Goodwill is dead… so let’s bury it!!
INTRODUCTION
Like beauty, Goodwill is in the eye of the beholder…. and the beholder is blind!!!
Like the Bermuda triangle or quantum entanglement, Goodwill is a fleeting concept.
The annual hunt to quantify and ensnare this number is akin to looking for and trapping the mystical unicorn. Most finance executives would agree that the process for goodwill impairment testing is onerous, riddled with assumptions and increasingly provides challenges to our rationality as we try to obtain evidence of its existence. The requirement to test for whether the Goodwill balance, on a company’s balance sheet, can be recoverable is based on assessing estimated cash flows well into the future – beyond a timeline that any reasonable person can predict with a reasonable level of certainty. This is in itself quite paradoxical as most companies, for good reason, find it challenging when asked to forecast future earnings with a high degree of confidence.
Like beauty, Goodwill is in the eye of the beholder…. and the beholder is blind!!!
The concept of Goodwill is a sound one as it attempts to put a value to the established reputation or the je ne sais quoi qualities of a business. However, if we step back and consider it critically, what reputation does a relatively new business have, when acquired? In established businesses with increased competition in many sectors, or availability of like assets being produced by competitors, does the goodwill value ascribed to a purchase really have significance or can it really be supported by a reasonable person?
To those of you who are cheeky enough to think ‘of course a reasonable person would be able to ascribe value to goodwill’, our question would then be “would you pay the value for just the goodwill component of a business?”
Of course not – that is why it is essentially a plug. Consider this point for a moment, if goodwill, as an intangible asset, is supposed to provide future benefits for periods extending beyond a year, then can anyone explain how Goodwill as an asset can reasonably do so, other than theoretically. After all, who is to say that it is not the new management, new economic circumstances, renewed focus on previously neglected lines of businesses, technological advances or the vision of a new board and/or CEO that unleashes the value by putting the company on the right track to generate future net positive cash flows? If such is the case, and in many cases it is, would your argument be that the acquirer is paying for their own efforts; that would be akin to purchasing a lawnmower, but paying the seller for the lawnmower AND the time it will take you to mow the lawn. How is that additional amount goodwill if the benefit received is from your efforts?
Please, don’t misunderstand us, as we understand that there is sometimes a valid reason for paying a premium, the value of which would be realized through the acquirer’s own efforts. However, that premium should not be wrongly categorized as goodwill, as if one can’t reasonable identify the specific asset (tangible or intangible) within the business acquired, such a plug should not be kept as an asset but appropriately recognized as equity within comprehensive income. We believe that finance professionals and accountants should spend more time focusing on generating cumulative returns with the goal of disclosing to shareholders how the company has progressed towards positive cash returns on each investment acquisition.
THE FAIR VALUE CONUNDRUM - WHICH VALUE IS CORRECT?
Goodwill, as defined by accounting standards, is purchase price paid in excess of the fair market value of assets acquired and liabilities assumed. IFRS defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date”. If fair value is what a market participant would pay for a business, does it not seem like a contradiction to mathematically deduce a value for goodwill? If goodwill is so apparent, would not the market participants be adept at identifying it and specifically identifying the value associated with it as part of the negotiations? Is this yet another requirement that seeks to distance accounting from reality and further create the notion that accounting is somehow complicated. Why should it matter that five valuators may estimate a different price on the company and its assets or that another company would pay a different price to purchase the same company? Does anyone benefit from this futile exercise at arriving at a value that we all can safely agree has little to no bearing on future reality?
What truly matters... creating value for shareholders, not chasing an illusion
Some would argue that by getting rid of Goodwill and allocating the purchase price to the real assets acquired, will somehow lead to an immediate impairment, as the calculation of discounted cash flows may result in the asset’s net present value (NPV) being lower than its carrying value and thus signifying that such a difference represents the amount which is likely not to be recoverable and therefore should be written-off. Our answer to that is “So what?”. This would be no different when testing Goodwill for impairment annually, except one now has only identifiable assets to test within a cash generating unit, and we propose, only when there is a trigger event, as opposed to having two impairment testing streams; one for assets with definite lives and one with indefinite lives. This maybe a paradigm shift which we accept may not find overwhelming acceptance by all finance and accounting professionals, but we believe it would align accounting with reality and get finance professionals focusing on what truly matters… creating value for shareholders, not chasing an illusion.
WE ARE NOT ALONE...AND THE FACTS ARE CLEAR
We came across a series of articles by Aswath Damodaran (Professor of Finance at the Stern School of Business at New York University) on goodwill and in particular an interesting statistic: “55% of companies after announcing an acquisition saw a decline in their stock value”. If goodwill is the existence of higher earning capacity over and above the fair value of identifiable tangible and intangible assets, then why should a company’s stock price decline? Are we continuing to hold on to a flawed premise which, adds little to no value in contributing to the assessment of the value of a business, but only keeps us accountants focused on non-value added analysis? Though the definition of Goodwill is sound in its purest sense, one should not take this to mean that somehow the accounting for such is sound, practical, and meaningful. Does it not scream out loudly that the current accounting paradigm for goodwill is flawed? If goodwill truly had value that endured, then goodwill impairments should be always accompanied by a decline in a company’s market value, but that is not the case.
The 'Real' Intangible Assets
The evolution of goodwill from the 1880s to date has been a subject of controversy and debate as academics and accounting professionals have constantly struggled to find a way to ensure that the consideration or purchase price in an acquisition is ascribed to the value of assets acquired and liabilities assumed. In the beginning, one would pay a premium to purchase a business to compensate the owner or owners for their time and efforts in building brand recognition, securing patents, customer acquisitions and long-term contracts, and other intangibles of value to generating net positive cash flows.
Over time, much effort has been made by standard setters to encourage and require companies to specifically place a value to such intangibles, instead of assuming it to be goodwill.
It is generally accepted that intangible assets are grouped in the following major asset classes:
Marketing-related (e.g. trademarks, trade names, non-competition agreements);
Customer-related (e.g. customer lists, customer contracts);
Artistic-related (e.g. plays, books, copyrights of other work);
Contract-related (e.g. licences, franchises, royalties, permits);
Technology-related (e.g. patents); and
Goodwill
An interesting observation and one that supports our viewpoint is that all of the five major asset classes, except for goodwill, provide the right to use something identifiable and specific in order to generate cash returns for shareholders. We cannot say the same for goodwill, which is the reason why it is NOT identifiable and a mere plug after all the assets which have been identified (tangible and intangible) have been valued.
Many argue that beyond the value established by the predecessor owners and management, Goodwill in this present day continues to be supported by the following:
Growth Potential
Growth Potential that would not have been possible if the company was not acquired. Our view still stands that the reason why one invests is to make money and therefore acquiring a company should lead to increased cash profits. Such increases in profits must be supported by being able to reasonably allocate the purchase price to the assets of the company, whether intangible or otherwise. This in no way should be supported by calculating a plug, as we challenge how reasonable it would be to estimate the recovery of a plug (i.e. the non-allocated portion of the purchase price). Moreover since valuation of intangibles includes the assumptions of growth a portion of this is already factored into the fair value of intangibles and other assets which would be used in realizing such growth.
Creation Of Synergies
Creation of Synergies as a result of utilizing the resources of both companies. While synergies, on the surface and in practice, add value, again one should be able to attribute the purchase price to identifiable assets. If there is reasonable expectation that the purchase price can be recovered, then that should be reflected in the fair value of the assets identified, as without them, no such returns would be realized. Moreover, synergies do not hold over the long term, as if the value of synergy can be quantified with certainty, it should be recorded as an asset with a finite life, which would be the estimated period over which the benefits will be realized. That in itself, in our opinion, would be an interesting valuation exercise which is not worth the time and effort.
Control Premium
Control premium can be quantified and valued. However, does the acquirer not explicitly describe the benefits of their control to shareholders? Almost every proposed acquisition is accompanied with many benefits which will be realized by the new management. Most shareholders will consider this table stakes for an acquisition that the benefit of the acquirer obtaining control will result in future improved profits.
Assembled Workforce
Assembled workforce certainly provides value at the time of the acquisition. No acquirer, with expectation of growth, ever leaves the acquired company and its workforce in exactly the same manner as when it was acquired. Eventually the workforce is complemented or supplemented with new or existing workforce. So why would we consider this to be a contributor to the value of an intangible asset with an indefinite life? Does that not seem like a fallacy of composition? It is reasonable to assume that not all employees remain employed with their current employers until retirement; and even then, the duration of employment is finite.
Overpayment
Overpayment may not always be a negative; an acquirer may wish to make a strategic acquisition to thwart a competitor or to maintain or improve its market share with the expectation of improved positive cash flow in the future. Most times though despite the market perception of overpayment or independent analysis which may indicate overpayment, the presupposition from an accounting standpoint is that this excess is represented by goodwill. Unless there is decline in the performance of the company this overpayment may never be realized from an accounting standpoint. Our view is that there are times when such a perceived overpayment can either be accepted as being included in the fair value of the assets acquired or should be recorded in equity within comprehensive income.
Our view is that if the purchase price allocation to identifiable assets cannot be reasonably estimated to be recovered, then rather than going through intensive introspection to identify the origins of this excess and to derive elaborate models to calculate fair value, it would be more expedient and practical to record this excess as an adjustment within comprehensive income until such time as the business is sold or abandoned. To the extent, in the future management can, create additional value that will drive growth, increase revenue and cash flow thus increasing the value of the company, such returns should be contributed to management’s efforts and not incorrectly assumed to be in support of goodwill. We consider such growth and increase in future value as upside and not goodwill as such increases will be reflected in the way true value should be reflected which is by sustaining increases in positive net cash flow generation and not sustaining a goodwill balance.
Some may argue that our recommendation is just a reclassification of goodwill from being an asset to part of equity on the balance sheet. While technically, this would be partially true, the fact is goodwill would no longer be considered an asset which in order to continue to have it remain on the balance sheet must meet the definition of an asset and result in the varied of estimates and assumptions that go into calculating the net present value of estimated cash flows out into the future in support of a plug.
Goodwill Or Overpayment?
The current accounting construct does not leave room for human failings which most agree exists; exuberance and overpaying for an acquisition will no doubt continue till the end of time. However, is there such a thing as overpaying for an acquisition? The assumption of overpaying seems to imply a fact, when invariably an assumption of overpayment by one person, could be a bargain for another; it all depends on what the acquirer intends to do with the company purchased; essentially, how it intends to utilize the assets (tangible and intangible) to generate positive net cash returns. When two willing parties arrive at a price for an acquisition, that price is the value at a point in time. In fact, the notion of a value for a business is not fixed at one amount as there can be several values for a business at any one time, given that the price someone is willing to pay for a business is dependent on many factors, not all of which are quantitative. The presumption is that a third party would be able to arrive at a true value, if given access to all of the facts. However, it would be wrong to assume that all of the facts are always available, known, and/or interpreted the same.
One way of looking at a business is that assets are like links on a chain that work together to create value for the business. For this reason, when impairment is assessed, assets that are part of a cash generating unit are assessed based on the assets’ contribution to generating cash profits, and thus recoverability. What this means is that the price one pays should be apportioned to the fair value of each asset, as presumably one would not pay more for a business than can be recovered through expected future cash generation. Would it not be far simpler to acknowledge this fact at acquisition and record the estimated deficiency in comprehensive income? It would serve to highlight the fact to all shareholders rather than wasting time with impairments the day after the acquisition or soon after. This may be a tough sell to many as most would argue that how can I tell shareholders that we purchased a company and half the purchase price is not included as an asset. In our opinion, this is a fallacy, as investors care about making money and not accounting manoeuverings; it is time we give investors credit for having a brain and not fooled by gimmicks. What an investor wants to see is increased cash returns, after an acquisition is completed, instead of cash losses or no growth, but a significant goodwill balance, year after year, that has been loosely supported by estimated future cash flows and the associated assumptions that come with it.
In the case of In process research and development (IPR&D), United States standard setters realized that though much time, effort, and money has been spent on work done to perform such research, the fact remains that it is difficult to assess the recoverability of IPR&D. As finance professionals, we could agree that while IPR&D is separately identifiable, tangible, and has potential for creating value, it is highly subjective and difficult to value. So why would we place so much faith in the value of a plug (goodwill) which is intangible, not separately identifiable (hence the plug), highly subjective (riddled with assumptions), and difficult to value.
Through The Eyes Of The Shareholder
One who invests in a company expects a return on investment either in the form of dividends or appreciation in the value of the stock and subsequent sale, both of which result in a cash flow event. In an acquisition, the original shareholders’ interest in the acquirer is diluted, in absolute or proportionate terms, because their interest in the cash flows of the company are reduced either due to the cash expended or the additional shares issued. If we all realize this why do we want to hang on to the notion of goodwill? Let us be clear that we are not asserting that there is no value in intangible assets; we do believe intangible assets such as customer lists, brands, assembled workforce, and other identifiable intangibles, all may possess a value. It makes sense to at least attempt to value them in an acquisition, but carrying a plug called goodwill on the balance sheet obfuscates the fact that the shareholders of the acquirer have been diluted, albeit presumably obtaining a smaller piece of a bigger pie.
Are We Confused?
Consider Coca Cola Company. One would say that there must be goodwill if this company is acquired. While we see the technical merits, we challenge this premise, by asking one question “Would Coke have the same value without the special formula(s) AND brand recognition? What if we were to change the formula of the drinks and replace with swamp water, would the value in terms of future cash generation exist? Our view is that it is the formula and brand recognition that make up the substantial value of the company. Also can you agree unequivocally that the Coca Cola Company’s ability to generate significant earnings would be static over time? Therefore, upon an acquisition, the purchase price should be allocated to such identifiable assets (PP&E, patents, etc…) that create value in terms of positive net cash flow generation; any excess purchase price should be recorded as a reduction to comprehensive income immediately. This also will address the contradictory accounting for instances of negative goodwill where the fair value of identifiable assets are adjusted on a pro rata basis due to the fact the purchase price is less than the fair value of identifiable assets acquired. In our opinion, if you cannot reasonably estimate the recoverability of the purchase price through fair valuing identifiable assets, not a second should be wasted on recording goodwill, just so you can impair it later; or waste time annually, with assumptions, attempting to prove that the goodwill balance has value in terms of recoverability.
Market Perspective
If we choose to look at it from a market dynamics perspective, why would the stock price of the acquirer decline when an impending acquisition is announced? Also why does the stock price typically rise when a goodwill impairment is announced? Is it perhaps because most rational investors discount the value of this goodwill asset? If accounting in its purest form is meant to reflect economic reality, the recognition of goodwill would seem to be a deviation from the fundamentals. As any competent accounting practitioner will agree, the annual impairment process is full of assumptions which the auditors are required to review for reasonableness. As market conditions deteriorate management teams seldom look at that indication as a beginning of a trend. It is only visible and acknowledged in hindsight and therefore most impairments lag the actual changes or declines in the underlying business and/or market.
It is a known and common fact that upon valuing a company, the discount rate for each asset class increases in the event the asset is deemed to be less realizable in cash. This falls under the basic definition of an asset that it has future value which can only be determined by estimating whether its value on the books can be recovered in cash. Naturally, if the likelihood is low, so will be the estimated value of the asset. If goodwill is calculated as a mathematical outcome and has such little relevance in current times, perhaps we should banish the concept to the times where it was relevant; i.e. in the past. Acquisitions historically were done for long term value creation; this is increasingly irrelevant today where performance is measured by quarterly earnings targets and the acquisitions are driven by many other factors that are more meaningful, all culminating in expected increased cash flow… or what would be the point?
Let’s breathe the fresh air of reality and banish goodwill to the closets of all balance sheets. The accounting profession will be embraced for doing the right thing.
Goodwill is dead… so let’s bury it!!