Goodwill of a business’ internally developed non-purchased goodwill
Goodwill is an intangible asset, probably the most intangible of all intangible assets, hard to measure and even more difficult to account for. Goodwill today constitutes a much larger part of acquisition prices than it did previously, resulting in a much greater impact on financial statements.During the twentieth century the concept of goodwill has changed significantly. In the earlier days goodwill was thought of as the good and valuable relationships of a proprietor of a business with his customers. The present concept is broader in that it encompasses many more intangible economic factors of a business enterprise and accountants now consider that goodwill results from the evaluation of the earning power of a business by investors (Johnson, 43).
From an accountant’s perspective, goodwill appears in accounts of a company only when the company has purchased some intangible and valuable economic source. Intangibles such as patents and copyrights are examples of identifiable intangible assets. On the other hand, intangibles such as favorable government regulations, outstanding credit ratings, superior management and good labor relations are examples of unidentifiable intangible assets (Tweedie, 27). Goodwill comprises the complete set of unidentifiable intangible assets held by the reporting entity. Generally, goodwill has appeared to be an umbrella concept embracing many features of a company’s activities that could lead to superior earning power, such as excellent management, an outstanding workforce, effective advertising and market penetration. Goodwill definitions may be defined in two different ways: the residuum approach and the excess profits approach. In the residuum approach, goodwill is defined as the difference between the purchase price and the fair market value of an acquired company’s assets.
Goodwill is a leftover amount that cannot be identified, after a thorough investigation, as any other tangible or intangible asset. In the excess profits approach, goodwill is the difference between the combined company’s profits over normal earnings for a similar business. Under this definition, the present value of the projected future excess earnings is determined and recorded as goodwill. This concept is very difficult to measure since future earnings have no certainty.
Goodwill can arise in two different ways: It can be internally generated or it can be acquired as part of the acquisition of another company. Purchased goodwill arising on the acquisition of one business by another is defined as the excess of the purchase price of the acquired business over the fair value of its net tangible and identifiable intangible assets. The pronouncements on accounting for goodwill in the United States and Canada apply equally to goodwill arising upon: acquisition of the net assets of a business, preparation of consolidated financial statements when the purchase method of accounting is followed for investments in companies consolidated, and accounting for investments by the equity method.
A broader concept of goodwill recognizes the economic value of a business’ internally developed non-purchased goodwill such as name, developed markets, managerial talent, labour force, government relations, ability to finance operations easily, etc. Such non-purchased goodwill has not been recognized in the balance sheet and expenditures that 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.When a company buys another company, they can use one of two accounting methods: Pooling of Interest and Purchase. When the pooling of interest method is used, the balance sheets of the two businesses are combined and no goodwill is created. When the purchase method is used, the acquiring company will put the premium they paid for the other company on their balance sheet under the “Goodwill” category. Accounting rules require the goodwill be amortized over the course of 40 years.
It is no wonder that managements, in order to avoid this reduction in reportable earnings, frequently opt to use the pooling of interest method when they complete a merger. Since no goodwill is created, over-eager managers are able to pay outrageous prices for acquisitions with little or no accountability on the balance sheet. Since it makes no sense to have two different ways for accounting for a merger, the FASB decided they should eliminate the pooling of interest method and force all transactions to be done via the purchase method.
Executives and politicians claimed this will significantly reduce the number of mergers since the new standards would cause reportable earnings to drop as soon as a company had completed an acquisition. As a concession, the FASB will no longer require goodwill to be written off unless the assets became impaired (which means it becomes clear that the goodwill is not worth what the company paid for it).The FASB’s six members unanimously approved two new accounting standards on Friday July 23, 2001. Financial Accounting Statement 141 will eliminate the pooling-of-interest method for booking mergers.
The method had been popular with dealmakers because it allowed companies to do deals at a premium without marking up their assets. These markups inflate the size of future amortization expenses and depressed reported earnings, supporters of pooling said. The FASB also passed Financial Accounting Statement 142 a closely- related standard that will alter the bookkeeping for an intangible asset known as goodwill (Schneider). Goodwill is often inflated when companies do deals without using pooling. Companies have long complained that goodwill amortization charges inaccurately deflate reported earnings, and one of the main advantages of pooling is it allowed companies to strike deals without creating new goodwill.
The new accounting rules will minimize goodwill’s impact on reported earnings. However, the new FASB Statements have brought much grief to the work laden financial service men and women. An article from the CFO.com best exemplifies the confusion being caused by these new rules.
The SEC’s guidance on disclosures was still puzzling auditors in November of 2001, particularly with respect to the treatment of intangibles that are separate from goodwill. FASB intended to reconcile its rules with the SEC’s in early November. Brian Heckler, a partner at KPMG Transaction Structuring Services, says that the subjective nature of the standards is a possible deterrent to early adoption, and suggests that companies wait and see how peer groups or similar industries handle the new rules (CFO.com).
In addition, as CFO online magazine notes, that one of the problems with the new statements is specifically as the rules take effect, the focus will shift from impacts on the income statement, such as boosts to EPS, toward impacts on the balance sheet. Herein lies the difficulty for CFOs, who will be required to test goodwill assets for impairment. A Merrill Lynch’s study of 44 industries finds that the FASB changes will result in accelerated merger and acquisition activity for companies with strong cash flows as well as a decline in P/E ratios for certain industries (ML.com). In conclusion, the new FASB statements, while perhaps necessary, however have caused very serious fluctuations in various markets. To best exemplify this the Merrill Lynch study reached the following key conclusions: Auto makers will experience an average 37 percent earnings decline in 2001 – dwarfing any EPS pickup–from the accounting change. Pharmaceuticals will be disadvantaged because the new rules would require them to amortize acquired patents since the assets have a clearly defined life.
Waste, death care, engineering and construction may face significant impairment issues because a number of companies in those industries now carry a goodwill asset that exceeds their market capitalization (a potential trigger event for an impairment review). Life insurance companies in the U.S. may become more active acquirers compared with European firms, which have driven M&A activity in the industry.
For airlines, foreign ownership limits will likely keep acquisition activity light. Some utilities could experience a negative impact on cash flow because goodwill is a recoverable regulatory asset in the rate base. Oil refiners and marketers have little goodwill and get little boost to EPS because they’ve bought most of their refinery assets below book value.These fluctuations may lead to other reforms in the stated markets, but until the dust settles on these financial changes one would hope not to be caught up in the encircling adjustments.Bibliography:Jeannie D. Johnson and Michael G.
Tearney, “Goodwill -An Eternal Controversy”, The CPA Journal, p: 58-62, April 1993.David Tweedie and Jeannot Blanchet, “Brands, Goodwill and the Balance sheet”, Accountancy, p: 20-22, January 1995.Merrill Lynch, “Goodwill Accounting: The overhaul affect.
” New York November 2001Schneider, Craig. “CFOs Sweat FASB’s Goodwill Accounting Changes, Says Study.” CFO.com November 13, 2001.Schneider, Craig.
“FASB Issues Statements on Goodwill, Other Intangibles.” CFO.com, July 7, 2001.Words/ Pages : 1,421 / 24