Audit of financial statements tends to be one of the most important tasks and objectives that need to be undertaken by listed and unlisted companies so that their investors have certainty that the financial statements have not been materially misstated.
To ensure that the auditing process is properly carried out, it is important to ensure that auditors plan out the overall process to make sure that they can cover the respective ground that can help them to gain evidence based on which they can give their opinion.
As far as auditing goodwill is concerned, it can be seen that auditing goodwill can be an increasingly important task for auditors, predominantly because it is an intangible asset. Companies mostly declare purchased goodwill on their financial statements.
Therefore, there is always a certain amount of ambiguity about goodwill, and if the figure mentioned on the financial statements is factually correct and not materially misstated. There are several risks associated with the auditing of goodwill.
Inherent Audit Risk in Assessing Goodwill
Goodwill is an intangible asset that represents the premium paid for acquiring a business over and above the fair value of its tangible assets and liabilities.
The assessment of goodwill is a significant and complex aspect of the financial statement audit process, and it presents a number of inherent audit risks that need to be considered by the auditor.
The following are some of the inherent audit risks associated with assessing goodwill:
- Complexity: Goodwill is an intangible asset and its value can be difficult to determine, which can increase the complexity of the audit process.
- Reliance on Management’s Estimates: The valuation of goodwill requires the use of management’s estimates, which are subject to bias and judgment.
- Lack of Verifiable Data: The information used to support the valuation of goodwill is often subjective and not readily verifiable.
- Subjectivity in Impairment Testing: Impairment testing of goodwill is subjective, and it requires the use of management’s estimates, which can be subjective and biased.
- Changes in Market Conditions: The value of goodwill is sensitive to changes in market conditions and economic trends, which can make it difficult to assess its value accurately.
- Complexity of Business Model: Goodwill is often associated with complex business models, which can make it difficult to assess its value accurately.
- Lack of Historical Performance Data: The lack of historical performance data can make it difficult to assess the value of goodwill accurately.
- Inaccurate or Incomplete Financial Data: The accuracy and completeness of the financial data used to support the valuation of goodwill is critical, and any errors or omissions in this data can have a significant impact on the assessment of its value.
- Changes in Accounting Standards: Changes in accounting standards and regulations can impact the assessment of goodwill and its value, which can increase the inherent audit risk associated with this asset.
- Limited Data Availability: Goodwill is often associated with complex business models, which can make it difficult to obtain all of the necessary information to support its valuation.
In order to manage the inherent audit risk associated with assessing goodwill, auditors must use a robust and comprehensive approach that involves a detailed review and analysis of the information used to support its valuation, as well as an assessment of the entity’s financial performance and market conditions.
Risks Associated with Auditing Goodwill
Several different risks are associated when it comes to auditing goodwill. These risks can broadly be categorized into two segments: Risk of Material Misstatement and Detection Risk. Subsequent explanation of both these risks are given below:
Risks of Material Misstatement: The risk of Material Misstatement implies that the amount of goodwill mentioned on the financial statements has been materially misstated.
As far as goodwill is concerned, it is a fairly ambiguous line item because of the inherent nature of goodwill. Therefore, the risk of material misstatement when it comes to auditing goodwill is considerably high.
Detection Risk: Detection Risk referred to the risk that is incurred because of the inability of the audit procedures to detect the respective account to be materially misstated.
In the case of auditing goodwill, the detection risk is also considerably high. In the case of purchased goodwill, the risk can still be managed.
Audit Assertions with Auditing Goodwill
During the audit of goodwill, there are a couple of audit assertions that need to be accounted for by the auditors. These audit assertions are mentioned below:
- Existence: The audit assertion of existence relies on ensuring that the goodwill figures mentioned on the financial statement actually exist by the company. Even though goodwill is an intangible asset, it is essential to ensure that the goodwill declared on the financial statement is actually justifiable through proper logic and rationale.
- Accuracy: In addition to the assertion of existence, it is important on the part of the auditors to ensure that the goodwill that has been represented on the financial statement is accurate and inculcates proper accounting principles. For example, if it is acquired goodwill, it should be calculated properly.
- Completeness: The audit assertion of completeness implies that all the components mentioned on the financial statement should be completely mentioned with proper disclosures in the financial statements. The proper breakup of accumulated goodwill, for instance, should be mentioned so that the users of the financial statements have a clear idea regarding the amount of goodwill that has been raised.
- Understandability: Financial Statements should be prepared so that they are easily understandable and comprehendible by the users of the financial statements. Therefore, understandability tends to be an important audit assertion because it requires auditors to ensure that the goodwill declaration can easily be understood without additional information.
- Rights and Obligations: The audit assertion of rights and obligations involves ensuring that the goodwill that the company has declared is actually belonging to the company. For example, if they have acquired goodwill on their financial statements, they should have a right (or a formal proof of understanding between parties) that they have the right to show this as acquired goodwill in the financial statements.
Audit Procedures during Auditing of goodwill
Auditing goodwill is considered a fairly cumbersome process because of all the different technicalities involved. Consequently, auditors need to ensure that they can gather sufficient evidence that can help them obtain reasonable assurance that the amount for goodwill has not been misstated.
Goodwill at Acquisition
As far as Goodwill at acquisition is concerned, it can be seen that it is measured by using the excess value of the purchase consideration that is paid by the parent and the net value of fair assets of the acquired subsidiary.
In simple terminology, the difference between the net assets acquired and the amount paid as settlement of the debt. This is further mentioned in the formula given below:
Goodwill at acquisition = Fair value of the consideration paid + value of non-controlling interest – fair value of the acquired subsidiary’s net identifiable assets.
Therefore, when goodwill at acquisition is audited, it makes sense for auditors to ensure that they can identify if the valuation and the existence assertion of goodwill are accurately calculated.
The main premise of auditors here is to ensure that goodwill has been calculated following the acceptable and applicable accounting standards. There can be several audit procedures that can be designed in this regard. These examples are as follows:
- Inspection of the purchase agreement ensures that the consideration is paid and the purchase date is correctly mentioned. The agreement will provide much-needed clarity regarding the agreed-on price, which can later be verified with the bank statements to check for the payments made.
- Reconciling the fair value of the net identifiable assets in addition to the due diligence report that the independent external party prepares.
- Reading through the board minutes of the client and the acquired subsidiary, and review for the discussion regarding the purchase of the subsidiary company.
- Recalculation of goodwill, in addition to comparison of goodwill that is recorded in the financial statements of the client
- Double-checking of the payment (for purchase consideration) has been made by the amount mentioned on the supporting documents.
Goodwill Impairment Review
The goodwill declared as an outcome of business considerations is also subject to an annual impairment review. This mainly ensures that the goodwill balance is not materially misstated in the financial statements of the company.
Impairment of goodwill mainly occurs when the asset’s carrying value is higher than the recoverable amount of the stated asset.
In the case of any impairment loss, the loss is charged directly to the Income Statement. In the same manner, as far as an audit of goodwill is concerned, it can be seen that the main focus of the auditors is to mitigate the risk of material misstatement.
This is a common occurrence resulting from the companies not performing impairment reviews on a continual basis.
To test for goodwill impairment, if it has been conducted properly, a variety of procedures can be crafted. Some examples of these audit procedures are as follows:
- Validating if impairment test or review has been made on goodwill.
- Verifying the validity of the relevant supporting documentation and data used by the management to assess the impaired amount.
- Evaluation of the extent to which management’s assessment regarding goodwill impairment is reasonable.
- Verifying the calculation of impairment to check for arithmetic errors.
Therefore, these audit procedures are designed in order to audit goodwill, in case of either case where goodwill is created.