To amortise, or not to amortise, that is the question

We discuss the challenges of accounting for goodwill.

I lead on valuation and accounting issues across all sectors, reviewing recommendations, challenging the rationale for existing holdings and developing valuation frameworks. I believe that financial reports, if interpreted carefully, can reveal a lot about both a company’s strengths and weaknesses, and the quality of management. The goal of my forensic reviews is to distil all the numbers into a few differentiated investment questions which can help enhance our multi-dimensional research, and lead to high-quality investment discussions with our fundamental analysts and with companies.

Key points

• There is a lot of confusion and debate about what goodwill represents and how it should be accounted for. Currently, goodwill is tested annually for impairment, but the US Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) are considering reintroducing the amortisation of goodwill.
• Those who think goodwill represents an indefinite-lived asset think the current impairment-only model makes sense. However, for those who think goodwill represents a finite-lived asset, amortisation makes sense.
• I argue that goodwill should be split into three component parts: an indefinite-lived asset which should be tested for impairment, a finite-lived asset which should be amortised, and the part which is not an asset at all which should be written off immediately. At first glance this might seem challenging for companies to apply, but I think it would provide investors with much better information, justifying the effort.

The question

Prince Hamlet opens his famous soliloquy with “To be, or not to be” before contemplating the difficult choice between the unknowns of death and the unfairness of life. Although arguably less dramatic, the US FASB and the IASB are posing another uncomfortable and difficult question: whether to amortise, or not to amortise, goodwill.

What is goodwill?

Accounting standards define goodwill as the difference between the fair value of the consideration paid and the fair value of the net assets acquired. Goodwill is the accounting entry which balances the books, but what exactly does it represent?

Lord Macnaghten offered his definition of goodwill 1901, in a House of Lords Case between The Commissioners of Inland Revenue and Muller and Company’s Margarine Limited.

“It is a thing very easy to describe, very difficult to define. It is the benefit and advantage of the good name, reputation, and connection of a business. It is the attractive force which brings in custom. It is the one thing which distinguishes an old-established business from a new business at its first start …. goodwill is worth nothing unless it has power of attraction sufficient to bring customers home to the source from which it emanates. Goodwill is composed of a variety of elements. It differs in its composition in different trades and in different businesses in the same trade. One element may preponderate here and another element there.”

I propose classifying goodwill into three component parts: an indefinite-lived asset, a finite-lived asset and what’s not an asset at all.

An indefinite-lived asset

The best example is the accumulated know-how in the business. So long as the business continues to prosper, the accumulated know-how should maintain its value. However, if lots of key employees leave or if the market opportunity suddenly declines, the value of this know-how is diminished.

It makes sense to test this type of goodwill for impairment if there are material events which suggest its value is permanently diminished.

A finite-lived asset

The most common example is the amount paid for expected cost synergies. I came across a company which excelled at running industrial plants. It specialised in buying underperforming companies, which it was confident it could run better and, in most cases, it was able to double the margin over a few years.

It makes sense to amortise this type of goodwill over its useful economic life, typically a few years. The balance sheet would reflect a wasting asset and the income statement would reflect both the cost synergies and the premium paid for these synergies.

Not an asset at all

This is the amount management overpaid for the acquisition.

It makes sense for this type of goodwill to be written off immediately. This is the theory, but how would it work in practice? If an auditor were to ask management how much it overspent on an acquisition, it is unlikely to give a reliable answer, even though studies have shown that most acquisitions destroy value. However, if both the acquirer and target are listed on stock markets, the overpayment can be estimated as the amount which the combined market capitalisation of the acquirer and target fell when the deal was announced.

Closing thoughts

The status quo, to test all goodwill for impairment only, flatters the income statement as it reflects cost synergies but not the premium paid for those synergies.

To amortise all goodwill would be nonsensical: why would you amortise an indefinite-lived asset? If the standard setters were to adopt this approach I suspect management, and investors, would ignore the amortisation, excluding it from adjusted profit definitions.

In my opinion, goodwill should be split into three parts, each treated differently. This would help investors understand the premium paid: was it mostly for cost synergies or for the benefits of buying an established business? It would also improve the relevance of GAAP (Generally Accepted Accounting Principles) profitability and net assets because only the appropriate amount of goodwill would be amortised.

Authors

Jeremy Stuber

Global analyst, valuation and accounting