Changes in accounting guidelines have led to the restatement of some companies' accounts and are helping to cast a little more light into the murky corners of annual reports

PUBLISHED : Tuesday, 11 September, 2001, 12:00am
UPDATED : Tuesday, 11 September, 2001, 12:00am

THE PRESENT interim reporting season is throwing up some interesting results, following changes to accounting rules to bring Hong Kong into line with international practice.

The most glaring example was last week's report by Pacific Century CyberWorks, which saw its losses for last year revised up from an already-staggering HK$6.9 billion to a mind-numbing HK$129.29 billion.

The company did a good job of persuading analysts and the media that this revision - which put CyberWorks into the record books as the biggest listed corporate loss-maker in Hong Kong history - was a mere technicality. Chairman Richard Li Tzar-kai insisted: 'It will not affect our cash flow, it will not affect our shareholders' funds.'

Analysts concurred, with one describing the revision as a non-issue. The huge goodwill write-off that accounted for the bulk of the loss could have been foreseen simply by looking at CyberWorks' share price, the analyst said. Perhaps. Analysts focus on what will happen in the future; that is where the key to current value is to be found. And one does not need a PhD in finance to know that the value of CyberWorks' business has gone down since last year.

A quick perusal of several post-results research reports showed that not one analyst had bothered to mention the restatement of last year's profit and loss account.

Yet it is worthy of note. The accounts of CyberWorks - and many other companies - had to be restated due to new accounting standards brought in by the Hong Kong Society of Accountants (HKSA) this year.

The effect of these changes will be to shine extra light on company accounts, enabling outsiders to see how much value has been destroyed by an ill-conceived or unfortunate acquisition. Until now, this often could remain hidden, because of the way companies were permitted to account for takeovers and mergers.

When a company buys another company, it usually pays more than the value of the target's assets. The difference between the value of the identifiable net assets and the price paid is termed goodwill.

Why pay more than the assets are worth? Because businesses often have value not recorded on any financial statement: a good reputation, customer loyalty and trust, high employee morale and so on - in other words, the 'goodwill' built up over years. This goodwill, or going-concern value, can translate into significantly higher earning power than the assets in place would warrant independent of each other.

The question arises of how to account for this goodwill, which is simply the balancing number between the price the buyer pays and the value of the identifiable assets (although it reflects the buyer's estimate of what those intangible benefits, such as customer loyalty, are worth).

Since there is some controversy over whether goodwill is an 'asset' at all (it cannot be separated from the rest of the business and sold, like other assets such as machinery or buildings, for example), one clean way to deal with it is simply to get rid of it in one fell swoop.

Britain's accounting rules allow companies to write off goodwill against reserves: simply to minus it from the liability side of the balance sheet, so it disappears. The alternative, which is mandatory under United States generally accepted accounting principles, is to record goodwill as an asset in the balance sheet and amortise it over up to 20 years, charging the amortisation as an expense to the income statement every year.

Companies generally prefer to write off goodwill against reserves for two reasons: it is a one-off balance sheet adjustment, so it never reduces earnings; and it reduces the company's asset and equity base, so makes return on equity and return on asset ratios appear healthier.

This is what CyberWorks did when it took over the former Hongkong Telecom (HKT) last year: it eliminated HK$172 billion of goodwill arising from the acquisition against reserves, a move that was largely responsible for the company reporting negative equity at its last balance sheet date.

Hong Kong has followed British accounting standards in the past, but is now moving gradually to bring its system into line with International Accounting Standards, a process that should benefit the SAR's standing as a financial centre.

This year it brought in a number of new statements of standard accounting practice (SSAPs), including SSAPs 30 and 31, which deal with business combinations and impairment of assets. The new standards took effect from January 1 this year. However, it is a cardinal principle of accounting that financial statements between two periods must be comparable: in other words, that they must be prepared on the same basis. Hence, companies have been required to restate last year's accounts.

Companies that previously had made an acquisition and eliminated goodwill against reserves are now required to apply an 'impairment test' to determine whether the goodwill is still worth what was paid for it. If not, the reduction must be charged to the profit and loss account.

This was the source of CyberWorks' revised loss for last year: the group performed an assessment of the fair value of goodwill previously charged to reserves and found it was worth HK$122.39 billion less.

There should be more to this than simply looking at the market price of CyberWorks shares. The market price is always the best indicator of value, but the value of the shares and the underlying assets need not be the same. Property companies often trade at a discount to their net asset value, for example, but accountants do not demand that they write down their properties to the value reflected by the shares. So the CyberWorks goodwill write-down does tell you something about the value destruction wrought on HKT.

It could be argued that to some degree the restating of accounts is a cosmetic exercise, but it should help to increase the transparency of companies that have made acquisitions.

For the users of financial statements, capitalising and amortising goodwill is clearly preferable: the goodwill remains as an asset on the balance sheet, and if it falls in value, a charge has to be taken against it.

Under the reserves treatment, the goodwill disappears into the ether and is never heard from again, unless the business is sold (whereupon the goodwill is restated). For all the reader of the financial statements is to know, the goodwill may be still worth all the company paid for it, or it may be worth next to nothing. The HKSA's new rules will force disclosure of such information.

How useful this extra information proves will depend on the accompanying disclosure. The disclosure of goodwill impairment in interim reports has been fairly vague, and has not included breakdowns by acquisition or sector.

For example, Citic Pacific's interim results included the reclassification of HK$1.45 billion in goodwill previously eliminated against reserves. This tells us little more than that the company bought some kind of turkey at some point in the past which has subsequently lost a fair amount of value. Given the range of Citic's businesses, this information is not terribly useful.

Particulars of the identity and date of acquisitions would make such disclosures far more meaningful. It is unclear whether such information will be included in full-year reports.

It will be worth keeping an eye on companies that made Internet acquisitions within the past 20 months or so, particularly if the transaction was connected.

Dotcoms typically had few assets, and so will have given rise to large goodwill figures when booked in the acquirer's accounts. Companies will now be forced to provide an assessment of their value, under the scrutiny of cautious accountants rather than helpful valuers: the results may be revealing.