Sunday, December 16, 2012

Acquisition Accounting II: Goodwill, more plug than asset

There is no asset on a company’s balance sheet that wreaks more havoc on valuation and good sense than goodwill. The first problem with goodwill is that it sounds good, and when something sounds good, people feel the urge to pay for it. The second problem is that, notwithstanding claims to the contrary, it is not an asset but a plug variable that measures everything and nothing at the same time.

A short history of acquisition accounting
To understand the treatment of goodwill in GAAP, it is worth taking a quick look at how acquisitions have been accounted for over time, at least in the United States. Until a decade ago, companies that acquired other companies could pick one of two approaches to “account” for the acquisition.
  • In the first, termed pooling, the acquiring firm was allowed to incorporate just the book value of the target firm’s assets into its balance sheet, and essentially ignore or hide the premium paid over this book value. Thus, there was no goodwill on the balance sheet, but to qualify for pooling, the acquiring firm was required to jump through hoops (some of which were very expensive); for instance, only acquisitions financed entirely with stock qualified for pooling. 
  • In the second, purchase accounting, the acquiring firm had to incorporate the market value of what it paid for the target firm on its balance sheet, and to show the difference between the market value and the book value as “goodwill” on its balance sheet. Under this old system, goodwill was amortized over a fixed period not to exceed 40 years, though this amortization was not tax deductible (at least in the United States).
In spite of the fact that goodwill was a purely accounting variable and that its “non tax deductibility” made it irrelevant for cash flows, the fear of the earnings hit from amortization led companies to go through contortions (and to pay more) to qualify for pooling. AT&T, for instance, paid an additional $325 million when it bought NCR, to qualify for pooling, making an awful deal even worse. The prevalence of two different acquisition accounting systems also made it difficult to compare the balance sheet numbers for acquisitive companies that used purchase as opposed to pooling. Finally, amortizing goodwill over 40 years for all acquirers essentially resulted in both good and bad acquisitions being treated the same way for accounting purposes.

To remedy these problems, the accounting rules were changed on June 30, 2001, with four key modifications. First, pooling was disallowed and all firms were required to use purchase accounting. Second, accounting rules were changed to give accountants more discretion, albeit within strict limits, to do a reassessment of the value of a target firm’s existing assets at the time of the acquisition. To the extent that a target firm had assets on its books that were recorded at below (or above) their “fair” value today, this accounting adjustment could lead to an adjusted book value (which is different from the actual book value). In addition, accountants were also allowed some leeway to bring in the values of “intangible assets” such as customer lists and technology patents into the book value of the target firm. Third, the goodwill was then computed to be the difference between the market value paid for the target company and the “adjusted” book value. Finally, rather than amortize this goodwill over 40 years, accountants were required to revalue the acquired company at regular intervals and impair the goodwill, if they felt that the target company had declined in value.

While these changes made sense at an intuitive level, there are two things worth emphasizing about them. First, for better or worse, it has been a lucrative jobs program for accountants & appraisers, since their services are now required both at the time of the acquisition (to reappraise the value of the existing assets) and each period thereafter (to assess target company values). Second, as is the case with most accounting rules, the rules have obscured the principles of what the changes were meant to accomplish: create more transparency for investors about acquisition costs and more accountability for bad acquisitions.

So, what does goodwill measure?
If goodwill is the difference between what an acquiring company pays and the “adjusted” value of its existing assets, what exactly goes into it? To answer that question, let me compare two visions of balance sheets:


The balance sheet to the top is a conventional accounting balance sheet, with book values recorded based on what was originally paid for the existing assets, net of depreciation and debt & equity, reflecting the company’s history. The balance sheet at the bottom is a intrinsic value balance sheet, with assets broken down into investments already made and growth investments (based upon expectations for the future).

Within this framework, here is what happens after an acquisition. The accountants are called in to reestimate the value of the existing assets and replace the conventional accounting book value with the estimated value. Goodwill then becomes the difference between the price paid by the acquiring company and the reassessed value for existing assets. So, what else goes into the price that an acquirer may pay, besides the value of the existing assets? Here is my attempt to break it down:

Thus, accounting goodwill is composed of both goodwill that has a rational basis (a fair value of growth assets, control, synergy) and goodwill that is built on sand. Why should you care? As a stockholder in the acquiring firm, you first want to separate out overpayment from the remaining reasons, since it is an immediate transfer of your wealth to the target company. You could, of course, wait for accountants to impair this portion of the goodwill but it not only happens too late to help investors, but it may also reflect unexpected disappointments on control, synergy and growth assets.

I have a simple proposal that I know has zero chance of being adopted that may give investors at least a heads up, with acquiring companies. At the time of the acquisition, I noted in an earlier post that the acquiring company’s stock price drops in about 55% of acquisitions. If you accept the argument that this is the market’s collective judgment of how much was overpaid, why not break goodwill down into two components: the “market correction” can be called foolhardy goodwill and the rest can be rational goodwill. Thus, if a company pays $12 billion for a company with an adjusted book value of $ 4 billion, and sees its market cap drop by $ 3 billion on the announcement, you should see $ 3 billion in foolhardy goodwill and $ 5 billion in rational goodwill on its balance sheet. While both types of goodwill may turn out to be wrong, in hindsight, and may need to be impaired, I would argue that firms  (their top managers and bankers) should be held much more accountable for failures on the former, because they chose to do the acquisition in the face of investor opposition.

The Goodwill Games: The Bottom Line
  • There is no correlation, positive or negative, between the magnitude of goodwill and the quality of a deal: Given the time and resources that accountants bring to the measurement and subsequent impairment of goodwill, you would think that their actions have substantial impacts on markets. In an accounting world, you should expect to see a differentiation across acquiring companies, based upon how much goodwill is created at the time of the deal. Presumably, if you accept the accounting interpretation of goodwill, deals that result in less goodwill should be better than deals that create more, with “better” measured as market reaction to the announcement of the deal or as performance after. As far as I know, I do not know of a single study that finds a correlation between the two. (If you do find any, please let me know….)
  • The presence of goodwill on the balance sheets of acquiring firms make it difficult to compare these firms to those that don't do acquisitions, because it exposes the inconsistency in accounting rules on the treatment of growth assets. A growth firm that grows entirely through internal investments will not show its growth assets on its balance sheet, until it makes those investments. If that growth firm is acquired by another firm, the goodwill that shows up on the company's balance sheets will include growth assets. Investors therefore have to wrestle with what to do about goodwill in both relative and DCF valuation: (a) If you use earnings multiples (PE, for instance) or book value multiples (Price to Book, EV to Invested Capital), comparing acquisitive firms to non-acquisitive firms can be skewed by the presence of goodwill. Since goodwill inflates the book values (of both equity and invested capital), acquisitive companies can look cheap on both price to book and EV to invested capital measures. Analysts and investors often respond by using only "tangible" book value, where goodwill is removed from the equation.  (b) In discounted cash flow valuation, a key ingredient that determines value is return on equity (or return on invested capital) and both can be pushed down for acquisitive firms, if goodwill is treated as part of book capital. Analysts again respond by eliminating goodwill from book value and invested capital for accounting return measures. That may tilt the scales too far in the other direction,  because it gives acquiring companies a free pass on acquisitions and makes them look better than they really are in terms on returns on invested capital. I would argue for an intermediate solution, where the foolhardy goodwill (see above) is left in invested capital and the control/synergy portions are phased in over a 3-5 year period. Firms that consistently over pay for acquisitions or fail to deliver on synergy or control will therefore be assigned lower returns  on invested capital and lower value.
  • The impairment of goodwill does have an effect on stock prices but it may have also damaged earnings quality. Since declining stock prices (for the acquiring firm or the peer group of the target) is a key trigger for an accounting impairment assessment, there is an open question as to whether the impairment is a surprise to investors. Looking at the studies over the last decade, there is evidence that even though goodwill impairment lags economic impairment by many years, stock prices still drop on the impairment of goodwill, with the price impact of goodwill impairment being greatest at small firms that have little analyst following. However, there are also many who contend that goodwill impairments have contributed to making earnings reports more difficult to decipher and thus reduced earnings quality. Finally, there is also evidence that the initial market reaction to the acquisition is a good predictor of the subsequent impairment of goodwill. Perhaps, my proposal to separate goodwill into foolhardy and rational goodwill is not so outlandish, after all...
In summary, then, the new rules on goodwill have not reduced the propensity of acquirers to overpay for target firms, have not made their financial statements more informative, and might have made it more difficult for investors to value serial acquirers. So, would it not make more sense to move back to a simpler, automated system for reporting on acquisitions, with less accounting judgment and more reporting of facts?

The Acquisition Series
HP's deal from hell: The mark-it-up and write-it-down two step
Acquisition Archives: Winners and Losers
Acquisition Hubris: Over confident CEOs and Compliant Boards
Acquisition Advice: Big deal or good deal?
Acquisition Accounting I: Accretive (Dilutive) Deals can be bad (good) deals
Acquisition Accounting II: Goodwill, more plug than asset

33 comments:

Anonymous said...

Prof. some thoughts -

Why should goodwill be segregated into 2 - foolhardy and sane portions - based on short-term market reactions?

Overpayment can only be evident over a period of time (unless in exceptions like HP).

Also, what if the fair value (tweaking book value) adjustment to book value itself is incorrect, resulting in more or less goodwill?

For instance, if adjustment to book value is pushed up aggressively, resultant goodwill will be lower.

Key is to watch the price that is paid relative to the assets that are bought - a fundamental valuation of business. If investors spend sometime on this, they can come to some (albeit approximate)sense as to overpayment.

This overpayment should then ultimately write-down both goodwill and other (impaired) assets.

ken BAily said...

Maybe part of the problem is both the acquirer's lack of identification of existing intangible assets, during the due diligence process, that underlie the pie in the sky synergistic value that the acquirer is paying for and the accountant's lack of legal knowledge regarding the existence and ownership of specific types of intangible assets that should be both identified and valued, thus reducing the goodwill plug, both at time of acquisition and during impairment determination.

Aswath Damodaran said...

Anonymous,
First, the market reaction is not short term, since the price drop does not go away in a few weeks. Second, whatever you may think about markets, studies seem to show that one of the best predictors of eventual impairment is the market reaction to the acquisition announcement. Third, when top managers choose to take actions that markets don't like, they are asking us to trust their judgment over that of the market. That is fine, but I think we need to hold them accountable for taking that bet.

Anonymous said...

Hello Prof. Damodaran - One question please on bond valuation.

1) Should we take gross interest or interest (1-t) as cash flow for pv calculation

2) Should we take discount rate (cost of debt) pre-tax or post-tax for pv calculation.

Thanks for help.

Anonymous said...

Hello Prof Damodaran, I have had a look at various places including your book and note that for bond valuation, gross interest (without netting of tax)is used as cash flow and pre-tax cost of debt is used as discount rate. However, I have not found any text where it is specifically mentioned. Just want to reconfirm this with you which will be of great help to clear my doubts. Please clarify. Many thanks in advance.

assignments web said...

Nice and informative Blog regarding Help me with Assignment this is really helpful for people who interested in Online Education. Thanks and Keep Continue to share useful information with us.

Jack Smith said...

Accounting companies aim to provide the friendly and efficient service for all accountancy requirements, from traders and partnerships to the limited companies.Small Business Accounting Sydney


QUALITY STOCKS UNDER 4 DOLLARS said...

Companies that do takeovers can deduct interest expense before earnings. This causes many private equity deals that involve lots of leverage.

Unknown said...

Nice blog, thanks for sharing the information. I will come to look for update. Keep up the good work.

asset management boston

Anonymous said...

Awesome blog! The most part I like in your blog is the short history of acquisition accounting. I learn a lot about the difference of pooling and purchase accounting. Thank you for sharing and I will also share this blog to all my friends.

Capital Accounts Collection

Free tablet Pc with accountant course said...

Very helpful and informative.
Its very informative post about accounting.....
Regards,
Get Free Tablet Pc on admission of E_accountant Course at ziitech

Anonymous said...

I wanted to thank you for this excellent read!! I definitely loved every little bit of it.Cheers for the info!!!! & This is the perfect blog for anyone who wants to know about this topic. You know so much its almost hard to argue with you ………
thanks

Startup Bookkeeping - California accounting firms provides financial accounting.

John said...

Our financial
accounting software
information is the most valuable and the most sensitive information we have.

Unknown said...

Accounting is not an end in itself; it is a means to an end. It performs the service activity by providing quantitative financial information that helps the users in making better business decisions & the information contained in the article is very helpful & informative..

thanks & keep sharing
Accountants in London

Unknown said...

Nice Concept in this Blog to Finance and Accounting Services. So Great post Thanks.

Unknown said...

What a blog post!! Very informative and also easy to understand. Looking for more such comments!! Do you have a facebook? I recommended it on digg. The only thing that it’s missing is a bit of new design. non-profit

nhlanhla said...

amazing blog , definatley want to follow through email....interesting how complex the valuation of "real equity" in a firm can actually be

Unknown said...

Such a nice blog, you really provide me some great information. i am going to bookmark this blog, share with my friends and will definitely visit here again. Thanks for your article.
Jimmy Wilson-Smallville Jacket Superman

Unknown said...

Prof. Damodaran, the changes of acquisition accounting also include the requirement to identify intangible assets if they meet the separability criteria or the criteria derived from contractual or legal rights. In this regard, some intangible assets appeared in the balance sheets, which were not identified before including customer base, brand, etc. In your opinion, do these changes improve the quality of financial reporting? Many questions arise around identification customer relationships separately from goodwill, because its depreciation affects cash flows of a company. In your opinion, are such assets plug variables likewise goodwill?

Unknown said...

Amazing publish
Resident Evil 6 Costumes PC

Unknown said...

Hi Friends how are you hope you fine I am share with you some tips hope you like. If you have staff, find out what they think of the current accounting system you have in place. Inquire about what software they may have used in the past and find out what they need to work effectively. It's best to get feedback before making any purchasing decisions. To get an idea of what to expect, review the costs and payment plans of available accounting software. Many of the software packages may end up costing more than the listed retail price. This is due to additional services required for features such as payroll updates and merchant services. Consider what financial resources you have for investment in software. Every investment made for your business has a cost-benefit analysis that you should assess. Many popular accounting software packages have the convenient attribute of allowing data to be converted from one program to another. Should the software not work as expected, firms may easily switch to more suitable accounting software products. Be sure to compare software capacity to your current and future business needs.

Maryam said...

Info is out of this world, I would love to read more.
irs tax liens
creative real estate investing
organ tax lean sales

Luetta Fox said...

This is such an informative article on acquisition accounting. Thanks for sharing a very helpful post.

Unknown said...

Berkmans is an esteemed firm of expert chartered accountants. We provide accounting and financial auditing services in central Coast. We also provide risk planning, wealth management, Tax planning, financial analysis, Business establishment and much more
Small business accounting Central Coast

Unknown said...

Nice post and nice information too. I read your post. It's really nice and I like your post. It’s very simple to understand........Thank you for sharing...........

Accounting services

Unknown said...

Your information about business accounting toowoomba
system is really appreciable.I am very lucky ot read this type of blogs.Your info is play a important role for accountants.

Unknown said...

the acquiring firm had to incorporate the market value of what it paid for the target firm on its balance sheet, and to show the difference between the market value and the book value as “goodwill” on its balance sheet. Under this old system. http://www.pinterest.com/1800accountant/

Unknown said...

Nice blog, thanks for sharing the information. I will come to look for update. Keep up the good work.
Chartered accountant in bangalore


Anonymous said...

If the company allocate all of the acquisition price to identifiable Assets and liabilities is that mean they don't have any goodwill?
Thank you

Anonymous said...

Very good title. Love it.

One can treat the whole of part of goodwill as an expense. If it was bad goodwill it might possibly be expensed later.

I liked that yahoo finance has a line for tangible book or tangible assets in their balance sheet page for stocks.

Chanos suggested that for tech companies that goodwill might be considered capitalized R&D.

Over paying does not seem to me to be an accumulation.

“Accumulate, accumulate! This is Moses and the Prophets!”

― Karl Marx, Capital, Volume 1: A Critical Analysis of Capitalist Production

Anonymous said...

I thought I am aware of everything about accounting but then I came across your blog. There’s so much to learn in our world of Blogs. Your blog and Anthony Ashcroft are decreasing the building knowledge gap

Anonymous said...

I would love to see your thoughts on the company FTD...months after being acquired by UNTD part of the goodwill and intangibles were impaired and the company was spun off a few years later. Goodwill and intangibles make up the bulk of their assets and there appears to be a mismatch to the liabilities (which are very much tangible). Thank you!

Unknown said...

Hi, Prof. Damodaran.
thank you for your blog and all the information you are sharing.
i have a small question, maybe you will be able to help.
what should be in case one company A is acquiring a group of companies B with goodwill already incorporated in consolidated BS. e.g one of the assets acquired is goodwill. I do understand that it should probably be not recognized, but i cannot imagine where should the difference go? should be be pre-acquisition RE of company B?
thank you in advance!