Exploring the problems associated with Goodwill

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Goodwill as a term was originally used to reflect the fact that an ongoing business had some implied value beyond its assets, such as the reputation the firm enjoyed with its clients or the chemistry between owners of the business. For this reason, a buyer may agree to pay more than s/he is supposed to because s/he believes that both companies will have a potential synergy. The accounting sense of goodwill followed as a likely explanation of why a firm is willing to buy another entity for more than the value of its net assets. In this paper, I will discuss the definition of Goodwill, how goodwill arises on financial statements, the problem that goodwill poses and propose a solution to the goodwill problem.

Introduction: What is Goodwill?

Goodwill is an accounting term used to reflect the portion of the book value of a business entity not directly attributable to its assets and liabilities; it normally arises only in case of an acquisition. It reflects the ability of the entity to make a higher profit than would be derived from selling the tangible assets. It is considered an intangible asset. Intangible assets are defined as "identifiable non-monetary assets that cannot be seen, touched or physically measured, which are created through time and/or effort and that are identifiable as a separate asset." There are two primary forms of intangibles - legal intangibles (such as trade secrets or copyrights) and competitive intangibles.

Goodwill in financial statements arises when a company is purchased for more than the fair value of the identifiable assets of the company. The difference between the purchase price and the sum of the fair value of the net assets is by definition the value of the goodwill of the purchased company. The acquiring company must recognize goodwill as an asset in its financial statements and present it as a separate line item on the balance sheet, according to the current purchase accounting method. In this sense, goodwill serves as the balancing sum that allows one firm to provide accounting information regarding its purchase of another firm for a price substantially different from its book value.

Goodwill can be negative, arising where the net assets at the date of acquisition, fairly valued, exceed the cost of acquisition. An example of goodwill would be a pharmaceutical company which has net assets of $5 million, but the company's overall value is $15 million (including intangible assets like patents and intellectual capital). The buyer of this company would record $15 million in assets acquired, allocating $5 million to physical assets and the remaining $10 million as Goodwill. This intangible asset has no predetermined value prior to the acquisition; its magnitude depends on the total amount paid for the acquisition and the value of the acquired business' net assets.

Goodwill could also be internally generated. A broader concept of goodwill recognizes the economic value of a business' internally developed non-purchased goodwill such as name, developed markets, managerial talent, labor force, government relations and the ability to finance operations easily . Such non-purchased goodwill has not been recognized in the balance sheet and expenditures which may result in internally developed goodwill have not been capitalized. The primary reason for not accounting for goodwill developed in this manner is the absence of generally accepted objective methods of measurement.

Goodwill in financial statements could also arise from a partner buying into the partnership by paying an amount in excess of the fair value of the assets s/he acquires.

Goodwill today constitutes a much larger part of acquisition prices than it did previously, resulting in a much greater impact on financial statements.

The basic formula for obtaining goodwill is:

Goodwill = Purchase Price - Fair Market Value of Net Assets

Fair Market Value of Net Assets = Net Tangible Assets + Write-up of Net Assets

Net Tangible Assets = Assets - Entity's Existing Goodwill - Liabilities

Note that goodwill, by definition, does not represent the total amount of the intangible assets incorporated in the market value of a company, merely the amount of the unidentifiable portion thereof. Notwithstanding this, accounting which does not properly take account of goodwill is becoming increasingly irrelevant to many users.

Accounting For Goodwill

Before the effective date of SFAS 142, Goodwill and Other Intangible Assets, goodwill was capitalized and amortized over an estimated period of benefit, up to a maximum of 40 years. Companies could structure many acquisition transactions to determine the choice between two accounting methods to record a business combination: purchase accounting or pooling-of-interests accounting. Pooling-of-interests method combined the book value of assets and liabilities of the two companies to create the new balance sheet of the combined companies. It therefore did not distinguish between who is buying whom. It also did not record the price the acquiring company had to pay for the acquisition.

"Negative goodwill was recorded as a deferred credit after reducing proportionately to zero the values of assets that would have otherwise been assigned to noncurrent assets (except long-term investments in marketable securities). Under SFAS 121, goodwill related to long-lived assets intangibles to be held and used was assessed for impairment; while goodwill not identified with impaired assets was reviewed for impairment following the guidance in APB 17" (Waxman, Robert N.).

The pooling of Interests method is no longer allowed since FAS 142 was issued. Instead of deducting the value of goodwill annually over a period of maximal 40 years, companies are now required to value fair value of the reporting units, using present value of future cash flow, and compare it to their carrying value (booked value of assets plus goodwill minus liabilities.) If the fair value is less than carrying value, the goodwill value needs to be reduced so the fair value is equal to carrying value. The impairment loss is then reported as a separate line item on the income statement. Also, the new adjusted value of goodwill is reported in the balance sheet. Under the new standard, negative goodwill is recorded as an extraordinary gain to the extent that it exceeds allocations to certain assets.

The advantages and disadvantage of Goodwill

Goodwill, which was once avoided at all costs, no longer cripples a company's financial statements in periods subsequent to the transaction, as it is no longer amortized. To the contrary, goodwill is an asset that remains carried on the balance sheet in perpetuity (assuming no impairment) helping to maintain the net worth of the company.

Another advantage of goodwill is that the federal tax treatment allows for the amortization of goodwill over 15 years. This is the best of both worlds --a tax deduction that is allowed for many years that is even and certain. Yet the related goodwill for financial reporting purposes can remain on the books indefinitely. Who could ask for more! (Taking that into consideration, it is likely that the tax treatment will be altered in the future.)

With the new ruling (SFAS 142) comes an improvement in management purchase price decisions. In a purchase transaction, the price paid for a business is clearly distinguishable. In a pooling transaction, this amount is camouflaged. Any impairment write-down in a period nearly following an acquisition, market conditions remaining without extreme changes in the market, would indicate an acquisition for which too much was paid when reported on financial statements and disclosed.

The non-amortization of goodwill and the related impairment tests "increase representational faithfulness" relative to income and "improve the transparency of accounting." This is because firstly, the balance sheet will provide a better indication of the remaining valuable information; balance sheets are bloated with goodwill that resulted from acquisitions when companies overpaid for assets by using overpriced stock. Over-inflated financial statements distort the analysis of a company mislead investors on the amount they should pay for that stock. The new rules force companies to revalue these bad investments, much like what the stock market has done to individual stocks.

Secondly, the income statement is void of arbitrarily determined, straight-line amortizations of a potentially still-valid asset, goodwill; and thirdly the financial statement and footnote disclosures relative to goodwill provides users with a better understanding of the expectations about and changes in those assets over time, thereby improving their ability to assess future profitability and cash flows.

One disadvantage of goodwill pertains to deferred Taxes. Tax experts warn that while goodwill should now be tested for impairment for accounting purposes, it remains amortizable under the existing U.S. tax code. Due to these additional deferred taxes, SFAS 142 will help most companies achieve improvements in their cash flow but not earnings.

Under the old accounting standards, management was obliged to recognize the amortization of goodwill in each reporting period and had no discretion over this expense. SFAS 142 has removed some of the discipline imposed on company management by regular amortization. The accounting rule allows companies a great deal of discretion in allocating goodwill and determining its value. Determining fair value has always been as much an art as a science and different experts can arrive honestly at different valuations. In addition, it is possible for the allocation process to be manipulated for the purpose of avoiding failing the impairment test. As managements attempt to avoid these charge-offs, more creative accounting will undoubtedly result.

Why is Goodwill such a problem?

The root of the problem is literally that debits, the assets acquired, do not equal

credits, the purchase price. The goodwill factor consists of the following characteristics:

* An asset on the balance sheet that cannot be identified as such

* Transaction costs lumped in with goodwill - and anything else, if you can get away with it.

* Impairment charges to the profit and loss account.

* In a liquidation: no value. (Dogra, Kenneth)

The amount reported as goodwill is, at its best, a accumulation of assets offset by liabilities.  Nowhere else in accounting would this be permitted. But even assuming that offsetting assets and liabilities with goodwill can be allowed, "of what use to investors is the assignment of a number to something that, by definition, is beyond description?" (Dogra, Kenneth) And who is to say that the amount reported as goodwill does not include other costs lumped in it.

Reported Goodwill is often characterized as "the lump left over."FAS 141R contains some significant exceptions to fair valuation of assets acquired and liabilities assumed.  Thus, the unknown difference between amounts recorded and their fair values are shoveled into the goodwill black hole.  "As if that weren't enough, the math of the goodwill calculation casually compares apples with oranges: prices paid with values received" (The Accounting Onion).  Goodwill implies that the number is associated with actual attributes, but instead, it is nothing more than an arbitrary number. Moreover, estimating the fair value of goodwill and other intangibles is a very difficult and subjective process. A majority of companies rely on outside consultants to compute such estimates. In addition to the valuation and assessment fees, testing for impairment also involves legal costs and additional staff compensation.

A Proposed Solution to the Goodwill Problem

When a business takes over another entity, it needs to find a method by which it can avoid reducing the net assets of the group by the excess over the fair-value net assets of the firm it has purchased. So we call this difference an asset that's not really identifiable. "The French have an appropriate term for when the purchase price exceeds the fair-value net assets: écart d'acquisition, or difference on acquisition." (The Accounting Onion)

"In olden days, the British permitted a charge to contributed capital for the amount that would otherwise have been recognized as goodwill.  While imperfect, it may be one solution to the problem; there can be no perfect solution. However, a charge to additional paid-in-capital seems to be a return to the part purchase part pooling mess of the 1960s." (The Accounting Onion)

Companies could change how they account for acquisitions by writing off the difference between the purchase price and fair-value net assets to a special section in the profit and loss account under the heading "Acquisition costs" (The Accounting Onion). Such an approach would make boards more accountable for the decisions they make when expanding their companies by acquisition.

Also, the surplus against net assets could be netted off against the share premium generated and not left on the balance sheet as goodwill. This will bring some sort of reality into financial reporting, and removing goodwill from financial statements.

Summary and Conclusion

Goodwill over the years has always been a problem. There may never be a perfect solution to the problem of goodwill or it might even take a combination of solutions to arrive at a suitable way out.

There were previously two methods of acquisition accounting: the purchase method and the pooling of interests method. The pooling of interests method involves adding together the balance sheet items of both entities. This method was the preferred method of accounting in mergers and acquisitions because no goodwill was created therefore the excess over net assets that was paid to purchase the new company is never reflected in the acquirer's books. It also resulted in higher reported earnings. The pooling of interest method however did not distinguish between who is buying whom. It also did not record the price the acquiring company had to pay for the acquisition. Most of all, managers who receive their compensation based on performance may be heavily inclined to acquire other entities even if the group does not fit strategically with the organization simply to report an increase in earnings.

Intangible assets increasingly became an important economic resource for many entities and that they were becoming an increasing proportion of the assets acquired in a lot of transactions. Consequently, financial statements needed to provide better information about intangible assets. Also, the amortization of goodwill was no longer useful in the analysis of investments. FASB then decided to eliminate the pooling of interest method of accounting for mergers and acquisitions and passed SFAS 142. The statement states that goodwill does not have a definite life but rather an indefinite one. As a result, goodwill will not be amortized but rather will be tested at least annually for impairment so its carrying value will be closer to its fair value.

During these impairment tests however, opportunities for manipulation abound due to complex impairment calculations and the need for specialists' valuation. The proposed solution to the goodwill problem is to write off any difference between the purchase price and fair-value net assets together with transaction costs to a special section in the profit and loss account under the heading "Acquisition costs". Although this will increase management accountability in acquisition transactions, it still does not reflect the benefits to be gained from the resulting synergies (which many times are overvalued and resulting in firms overpaying for takeovers and mergers).