Delhi Business Review X Vol. 4, No. 2, July - December Mohammad Talha

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1 Dehi Business Review X Vo. 4, No. 2, Juy - December 2003 TREATMENT TMENT OF GOODWILL IN ACCOUNTING Mohammad Taha GOODWILL is usuay ony recorded in an accounting system when a company purchases an unincorporated business or acquires a subsidiary or associated undertaking and prepares consoidated accounts. It is an item whose accounting treatment produces both conceptua and practica probems, with remarkabe impications on the true and fair view. As on June 30, 2001, FASB changed the rues for the mergers and acquisitions game. Companies no onger can use the pooing-of-interests accounting method for business combinations. Nor wi they account for mergers on their financia statements under the traditiona purchase method, which required them to amortize goodwi assets over a specific time period. Instead purchased goodwi wi remain on the baance sheet as an asset subject to impairment reviews. FASB s new standards, Statement no. 141, Accounting for Business Combinations, and Statement no. 142, Accounting for Goodwi and Intangibe Assets, are a radica change, and now management accountants, auditors and financia executives must understand and work with a very different accounting process. Some beieve FASB eiminated amortization to make purchase accounting techniques more appeaing to corporate America. Traditiona purchase accounting required companies to amortize purchased goodwi on a periodic basis, for as ong as 40 years. Now companies wi be abe to make acquisitions without being forced to take arge periodic earnings write-downs, which some corporate executives view as an unnecessary drag on earnings. The eimination of pooing is one of the most significant and drastic modifications in accounting methodoogy in many years. Business combinations are important, and so is how they are treated in financia statements. Anaysts wi have to understand the impact of the two new FASB standards, and companies and their auditors wi have to earn how to impement them. Introduction The Financia Accounting Standards Board (FASB), the governing body responsibe for estabishing the standards of financia accounting and reporting, recenty enacted two statements that overhaued the treatment of goodwi on the baance sheet and the accounting for business combinations. The new rues do away with goodwi amortization and the pooing-of-interests method of accounting for business combination. Under the proposed modification, pooing-of-interest accounting treatment woud sti ikey to be eiminated, but the goodwi generated in a purchase accession transaction woud not be amortized earnings. Rather goodwi woud be recorded as a permanent asset and woud be reviewed for impairment and expenses against earnings ony in the periods in which its recorded vaue exceeded its fair market vaue. It is important to note that apparenty the non-amortization approach woud appy ony to goodwi, and that various other assets categories woud remain subject to potentia write-ups and post-acquisition amortization / depreciation in connection with a purchase acquisition transaction. The FASB s decision on goodwi amortization is in direct response to the significant input which the FASB received from the investment and high tech communities and others concerning its origina proposa, as we as the resuts of recent company fied visits which indicated that an impairment approach coud be deveoped that woud be operationa. Under the new approach, goodwi woud be reviewed for impairment at the owest financia reporting unit or units that incude the acquired business. The acquirer woud be required to determine the vaue of the reporting unit and the vaue of the recognized net assets excuding goodwi of the unit. The 63

2 Mohammad Taha difference between those amounts (namey, the impied vaue of the goodwi) woud then be compared to the carrying amount of the goodwi, and if the carrying amount of the goodwi was greater than its fair market vaue an impairment oss woud be recorded in the company s income statement. Impairment reviews woud be performed initiay based upon the significance of the eve of goodwi to any particuar reporting unit. Subsequent reviews woud ony be required upon the occurrence of events indicating that goodwi of the reporting unit might be impaired. Definition of Goodwi The rue, estabished by the Financia Accounting Standards Board, is caed FAS 142 and modifies the treatment of goodwi. By impementing the new rue, many companies wi acknowedge in their first-quarter earnings just how much they overpaid for recent acquisitions, or more precisey, that some of these acquired assets wi generate ess cash than expected. Goodwi perhaps is best defined with an exampe. Say a company pays $100 miion to buy Company X, which has tangibe assets cash and equipment worth ony $40 miion. The other $60-miion of the purchase price is aocated to goodwi, or the vaue of the intangibe assets, such as the Company X-brand name, inteectua property and workforce. According to some anaysts, at the height of the tech boom, it was common for more than haf of an acquisition price to the goodwi, because most of the purchased companies had itte in the way of tangibe assets. Under the od rues, companies woud often have had to take that $60 miion and diminish, or write down, its vaue on the baance sheet over severa years. But that process, caed amortization, diuted quartery and annua earnings. If a company writes off $60 miion over 10 years, it woud be as $6 miion hit to earnings each year. In the 1880 s, the first definition refected goodwi as the difference between the purchase price and the book vaue of an acquired company s assets. Goodwi definition s has evoved since that time and may be defined in two different manners today: The residuum and the excess profits approaches (Johnson, 1993). In the residuum approach, goodwi is defined as the difference between the price and the fair market vaue of an acquired company s assets. Goodwi is a eftover amount that cannot be identified, after a thorough investigation, as any other tangibe or intangibe assets. This is very simiar to the nineteenth century definition. Both definitions impy that goodwi is the eftover amount. In the excess profits approach, goodwi is the difference between the combined company s profits over norma earnings for a simiar business. Under this definition, the present vaue of the projected future excess earnings is determined and recorded as goodwi. This concept is very difficut to measure since future earnings have no certainty. One characteristics of goodwi that has emerged over the past century is that it is inseparabe from the business. It can not be sod without seing the business that is associated with it. If you can se what you are caing goodwi, then it is something other than goodwi. It may be contract rights, a cient ist, distribution channes, or any number of other things and shoud be abeed as such, instead of umped into the goodwi account. Goodwi can be raised in two different ways: (i) It can be internay generated or (ii) it can be acquired as part of the acquisition of another company. Both types of goodwi have been recorded in the past. However, ony acquired goodwi is currenty aowed to be recorded. Accounting Treatment of Goodwi The three quaitative characteristics most directy concerned with goodwi are reiabiity, prudence and consistency. The treatment of goodwi has changed over the years. The four methods of accounting for goodwi are discussed in the foowing manners ( Write-off Under this method, goodwi is immediatey written off against an account in the stockhoder s equity section, generay retained earnings. Advocates of this method argue that goodwi is not measurabe and has no true future vaue. Thus, it shoud be written off against stockhoder s equity. 64

3 Dehi Business Review X Vo. 4, No. 2, Juy - December 2003 Another rationae for this method is that overpayment for the assets of an acquired company represents the expectation of superior future earnings. Since these earnings eventuay end up in the stockhoder s equity, they can be offset against the excess acquisition payment. Athough there are some good arguments for write-off method, it appears that it was used because it was the easiest and most widey used and not because it was conceptuay correct. Capitaization This approach s proponents argue that if goodwi is as important as asset as many beieve, it beongs to the baance sheet. One probem with capitaization of goodwi is determining the proper amount to capitaize. Current practice foows the residuum approach. One way of correcting the misuse of goodwi is through the hidden assets approach, Under this approach, the excess purchase price that companies pay over fair market vaue of the assets is for assets that are hidden from the baance sheet, then amortized over their usefu ife. If they were, goodwi account woud probaby be much smaer than in current practice and financia statements woud probaby be more usefu. Non-amortization Capitaization of goodwi without amortization aows the most advantageous financia reporting figures. A company gets to record an assets instead of a decrease in stockhoder s equity and net income is not periodicay reduced. However, it probaby woud resut in more abuse than any other method. The rationae for nonamortization is premised on the notion that goodwi does not decrease in vaue. High manageria abiity, good name and reputation, and exceent staff generay do not decrease in vaue but they increase in vaue. Goodwi coud be viewed as an investment and shoud stay on the baance sheet unamortized. But, without amortization, abuse may occur, and the goodwi account wi ose what imited significance it has now. Amortization Amortization enabes companies to match the cost of intangibe assets over the period deemed to benefit from their acquisition. Main arguments for amortization are the abuse of non-amortization and the unreiabiity of earnings without some attempt to recognize the impact. When amortization became is required, the period for write-off becomes the focus. If the ife of the assets is non determinabe, which is normay the case with goodwi, amortization over a maximum of twenty years shoud be used. This engthy period was set to aow a minimum impact to the net income (McCenahen, 2001). Pooing is Eiminated In Juy 2001, the Financia Accounting Standards Board (FASB) reeased SFAS 141, Business Combinations, and SFAS 142, Goodwi and Other Intangibe Assets. These standards are the resut of a ong FASB project that began in 1996 due to the increase in M&A activity that brought great focus to the differences between purchase and pooing accounting in conjunction with business combinations. A business combinations wi be treated as purchases. Because pooing paced restrictions on dea structure, post-dea rationaizations and compensation structures, its end wi have the foowing impact upon future deas: Fexibiity to se non-core assets. Pooing restrictions did not aow for the disposa of non-core acquired assets. Increased use of cash in deas. Because pooing forbade the use of cash consideration, often the high bidder was the one who coud pay in stock without suffering the effect of goodwi amortization, Cooper expains. Since the choice of cash versus stock no onger affects the accounting resut, the advantages of being a cash bidder may now tip the scaes. Treasury stock repurchases may become more popuar. Pooing restricted the reacquisition of Treasury stock. Now companies are free to use stock repurchasing as a means of maintaining earnings per share especiay when management beieves the shares are undervaued. 65

4 Mohammad Taha Greater fexibiity in structuring compensation programs. Pooing paced restrictions on a company s abiity to cash out, ater or grant new equity awards and that wi now cease to be reevant in future transactions, says Yeftich. More contingent consideration. Pooing forbade earn-out structures, Cooper expains, so now that pooing is not an aternative, a bidders are on equa footing to offer earn-outs as a potentia dea provision. For some time, we ve been seeing bidders more incined to take a prove-it-to-me stance in the Vaey anyway, he notes, and now it s no onger a disadvantage because no one wi be competing against a pooing bid. Measurement of Purchased Goodwi In determining the amount of purchased goodwi the purchaser needs to recognize a assets acquired, whether of a tangibe or intangibe nature. This might invove recognizing some intangibe assets which, if internay generated by the purchaser, woud not normay be recognized as assets because the absence of an exchange transaction usuay prevents them from being measured reiaby. Fair vaue is a measure of the worth of an asset at a specified time, and is utiized in this Standard as the amount which the purchaser attributes at the date of acquisition to the identifiabe assets acquired. When making an assessment of the fair vaues to be attributed to individua assets, the purchaser may sometimes find that a number of such assets are combined into a reated or composite group. Under these circumstances, it may be more appropriate to consider the fair vaue of the composite group rather than the aggregate of the fair vaues of the individua assets ( home.att.net/~s-prasad/gw.htm). The purchase consideration may incude any one, or combination, of the foowing: (i) Cash; and /or (ii) Other monetary assets; and /or (iii) Non-monetary assets; and /or (iv) Liabiities undertaken. When the purchase consideration incudes cash and/or other monetary assets, its vaue is usuay readiy determinabe. However, where the purchase consideration comprises (either partiay or totay) non-monetary assets, its vaue wi need to be ascertained by reference to the fair vaues of the non-monetary assets given. Where the purchase consideration comprises shares or other securities of the purchaser and these securities are isted on an Austraian Stock Exchange, the price at which they coud be paced in the market wi usuay be an indication of their fair vaue. Where the securities issued are those of an unisted entity, it may be necessary to make a vauation of those securities. It shoud not be assumed that the par vaue of securities refects their fair vaue, as this rarey is the case. Where an entity incurs cost that directy reate to the acquisition, these need to be incuded in the determination of the cost of acquisition. These costs woud normay incude ega fees, stamp duty and other government charges, and professiona fees in the nature of feasibiity tests and investigations preceding acquisition. To the extent that the cost of acquisition incurred by the entity exceeds the fair vaue of the identifiabe net assets acquired but the difference does not constitute goodwi, such difference must be recognized immediatey as an expense in the profit and oss account. Effective Management By one recent estimate, 70 percent of mergers and acquisition do not add to sharehoder vaue or actuay subtract from it. And paying too much for an acquisition and underestimating the difficuty of integrating assets are merger phenomena that aren t going away, says Stern Stewart s Pettit. The new rues wi put more focus on how effective management has been in transating the reasons behind doing a dea into resuts, stresses KPMG S Hecker. As goodwi wi not onger the amortized, management wi be chaenged propery to identify and vaue a assets that wi be consumed by the company in its earnings process, and those that do not, but provide for a 66

5 Dehi Business Review X Vo. 4, No. 2, Juy - December 2003 competitive advantage, says, Torres, I beieve the new (rues) wi provide more information to financia statement users, more consistent earnings comparisons between companies, and strong post merger evauation of a business combination. The process of evauating the performance of goodwi is technicay known as testing for impairment. In practice, that means checking for a decine in vaue and then taking a write-off for those operations that Pau Munter, a Professor at the University of Miami s Schoo of Business, describes as not doing as we as you were expecting. Particuary if a company is trying to focus on its core earnings, says Munter encouragingy, a onetime, non-recurring write-off is a ot easier to expain to anaysts than is an annua amortization charge against earnings spread over 30 or 40 years. Indeed, Munter expects once the goodwi rues take effect a bunch of companies wi suddeny take one-time write-offs for under performing acquired assets. Athough those write-offs wi somewhat decrease companies current earnings, securities anaysts and investors coud we be favoraby increased since, without the writeoffs and amortization of goodwi, future earnings for the companies wi be higher, says Munter. Tax Treatment Currenty, IRC Reg. Sec (a)-3 specificay prohibits the write off of goodwi. Amortization is aowed on other intangibe assets as ong as the asset meets the foowing criteria estabished in Rev. Ru : 1) A specific usefu ife can be determined and 2) the asset has a vaue separate and distinct from goodwi. IRC Sec. 1060, resuting from TRA 86, requires both the seer and the buyer to use the residua method for measuring goodwi. Under this method, goodwi is computed as the difference between the purchase price and the fair market vaue of the assets of the acquired company. Obviousy this is the same as the residuum method discussed earier. The purchase price is to be aocated to assets in the foowing order: 1) Cash and items simiar to cash, 2) marketabe securities and simiar items, 3) tangibe and intangibe assets excuding goodwi and going concern vaue, and 4) goodwi and going concern vaue. Going concern vaue resembes goodwi and is treated simiary. The aocated purchase price must be reported to the IRS by both companies in their tax returns fied in the year of acquisition. Goodwi is considered as a capita asset. Therefore, the seer wi want to aocate as much of the seing price to goodwi as possibe. Even though current capita gains rates are the same as the reguar corporate rates, this coud change with future egisation. Aso, capita gains created can be used to offset any previous capita oss carry forwards. The buyer wi want to aocate more of the seing price to non- goodwi assets because goodwi amortization is not tax deductibe whie depreciation and amortization of other assets is tax deductibe. This negotiated goodwi wi stand as the IRS vaue. Thus, the IRS has effectivey forced the controversia goodwi determination on the buyers and seers of the acquired companies. This makes it even more imperative for buyers to specificay identify any hidden assets they are acquiring at the time of purchase. Recent court decisions have aowed depreciation for severa intangibe assets where separate and distinct vaues from the business coud be estabished and imited usefu ives existed. Newspaper subscription ists have proven separabe in two instances. In Donrey v. U.S., separate existence was proven for the subscription ist because it was used in determining advertising rates and in seing advertising. In Newark Morning Ledger Co. v. U.S., a separate fair market vaue was estabished for the subscription ist by using the income approach. Life annuity tabes were then impemented to determine the usefu ives of the subscribers. Customer ists have proven to be deductibe in severa cases incuding Manhattan Company of Virginia v. Commissioner, Panichi v. U.S. and ABCO Oi Corp. v. Commissioner. Customer ists are considered to have a separate existence as ong as one of the individuas on the ist continues as a customer for more than one year. Deposit bases of banks have recenty been aowed as intangibe assets. In Citizens & Southern Corporation v. Commissioner, a depreciabe intangibe asset separate from goodwi was identified for the present vaue of the 67

6 Mohammad Taha future stream of income from the core deposits of the bank. The amount of annua amortization was the difference between the beginning and the ending present vaues. A variety of contracts ocation, empoyment, management and genera business have been hed deductibe as ong as a specified ife and separate existence has been estabished. Unimited renewa options precude the deduction. In Business Service Industries v. Commissioner, the ocation contracts acquired in a merger were used to obtain a bank oan. The bank s recognition of the separate existence of the contracts heped estabish the tax basis for the depreciabe intangibe asset. Tax incentives, which affect rea cash fow, are usuay reasons enough to aocate as much of the residua vaue as possibe to intangibe assets other than goodwi. The above cases show that certain intangibe assets do have vaue and ives separate from the ongoing business. One of the main such intangibe assets is key personne. However, this intangibe generay cannot be recognized as an acquired asset for tax purposes. For exampe, in the eectronics industry key empoyees pay a big roe in the success of a business. In acquisitions of these companies, substantia amounts are paid for key personne. The abiity to identify the amount paid for key personne and ist separatey and amortize over an appropriate ife, woud hod significant advantages. Concusion It summation, it has been brought out that the FASB has proposed a new accounting standard that wi eiminate the use of the pooing of interests treatment in acquisitions and aso end the amortization of a goodwi (Moehre and Jennifer, 2001). Goodwi wi remain on the baance sheet and be tested for impairment if certain trigger events occur. Companies that have made purchase acquisitions in the past wi get a one time expected step-up in EPS. These changes coud resut in increased M&A activity since acquirers no onger have to consider the possibe diution from goodwi charges (McCenahen, 2001). This preposition appears to satisfy most of the constituents that opposed FASB s earier proposas on business combinations, in particuar those in the domains of technoogy and finance industries. Anaysts and other users of financia statements, as we as company management, noted that intangibe assets are an increasingy important economic resource for many entities and are an increasing proportion of the assets acquired in many transactions. As a resut, better information about intangibe assets was needed. Financia statement users aso indicated that they did not regard goodwi amortization expense as being usefu information in anayzing investments. References Accounting for Goodwi, AASB 1013, Austraian Accounting Standard Board. p Financia Accounting Standard Board (FASB). accessed on Juy, John S. McCenahen (2001) Goodwi Accounting: The FASB Books New rues, Industry Week. Juy 18, U.S. Johnson, Jeannie D. (1993) Goodwi - an eterna controversy, The CPA Journa onine Apri 1993, p1-10. Stephen R. Moehre and Jennifer A. (2001) Say Good-Buy to Pooing and Goodwi Amortization, Reynods-Moehre. Journa of Accountancy 192(3): p.31, September. Literature Cited Barry Eiott and Jamie Eiott (2002) Financia Accounting and reporting Sixth Edition, Prentice Ha. Linda, Engish (1990) Accounting for Intangibes, Austraian Accountant, p:18-24, August