounting treatment represents one of the biggest challenges to Malaysian reporting entities as no such standard existed pre-IFRS adoption. Before the achievement of this significant milestone three approaches to goodwill reporting were commonly used in Malaysia. First, goodwill was capitalised as a permanent item but subject to periodic review for write-down purposes.2 Second, goodwill was capitalised and subject to systematic amortisation against profit and loss3, and third, goodwill was immediately written-off against reserves.4 The highly prescriptive and technical provisions of FRS 136 therefore represent a substantial variation from past practice. Recent empirical evidence on Malaysian listed companies and auditors reveals that the rate of compliance with the provisions of FRS 136 has been very poor and in some specific instances, extremely unusual patterns were evident in company-level data disclosures (Carlin et al., 2009a; Carlin et al., 2009b). Studies in 1 Malaysian Accounting Standards Board standards (MASBs) are now called FRS. In 2005, the MASB renamed and renumbered the MASBs as FRS and the numbers coincide closely with the numbering of International Accounting Standards and IFRS. 2 In contrast to the requirements of the IFRS framework however, there was no prescription in relation to the timing or frequency of valuation reviews, or in relation to the methodologies to be employed as the foundation for such reviews or disclosures in relation to key assumptions used in the review process. 3 Goodwill is an on-going asset that in principle is no different from any other asset. Thus, acquired goodwill is recognised as an asset and amortised over the period that will benefit from its acquisition, and this is in line with the accruals concept (Seetharaman et al., 2004). However, some argue that amortisation is arbitrary and distorts net income (Spacek, 1963) (Spacek, 1963). 4 This is in line with the prudence concept (Vance, 2006). Advocates argue that goodwill poses difficulties and carrying the asset in the balance sheet is of little value to users of accounts. Yet writing off goodwill immediately can lead to distorted results as goodwill tends to be overstated (Johnson, 1993). 2 CHAPTER ONE: INTRODUCTION other jurisdictions including Australia, Singapore and Hong Kong have reported a low rate of compliance with regard to the new goodwill impairment regime (Carlin & Finch, 2010; Carlin et al., 2010a; Carlin et al., 2010b). Given the empirical evidence of the implementation of the new goodwill impairment testing across other jurisdictions, it is important to raise questions about the extent to which Malaysian companies and their auditors have fared during the process of transition to FRS 136 and how this has impacted upon the quality and consistency of reports produced pursuant to that new regime. Thus, this thesis examines the disclosure practice based on the requirement of FRS 136 by a large sample of Malaysian listed companies. The focus is specifically on, first, the compliance level of audited consolidated financial accounts and the quality of disclosures provided in accordance with that standard. Second, by looking at the disclosure requirements of FRS 136 as a proxy for audit quality, the research investigates whether there is a variation in audit quality among the sample of Big 4 audit firms (the Big 4) pursuant to the new goodwill Standard. 1.2 An Assessment of Compliance Levels and Disclosure Quality The adoption of IFRS in Malaysia has not changed all aspects of financial accounting and reporting. However, with regard to goodwill, the new accounting treatment represents one of the biggest challenges to Malaysian reporting entities, as it requires more rigorous techniques, disclosure of goodwill impairment testing and significantly expanded disclosure requirements. FRS 136 introduced a formal requirement that goodwill acquired in a business combination could no longer be amortised but would be tested for impairment annually or whenever events 3 CHAPTER ONE: INTRODUCTION or circumstances indicate its value may have been impaired.5 Pursuant to this new treatment, the carrying amount of goodwill must be written down to the extent of any impairment and the impairment loss recognised in the calculation of profit.6 The highly prescriptive disclosure requirements pertaining to the nature of goodwill impairment testing processes undertaken by reporting entities provides far greater transparency (Sevin et al., 2007). Advocates of the IFRS-based approach to goodwill reporting point to a range of putative benefits associated with the adoption of an impairment testing-led approach to goodwill accounting and reporting, including evidence of the improved value relevance of impairment losses compared to annual amortisation charges (Li & Meeks, 2006). The new impairment testing also promotes transparency, because the valuation of goodwill reflects the underlying economic or business conditions as a result of the reporting which is based on current events that affect the business (Moehrle & Reynolds-Moehrle, 2001). Thus, it should provide users with a better understanding of the expectations and changes in the assets over time, therefore improving their ability to assess future growth and future earnings (Jerman & Manzin, 2008) (Jerman & Manzin, 2008). However, the valuation of goodwill impairment is not easy and indeed, impairment testing has been categorised as one of the five most difficult challenges arising from the transition to IFRS (Hoogendoorn, 2006). Testing goodwill for impairment is a complex process; the new Standard on goodwill requires more rigorous techniques and there is a higher degree of complexity in relation to conceptualising, measuring and reporting on goodwill. In addition, FRS 136 calls for the disclosure of a range of factors which organisations 5 Paragraph 9 of FRS 136. 6 Paragraph 60 of FRS 136. 4 CHAPTER ONE: INTRODUCTION may view as sensitive, including projected growth rates and the provision of a segmented perspective on company risk characteristics. The new accounting treatment for goodwill is filled with subjectivity and ambiguity for financial report prepares and auditors alike. In the absence of adequate audit and regulatory oversight, the complexity of the FRS 136 regime, together with the frequency with which its application calls for the exercise of discretion and judgment, may conspire to result in the production of information of a lower quality, and this is of concern to accounting scholars. Focusing on the disclosure requirement pursuant to FRS 136, this thesis specifically examines the level of compliance with a variety of the provisions of FRS 136 and assesses the quality of disclosures provided in accordance with the new accounting standard. The sample drawn upon in this thesis comprises 275 companies in 2006 and 490 companies in 2007 which reported goodwill as an element of their asset base in their 2006 and 2007 consolidated financial statements with fiscal years ending 31 December. (The 2006 and 2007 financial years were the first two years in which financial statements were prepared in accordance with the requirements of IFRS by Malaysian listed companies.) Based on a two- tiered comparative/evaluative method, the research documents that the level of non- compliance is high, with more than 50% of the sample companies in both years making no disclosure in their consolidated financial
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