The recognition and measurement of Goodwill

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The term 'Goodwill' is a much discussed subject and has raised many struggles in the International Financial Reporting Standards. Many amendments have been made to this topic and eventually the regulators decided that every year a impairment on goodwill has to be made. Why is goodwill so hard to measure and what is goodwill actually?

One of the descriptions men gave to this term is: 'An asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually indentified and separately recognized' [1] .

In this definition you can already notice the problem of goodwill. The part which contains future economic benefits is the part why this topic raises so many problems. Because its value finds itself in the future, it is very hard to measure this asset now.

Therefore goodwill often is described as just air, because it isn't tangible at all so how you can measure and put on the balance sheet something that is not visible?

Of course there is a solution for this, namely the account of intangible assets. In this essay we are going to discuss the possibilities of measuring goodwill and the relevancy of goodwill, despite of its intangible character. Besides this important amendments have been made since 2001 to the topic Goodwill by the FASB. We also going to discuss these adjustments.

Our research question for this essay therefore is:

Can Goodwill be measured reliable and what are the requirements for reporting?

2. SFAS 142, Goodwill and Other Intangible Assets

We are going to analyse now the changes that happened when the FASB issued SFAS 142, Goodwill and Other Intangible Assets, in June 2001.

It made major changes to the accounting treatment of goodwill for the first time in over 30 years. These changes occurred concurrently with the issuance of SFAS 141, Business Combinations, which eliminated the pooling-of-interests method of accounting for business combinations, a method that avoided the goodwill issue entirely.

The new accounting rules have had a substantial effect on financial statements causing discontinuities in data time series, creating difficulties for users of financial statements in estimating trends and forecasting future performance. And the nominal tax-related cash flow effects associated with these changes demand that more attention be paid to operating cash flow when assessing a company's financial performance.

Prior practice followed APB Opinion 17, issued in 1970, which called for any goodwill recorded following an acquisition to be amortized over a period not to exceed 40 years. Subsequent observation suggested that many companies adopted the 40-year maximum as the useful life in computing amortization to minimize the periodic earnings effect.

Because ending amortization while keeping other factors constant will increase earnings and decrease price-to-earnings (P/E) ratios, there was controversy over the potential effect the new rules would have on stock prices.

2.1. The New Accounting Treatment of Goodwill

SFAS 142 made two major changes to goodwill accounting:

Amortization of all goodwill ceased, regardless of when it originated. Goodwill is now carried as an asset without reduction for periodic amortization.

Companies are to assess goodwill for impairment at least annually. If goodwill is impaired, its carrying amount is reduced and an impairment loss is recognized.

Companies were required to implement these new standards in fiscal years beginning after December 15, 2001, with early adoption permitted for fiscal years beginning after March 31, 2001.

During the first six months following adoption of SFAS 142, companies assessed existing goodwill balances for impairment and reported any such transitional impairment losses as due to a change in accounting principle.

FASB gave companies a reporting benefit during the transition period by allowing them to report real declines in economic value as the effects of changes in accounting principles.

3. Goodwill Impairment-Testing Process

To test goodwill for impairment, companies must first assign the recorded goodwill to "reporting units." In general, companies assign goodwill to each unit by comparing the estimated fair value of the reporting unit as a whole with the fair values of the unit's identifiable net assets.

This process is similar to the process for allocating purchase price differentials among assets acquired, liabilities assumed, and goodwill, in accounting for an acquisition.

After the goodwill is assigned, at the next impairment testing point the company applies the following two-step process to each reporting unit.

Step 1

- The first step of the goodwill impairment test, used to identify potential impairment, compares the fair value of a reporting unit with its carrying amount, including goodwill.

- If the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not impaired, thus the second step of the impairment test is unnecessary.

- To determine the carrying amount of a reporting unit, deferred income taxes shall be included in the carrying value of the reporting unit, regardless of whether the fair value of the reporting unit will be determined assuming it would be bought or sold in a taxable or non-taxable transaction.

- If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill impairment test shall be performed to measure the amount of impairment loss, if any.

Step 2

- The second step of the goodwill impairment test, used to measure the amount of impairment loss, compares the implied fair value of reporting unit goodwill with the carrying amount of that goodwill.

- If the carrying amount of reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss shall be recognized in an amount equal to that excess. The loss recognized cannot exceed the carrying amount of goodwill.

- After a goodwill impairment loss is recognized, the adjusted carrying amount of goodwill shall be its new accounting basis.

- Subsequent reversal of a previously recognized goodwill impairment loss is prohibited once the measurement of that loss is recognized.

3.1. Impact of the New Standard: Impairment

Here, we are going to try to explain the impact of the new standard: impairment, and we are going to use a report of the effects over 100 important companies to see this impact. In the first quarterly reporting period after the adoption of SFAS 142, companies assessed existing goodwill balances for impairment. Some of the results were as follows:

Collectively, the 100 companies reported $135 billion of goodwill as impaired and written off upon adopting SFAS 142 in 2002. This is about 14.5% of the total goodwill carried, an average of $1.35 billion per company.

For the 33 companies that recorded the $135 billion of impairment write-offs during the first six months of 2002, these write-offs amounted to 33%, an average of $4.1 billion per company.

AOL Time Warner reported the largest dollar write-off at $54.2 billion. The largest percentage write-offs were 84% by Qwest, 63% by Clear Channel Communications, 47% by Boeing, 45% by Aetna, and 43% by AOL Time Warner. The smallest write-offs occurred at Dow Chemical, 0.7%, and Alcoa, 0.6%.

The figures cited above may understate the impact of the SFAS 142 goodwill impairment rules, for two reasons.

First, several companies made large write-offs in 2001, after the requirements of SFAS 142 became clear but before the official implementation date. By recognizing the impairments in 2001, these companies fell under the more general long-lived asset-impairment reporting provision of SFAS 121, which requires classification of the write-off as an operating expense.

Second, the transition standards of SFAS 142 allow companies to make the impairment determination anytime during the first year and then retroactively restate the first quarter's results.

Why were so much write-offs of an amount of nearly 135$ billion by just 33 companies in early 2002? There are many factors that explain this situation. Between this factors we can include the moment of declining in the economy and the corresponding declining in stock prices. Also, the terrorist attack of September 11 had a very important impact and there were numerous accounting scandals reported throughout 2001 and 2002 depressed overall market values.

It is worth remembering that 67 of the 100 companies of the study recognized no impairment write-offs in none of the first two quarters of 2002. Their aggregate goodwill balance of some 446$ billion was carried forward untouched by the new rules.

3.2. Effect on net income

Now we are going to see the effect of the new rules on the net income by the example of the companies. We are going to take consideration of the quarter-by-quarter impact indicates that, of the 33 companies reporting goodwill write-offs in the first six months of 2002, 26 companies reported an aggregate write-off of $126 million in their first-quarter 10-Q reports.

These write-offs had a major impact on reported net income. Aggregate 2002 first-quarter net income for the 100 companies studied was $7 billion, meaning that the $126 billion in write-offs reduced reported net income by about 95%, from $133 billion to $7 billion. There was little difference between pre-tax and post-tax goodwill impairment amounts. For companies reporting both amounts, the post-tax impairment was about 96% of pre-tax impairment. Twenty-two companies reported first-quarter net losses, including 15 of the 24 companies recording an impairment write-off

The impact diminished in the second quarter of 2002, when 11 companies (including two that had reported first-quarter impairments) reported an additional $8.6 billion of goodwill impairment. Aggregate second-quarter net income was $30.3 billion, meaning that the $8.6 billion in write-offs reduced reported net income by about 22%. Sixteen companies reported second-quarter net losses, including four of the 11 companies recording an impairment write-off.

3.3. Impact of the New Standard: Amortization

The other factor of the new standard that have most impact on the financial statements of the companies is the amortization. SFAS 142 also provides for the discontinuation of goodwill amortization, which partially offsets the income effects of impairment write-offs and will contribute to higher reported profits in future periods. To aid financial statement users, paragraph 61 of SFAS 142 requires that during the transition period, companies are to report pro forma income figures for the corresponding quarters of 2001 (and for any other periods reported), with the amortization effects removed. Some companies provided these data in narrative form whereas others offered more useful tabular formats.

Philip Morris' first-quarter 10-Q said simply that "The Company estimates that net earnings and diluted earnings per share would have been approximately $2.0 billion and $0.91, respectively, for the three months ended March 31, 2001, had the provisions of the new standards been applied as of January 1, 2001."

Liberty Media's first-quarter 10-Q provided a table showing how the $152 million net loss reported in the first-quarter 2001 would have been net income of $216 without the amortization.

Overall, the 100 companies studied reported goodwill amortization, net of tax, of $5.1 billion and $5.7 billion, respectively, for the first and second quarters of 2001.

Projecting these amounts to a full year, reported annual profits under SFAS 142 might be $20 billion to $25 billion higher than under the previous APBO 17 amortization rules. Based on the net incomes reported by the 100 companies for the first and second quarters of 2001, the elimination of $10.8 billion of amortization expense would have increased reported income by about 17%.

Combined Impact

In this point we are going to show the combined effect of impairment and amortization in the new standard. As we said before the elimination of amortization partially offsets the income-reducing impact of impairment write-offs. To examine the extent to which companies may have benefited from the new rules in the form of higher reported incomes, our studied case splits the 100 companies between the 24 that reported first-quarter goodwill impairment and the 76 that did not.

- The 24 impairment-reporting companies reported an aggregate net loss of over $25 billion, and had a 127% reduction in reported profits compared to pre-SFAS 142 reporting.

- The 76 companies that reported no first-quarter 2002 impairment had aggregate profits in excess of $32 billion and enjoyed a 14% increase under the new standard.

Thus, implementation of SFAS 142 enabled most companies to enhance their first-quarter reported results, but among those companies where the first-quarter results were negatively impacted, the impact was very large.

4. Implications for Users of Financial Statements

For the last part of the study we are going to see which are the implication of the new standard for the users of financial statements. The fact of avoided recognizing and amortizing goodwill, and the concurrent replacement of goodwill amortization with periodic impairment testing, are the major events of great significance to users of financial statements. Probably the biggest problem that involves the effects created by the discontinuity in data series created by the new goodwill rules:

Eliminating amortization raises net income with no corresponding increase in operating cash flow.

SFAS 142 attempted to mitigate the discontinuity effect of the cessation of amortization by requiring companies to provide pro forma 2001 quarterly income for comparison.

Impairment write-offs create earnings volatility with no cash flow effects but cannot be ignored, because the write-offs signal a loss in economic value.

Going forward, the higher net income and discrete write-offs that lower asset and equity balances means that return on assets and return on equity measures should increase.

The lower asset and equity balances resulting from write-offs will increase debt ratios, such as total liabilities/total assets and debt/equity, creating unfavourable signals.

Higher reported income (without amortization) will produce increases in interest coverage/times interest-earned ratios that appear favorable, but cash flow coverage remains unchanged.

The conclusion of this study suggests that impairment write-offs produced significant income and asset effects, especially in the first quarter following adoption, for about one-third of the company pool.

Elimination of goodwill amortization impacts all companies' reported incomes by an average increase of about 15% to 20%.

The lack of economic effect associated with eliminating amortization should have no effect on firm valuation, but the mechanics of price/earnings ratios could drive stock prices up unless the ratio falls to offset the rise in income caused by the cessation of amortization. Even so, if P/E ratios begin to look "cheap," prices might rise to compensate for this.

5. Purchased Goodwill: Accounting for Purchased Goodwill

- Goodwill which is purchased by the entity must be recognised as a non-current asset at acquisition, except in the case of an investment in an associated company.

- When goodwill is purchased in a business acquisition the exchange transaction enables the value of goodwill to be measured reliably. A number of methods of accounting for such purchased goodwill exists.

Principally these methods include either recognising the expenditure as:

(a) an asset; or

(b) an expense at the time when the acquisition is made.

- The view adopted in this Standard is that purchased goodwill

represents future benefits acquired in an exchange transaction which need to be recognised as an asset.

- The alternative accounting treatment, whereby purchased goodwill is recognised as an expense at the time of acquisition, is not supported because it fails to recognise the future benefits (including synergistic benefits) arising from the unidentifiable assets acquired.

- Another alternative accounting treatment for purchased goodwill is to write off goodwill against reserves at the time of acquisition. This treatment is unacceptable since it too fails to recognise the future benefits acquired, contravenes the requirements of Australian Accounting Standard AAS 1 "Profit and Loss or Other Operating Statements" and is contrary to the spirit of Australian Accounting Standard AAS 4 "Depreciation of Non-Current Assets".

- In this Standard the view adopted is that goodwill comprises the future benefits from unidentifiable assets which, because of their nature, are not normally individually recognised. Unidentifiable assets would usually include market penetration, effective advertising, good labour relations and a superior operating team.

AAS 18 9 5.1.5 This would exclude assets of an intangible nature which are capable of being both individually identified and specifically recorded, as may be the case with patents, licences, rights and copyrights.

- A distinction is frequently drawn between goodwill which is purchased and goodwill which is internally generated. The view taken in this Standard is that the concept of goodwill is the same regardless of whether it has been purchased in an exchange transaction or generated internally. The only distinction is that purchased goodwill can be measured reliably on the basis of the amount paid for it, while internally generated goodwill is not usually capable of being measured reliably. Consequently, the accounting treatment specified in this Standard for purchased goodwill differs from that specified for internally generated goodwill.

- Goodwill is normally only recognised by a purchaser in connection

with the acquisition of a business entity, or part thereof, through acquisition of the assets therein or, in the case of an investment in a subsidiary or in an associated company, the acquisition of some or all of the shares in another entity. Such purchased goodwill reflects future benefits from two sources: those which have been internally generated by the vendor prior to the date of acquisition and which are expected to flow to the purchaser, and those which arise from the combination or inter-relationship of entities or groups of assets (synergistic benefits).

5.1. Amortisation of Goodwill

- Purchased goodwill must be amortised so that it is recognised as an expense in the profit and loss or other operating statement on a straight-line basis, over the period from the date of acquisition to the end of the period of time during which the benefits are expected to arise. This period must not exceed twenty years from the date of acquisition

- In accordance with paragraph 5.6, the unamortised balance of goodwill must be reviewed as at each reporting date and recognised as an expense to the extent that it is no longer supported by probable future benefits. AAS 18 10 5.2.2

- In order to amortise goodwill over the period during which the associated benefits are expected to arise, separate assessments may need to be made in respect of different goodwill components (such as those relating to the purchase of different businesses) to the extent that such components can be separately identified.

- Factors which ought to be considered in estimating the useful lives of the assets comprising goodwill include:

(a) effects of obsolescence, demand and other economic factors; and

(b) the service life expectancies of individual employees or groups of employees; and

(c) expected actions by competitors or potential competitors; and

(d) relevant legal, regulatory or contractual provisions; and

(e) foreseeable life of the entity or industry.

- Because the period of anticipated benefits will in many circumstances be difficult to identify, decisions concerning the period of amortisation may be arbitrary. For this reason, in no circumstance does this Standard permit the amortisation period to exceed twenty years. However, it is anticipated that in many circumstances the period will be considerably shorter than twenty years from the date of acquisition.

- Subject to paragraph 5.2, the period over which goodwill is to be amortised must be reviewed as at each reporting date and, if necessary, adjusted to reflect the amount and timing of expected future benefits. The period must not extend beyond twenty years from the date of acquisition.

- The period over which goodwill is to be amortised needs to be reviewed as at each reporting date and, if necessary, adjustments made in a manner consistent with the provisions of Australian Accounting Standard AAS 4 "Depreciation of Non Current Assets". AAS 18 11 5.4.

5.2. Measurement of Purchased Goodwill

On acquisition of some, or all, of the assets of another entity, or in the case of an investment in a subsidiary or associated company, on acquisition of some, or all, of the shares of another entity, the identifiable net assets acquired must be measured at their fair values.

- Fair value is a measure of the worth of an asset at a specified time, and is utilised in this Standard as the amount which the purchaser attributes to the assets acquired. When making an assessment of the fair values to be attributed to individual assets, the purchaser may sometimes find that a number of such assets are combined into a related or composite group (such as the units of plant in a steel mill). In these circumstances, it may be more appropriate to consider the fair value of the composite group rather than the aggregate of the fair values of the individual assets

- Purchased goodwill must be measured as the excess of the purchase consideration plus incidental expenses over the fair value of the identifiable net assets acquired.

- The purchase consideration may take the form of any one, or combination, of the following:

(a) cash; and/or

(b) other monetary assets; and/or

(c) non-monetary assets; and/or

(d) securities issued; and/or

(e) liabilities undertaken.

- Where the purchase consideration is in the form of cash and/or other monetary assets, its value is usually readily determinable. However, where the purchase consideration comprises (either partially or totally) non-monetary assets, its value will need to be ascertained by reference to the fair values of the non-monetary assets given. AAS 18 12 5.5.3

- Where the purchase consideration comprises shares or other securities of the investor and these securities are listed publicly on an Australian Stock Exchange, the price at which they could be placed in the market will usually be an indication of their fair value. Where the securities issued are those of an unlisted entity, it may be necessary to make a valuation of those securities. It should not be assumed that the par value of securities reflects their fair value, as this is rarely the case.

- To the extent that the purchase consideration plus incidental expenses exceeds the fair value of the identifiable net assets acquired but the difference does not constitute goodwill, it must be recognised immediately as an expense in the profit and loss or other operating statement. Similarly, the unamortised balance of goodwill must be reviewed as at each reporting date and written down to the extent that it is no longer supported by probable future benefits. Any loss must be recognised immediately as an expense in the profit and loss or other operating statement.

6. Conclusion

In this essay it becomes clear why there is a lot of attention to Goodwill measurement the last years. The financial crisis has raised many questions to the goodwill methods and besides that a lot of impairments are made on goodwill.

A lot of amendments are made to the goodwill reporting standards like we discussed before, which made clear that the regulators imply that with more rules the measurement gets more reliable. This gives answer to the first part of our research question. We have discussed earlier how these impairments should be applied and why.

In this essay we tried to explain the goodwill issue described in the introduction and to expose which methods there are for measuring goodwill.

To give answer to the second part of our research question, there are many requirements for measuring goodwill and therefore many ways to report goodwill. The method which seems to be mostly used is the method in which the entity puts the goodwill as a asset on the balance sheet and thereafter depreciate it. This depreciation is done yearly.

We also mentioned the so called measurement of purchased Goodwill. This is a separate topic in that manner because hereby a impairment is required according to IFRS.

Final we see that goodwill is and remains a very hard topic, because we have shown that goodwill is more than just an invisible asset. But still it is difficult to give a reliable view despite all the rules and amendments.