7(a). Goodwill
[Context] The following brief summary of the topic "Accounting for Intangible Assets," is from the "Executive Summary" of the report the AIMR's Financial Accounting Policy Committee (FAPC):
Current accounting for intangible assets has great potential for confusion. Purchased intangibles are initially recorded at cost and amortized over periods of time that often are arbitrarily determined. Self-developed intangibles are for the most part not recorded. Financial statement comparability between and among enterprises suffers accordingly. Our contemplation of this situation leads us to two major recommendations that we believe will increase comparability. Both recommendations are controversial and should be considered in the light of the full discussion of them in the report. [Also included in 7(b) and 8(c)] [AIMR/FAPC92, p. viii]
First, we advocate capitalization of all executory contracts with an initial duration of more than one year. We would include not only leases, but also employment agreements and similar contractual arrangements. Our recommendation does not advocate any change that would weaken the standards governing revenue recognition. [Also included in 7(b) and 8(c)] [AIMR/FAPC92, p. viii]
Second, we recommend that purchased goodwill will be written off at the date it is acquired. We believe that it is an important number, but only to depict a value at a particular date, a value that undoubtedly is subject to rapid and sizable change thereafter. We cannot see how its presence on the balance sheet is of use in estimating a firm's future cash flows or gauging its contemporaneous value. Therefore, we recommend banishing goodwill from an enterprise's list of assets, but preserving a record of it by having it show as a separate and distinct reduction of shareholders' equity. [Also included in 7(b) and 8(c)] [AIMR/FAPC92, p. viii]
[Context] It indicates the scope of the discussion of the topic and lists the report's major recommendations, providing an introduction to the following excerpts from the report.
An earlier part of this report, [pp. 17 and 18, quoted in 7(b)] discusses implications for financial reporting of the rise in the proportion of economic activity attributable to the service sector. One ramification is its exacerbation of the persistent and vexing question of how to account for intangible assets. Service businesses are, with certain notable exceptions such as telecommunications, generally labor intensive. These firms have few tangible assets and in many cases have balance sheets that under conventional accounting show meager or even negative owners' equity. In fact, however, they may possess sizable unrecorded economic resources in the form of anticipated future cash flows. Yet, under traditional accounting methods, the value of those future cash flows is recorded only when: (a) they are acquired in a purchase transaction with an unrelated party, or (b) the anticipated cash finally is received. On the other hand, equity investors and lenders are forced to acknowledge the value of future cash flows in order to make sensible investment and lending decisions in competition with other rational suppliers of capital. Our views on this matter are set forth below. [Also included in 7(b) and 8(c)] [AIMR/FAPC92, p. 29]
Nature of the Problem
All economic value must ultimately result in cash inflow(s). In fact, it is future cash flows to which both equity investors and lenders look for a return on and return of their investments. Tangible assets offer an additional measure of comfort in that they usually but not always have some value at liquidation even though it may be modest. Furthermore, tangible assets are, without significant exception, acquired in exchange transactions with outsiders and, except for business combinations, are usually acquired individually or in groups of related items. Even when acquired in a basket purchase, it usually is not particularly difficult to obtain competent data to allow their values to be reported separately. Therefore, ordinarily there is little problem in recording at least the initial values of tangible assets. The same is true of intangible assets (patents, franchises, etc.) purchased separately. [Also included in 7(b) and 8(c)] [AIMR/FAPC92, p. 29]
Major problems arise with accounting for intangible assets that either are self-developed or acquired in a business combination. Other problems emanate from intangibles whose sole value comes from their ability to enhance the cash flows of a going concern. For example, how are analysts sensibly to compare two firms, one of which has developed strong brand names through sizable expenditures none of which has been capitalized (say, the Proctor and Gamble Company), the other of which has grown by purchasing the brand names of others (say, RJR Nabisco)? How are analysts to find useful the financial statements of cable television and other media firms that have significantly negative net worths because they have borrowed against future cash flows and used the proceeds either to cover reported losses or to make payments to stockholders?7 [Also included in 7(b) and 8(c)] [AIMR/FAPC92, p. 30]
Sources of Future Cash Flows
Intangible assets comprise all sorts of contractual, institutional and informal arrangements, all of which are characterized by associated expectations of future cash inflows. Many of these values are attributable to human beings who are talented, well-trained, acculturated, or otherwise able and willing to contribute to the enterprise's economic well-being. Arrangements between the firm and its employees vary. Some, mainly senior managers and others who make unique contributions, serve under individual contracts. Some of those contracts may contain provisions that activate sizable payments at or after the individual's separation from the firm, so-called "golden parachutes" and similar arrangements. At the other end of the scale are collective bargaining agreements with unions and other worker organizations. In between are the ordinary day-to-day, month-to-month continuances of employment and service. [Also included in 7(b) and 8(c)] [AIMR/FAPC92, p. 30]
Future cash flows may also be attributed to franchises. That term is used in its broadest sense to include not only contractual arrangements, but also other exclusive accesses to customers. A brand name might be said to be a "franchise." For example, one thinks of the position of the Campbell name in canned soup, H.J. Heinz in ketchup or Bayer in aspirin. Anther example of an exclusivity is a long-established reputation, such as those carried by the "Big Six" accounting firms, certain major law firms, advertising agencies, actuaries, consultants and a host of other professional services providers. Health care organizations are very likely to have franchises arising from both their reputations and their proximity to patients. A news distributorship in Manhattan, New York City, is worth more than one in Manhattan, Kansas. The examples could go on and on. [Also included in 7(b) and 8(c)] [AIMR/FAPC92, p. 30]
In many cases expectations of future cash flows may dissipate in the face of competition and are able to continue to flourish only if the enterprise continues to support them with attention and expenditures. Alternatively, exclusive rights may be obtained either under law (patents, copyrights, trademarks, etc.) or by contract. An enterprise may contract for a franchise (in the narrow sense of the word) for human services, for services to be provided by another organization, or for the rights to use real assets (plant and equipment) for limited periods of time. [Also included in 7(b) and 8(c)] [AIMR/FAPC92, p. 30]
All of the above are intended to be an illustrative but not exhaustive list of the incredible variety of sources of intangible value. All of them illustrate cases of valuable assets that, with two exceptions, are not recorded. One exception is when the asset is purchased in an arms-length exchange transaction. The other exception is for certain lease agreements that meet one of the conditions that qualify them as capital leases. [Also included in 7(b) and 8(c)] [AIMR/FAPC92, p. 31]
The Problem of Goodwill
We are not concerned with the theory of goodwill except as it pertains to the usefulness of financial statements to analysts. We view goodwill as the amount that an enterprise as a whole is worth in excess of the values of its individual assets less individual liabilities. We are wholly in agreement with Opinion No. 16 of the Accounting Principles Board with respect to the computation of goodwill. We also agree that there is no reliable valuation of it in the absence of an exchange transaction involving controlling interest in an entire enterprise. We balk at the notion of goodwill being recorded without the authentication of a transaction. [AIMR/FAPC92, p. 31]
What we disagree with is Accounting Principles Board Opinion No. 17 which allows purchased goodwill to linger on the balance sheet for up to forty years. Once it has been established for the record how much was paid to acquire goodwill, it ought to be removed from the list of assets forthwith.8 That would remove a major impediment to comparing companies whose economic statuses are relatively similar, but balance sheets are not. It is a drastic solution to the problem of noncomparability, but it is preferable to allowing other firms to record self-developed goodwill. [AIMR/FAPC92, p. 31]
One might ask whether a goodwill write-off should appear on the income statement or go directly to owners' equity. Regardless of the answer, a more appropriate question is where on the income statement or where in the owner's equity section it should emerge. We believe that it should appear on the income statement as part of comprehensive income and that this is another instance that illustrates the need for the FASB to develop standards for reporting comprehensive income. Cumulative amounts of goodwill write-offs also should be reported as a separate component of shareholders' equity together with complete disclosure of the changes in those amounts during each of the periods covered by the financial report. [Also included in 5(a)] [AIMR/FAPC92, p. 31]
Costs to Create Intangible Assets
We are not enamored of recording self-developed intangible assets unless their values are readily apparent. We consider the cost of creating them to be so often unrelated to their actual value as to be irrelevant in the investment evaluation process. Furthermore, it usually is next to impossible to determine in any sensible or codifiable manner exactly which costs provide future benefit and which do not. For example, even though we would record the contractual amounts of employment agreements, we would not go so far as to capitalize the costs of training and developing human resources. [Also included in 7(b) and 8(c)] [AIMR/FAPC92, p. 32-33]
We cannot quarrel with capitalization of the costs of intangible assets that are purchased. In that case, the cost is the value of the asset: no heroic or outlandish assumption is required. However, to approach comparability with firms that have created similar intangibles with their own resources, we recommend amortization of the purchased variety over economic lives that we expect will be short. In most cases a purchased intangible will maintain its value only if it is tended and cared for by the type of expenditures that create self-developed ones. A better way of looking at it is that if the purchased intangible is not maintained, it will be exhausted quickly not to be replaced by a self-developed one. [Also included in 7(b) and 8(c)] [AIMR/FAPC92, p. 33]
We reiterate our strong feeling that goodwill should not be recognized except briefly and only when it is determined by the exchange price for an entire enterprise. [Also included in 7(b) and 8(c)] [AIMR/FAPC92, p. 33]
The Importance of Cash Flows
The discussion above makes it clear that intangible assets derive their value from the prospects they engender for future cash flows and that it is difficult or impossible in many cases to obtain a sufficiently reasonable measure of their value to place on the balance sheet. Therefore, it is important in extremis for financial reports to disclose clearly the amounts and sources of past cash flows. The ultimate test of the value of an intangible asset is whether or not it contributes to the stream of cash entering the firm. This is exactly the reasoning implicit in FAS 2, "Accounting for Research and Development Costs." Because the expectation of future benefits from research expenditures is so uncertain, their value cannot be recorded in advance. We must wait until they are received in cash. [Also included in 7(b) and 8(c)] [AIMR/FAPC92, p. 33]
Not only do we have to know the source of cash flows from intangible assets in detail, we also have to know how likely it is that they will continue and at what rate. While the flows continue we need to know what is being done with them. Are they being distributed or reinvested? Are the reinvestments in kind or are they a divergence from past practice? Much of the needed cash flow information requires both disaggregation of historic data and candid management discussion of the future. We speak later in this report at greater length about other aspects of the usefulness of the cash flow statement. [Also included in 7(b) and 8(c)] [AIMR/FAPC92, p. 33]
Conclusions about Intangible Assets
Our overall conclusion on intangible assets can be summarized as follows. It is an area fraught with difficult conceptual and implementation problems and we do not have a monopolistic position with respect to their solutions. However, we believe that financial reporting can be modified so as at least to recognize more of the economic reality of intangible assets than it does now. We recommend the following: [Also included in 7(b) and 8(c)] [AIMR/FAPC92, p. 33]
1. Assets and liabilities should be recognized for the present values of future cash flows when: (a) they are the result of contractual arrangements, and (b) the cost of providing the service does not directly determine its selling price.
2. Goodwill should not be recognized except briefly as it is determined by the exchange price for an entire enterprise because: (a) its determination (except at the rarely-encountered moment of an exchange) is the stuff of financial analysis, not accounting, and (b) its value at that moment is fleeting and has no necessary or causal relationship to its value in the future.
3. Reserve recognition accounting should be reconsidered, supported by adequate prior research.
4. Past cash flows are extremely important and should be reported in terms of: (a) their source, (b) the likelihood of their continuance, and (c) the means to replace them when it becomes necessary. [Also included in 7(b) and 8(c)] [AIMR/FAPC92, p. 34]
__________
[Context] Meeting of the Investor Discussion Group on October 16, 1992. When discussing the types of information they use and the adjustments they make to that information to achieve their objectives, investors were specifically asked about goodwill.
Committee/Staff/Observer
What about goodwill? [Also included in 1(b)] [TI 10/16, p. 33]
Participant I-5
I will automatically write goodwill off the balance sheet and add it back on the income statement. There is no economic value to it on the balance sheet and there is no economic cost in the income statement. Further, whenever you have a cash flow statement, I will separate depreciation of plant and equipment from goodwill amortization. [Also included in 1(b)] [TI 10/16, p. 34]
Committee/Staff/Observer
So you differentiate goodwill from other intangibles. [Also included in 1(b) and 7(b)] [TI 10/16, p. 34]
Participant I-5
Goodwill is an easy one. Other intangibles, you have to think about. Goodwill is virtually automatic. [Also in sections 1(b) and 7(b)] [TI 10/16, p. 34]
Committee/Staff/Observer
A quick poll: how many agree with [participant I-5] that goodwill as a charge on the income statement is taken out and add back? How many leave it as a charge? What about on the balance sheet: how many take goodwill out and say whatever is reported there isn't really an asset? [Also included in 1(b)] [TI 10/16, p. 34]
Participant I-8
Let me ask you why would you care if we leave it in or take it out? [Also included in 1(b)] [TI 10/16, p. 35]
Committee/Staff/Observer
Maybe we want to recommend a change in accounting for goodwill because it has been debated for 50 years as to whether it should be charged immediately to the equity section (not even set up as an asset). The argument being why that piece of goodwill, purchased goodwill, is capitalized as an asset; doesn't a company that has spent nothing but built up a trademark, a logo, or name have a value? So there is a dichotomy in what is really goodwill? [Also included in 1(b)] [TI 10/16, p. 35]
Participant I-8
When it doesn't affect cash, it doesn't matter. So whether you have it on the balance sheet or not is not relevant. Whereas if it's affecting reported earnings because it's a noncash depreciation charge, you have to make the adjustment. If you wrote it off, you would look at a company that would have an enormously high return on investment and look like they did something good. In fact, they may be having a lousy return on the money they spent which gave rise to that goodwill on the balance sheet. [Also included in 1(b)] [TI 10/16, p. 35]
Committee/Staff/Observer
What distinguishes goodwill from a productive asset, like a machine or other equipment which, from an economic standpoint, you paid for the same way you paid for goodwill? [Also included in 1(b)] [TI 10/16, p. 35]
Participant I-5
Machines get old and their value goes down; goodwill doesn't really get old. Why would [one company] have a different earnings number based on how the corporation ended up to be where they are today versus [another company]? I can't say that [one company] has more goodwill in their businesses than [another company]. I think [the latter company's] brand names are a bit better respected. So when I look at those two companies, to compare apples with apples, either both need to have the goodwill in and amortize it. The fact is both companies keep adding to their goodwill and it will probably continue growing, not depreciating. [Also included in 1(b)] [TI 10/16, p. 35-36]
Participant I-7
The company has made that as a specific choice in order to grow their business. I want to know about it and I want to penalize it, as opposed to somebody like [name deleted] who has it, who's growing from an internal point of view. So I won't take it out; that's a cost of growth, that's a cost of doing business. [Also included in 1(b)] [TI 10/16, p. 37]
Participant I-4
It's certainly an item to be reckoned with but not necessarily to penalize for. If X buys Y and incrementally the returns on buying that are far above the cost of capital, that should be an item that appreciates in value. X should be awarded something for that. [Also included in 1(b)] [TI 10/16, p. 37]
Participant I-8
I'd rather see goodwill stay just the way it is. [TI 10/16, p. 37]
Participant I-1
Then you can make your own choice, rather than the U.K. situation where it is just gone. [TI 10/16, p. 37]
Participant I-8
It's also important historically. If that goodwill wasn't there and the acquisition took place 4 or 5 years ago, it might not be evident to me how that company grew. Whereas with the goodwill you know that there was some purchase. I don't see what's gained by getting rid of goodwill; I think it should stay. [TI 10/16, p. 37]
Participant I-11
Conceptually, there is probably no good reason why goodwill should be treated differently from other intangibles. In fact, we look at goodwill differently because we suspect that, in many cases, we are creating an asset because somebody overpaid to buy something. But it's not necessarily so. [TI 10/16, p. 37-38]
Participant I-4
The way goodwill is added or taken out of the balance sheet has little to do with real world or with the ongoing fortunes or misfortunes of the company. I tend to not think about it; the goodwill number is a fill-in number. [Also included in 1(b)] [TI 10/16, p. 38]
Participant I-12
Goodwill is one of those things that I look at because, for purposes of the BIS capital rules, you have to write goodwill off against capital. It also brings up another issue which is going to be the most important issue to be faced by analysts, and that is comparability of our accounting and reporting systems with those overseas, as all of us become more and more oriented toward global investing. Overseas, I believe that goodwill for the most part is written off the day an acquisition is made. [Also included in 1(b) and 18(a)] [TI 10/16, p. 38]
Participant I-9
I consider goodwill a nuisance and a misnomer. My main complaint with it is that it prevents business transactions that I would like to see occur. The German or the Swiss drug companies would have bought some of the "doggier" U.S. drug companies, but U.S. companies would not pay the same price because their earnings would be killed going forward. I don't think that's helping facilitate commerce. If it is a legitimate transaction, it will show up in the return on investment numbers going forward. [Also included in 1(b)] [TI 10/16, p. 38]
__________
Participant I-5
In our discussions today, we seem to be focusing to a very large degree on the income statement as juxtaposed against the balance sheet. One evidence of that was when we talked about goodwill; the notion of amortizing it was construed as a greater penalty than taking it off the balance sheet. I think that if it's not an asset on the balance sheet, it's as much a penalty as being a charge on the income statement. [TI 10/16, p. 43]
[Context] Meeting of the Investor Discussion Group on December 9, 1992. Part of the meeting was devoted to the topic of alternative accounting procedures. During the discussion, several investors commented on goodwill.
Participant I-12
I have a great example. [One company] acquired [another company] and the goodwill went from $500 m to $1 billion or so and is written off over 40 years. The reality is that those are bad loans but somehow those amounts are included in goodwill. This is very confusing. [Also included in 8(b)] [TI 12/9, p. 47]
Participant I-8
For example, if you took pooling away, in the real world of economics, it possibly would inhibit the acquisition of a high valuation company by another high valuation company, and I'm not sure that we should do that. [Also included in 8(b)] [TI 12/9, p. 47]
Committee/Staff/Observer
Why would it inhibit? [Also included in 8(b)] [TI 12/9, p. 47]
Participant I-8
Because they would have to account for it on a purchase basis and they don't want all this goodwill. [Also included in 8(b)] [TI 12/9, p. 47]
Participant I-4
That's the case now. There's a number of companies we talked to that are not purchasing because they don't want the goodwill. [Also included in 8(b)] [TI 12/9, p. 48]
Committee/Staff/Observer
I've heard companies assert that but I've never heard analysts say we can't see through it. [Also included in 8(b)] [TI 12/9, p. 48]
Participant I-4
I think they're saying there's something wrong with the idea of the creation and write-off of goodwill. [Also included in 8(b)] [TI 12/9, p. 48]
Participant I-8
They see it as a problem; I don't see it as a problem. [Also in section 8(b)] [TI 12/9, p. 48]
Committee/Staff/Observer
What [participant I-8] says is that the transaction won't take place if the opportunity to use pooling is taken away. [Also included in 8(b)] [TI 12/9, p. 48]
Participant I-7
Even if goodwill was a taxable item? [Also included in 8(b)] [TI 12/9, p. 48]
Participant I-11
That's not going to happen. [Also included in 8(b)] [TI 12/9, p. 48]
Participant I-12
In my industry, we immediately substract goodwill from equity. That's a real problem. And the regulators will substract twice the goodwill from the equity. I'd rather see both methods available. [Also included in 8(b)] [TI 12/9, p. 48]
__________
Committee/Staff/Observer
Goodwill. If goodwill or some debit is required by a transaction, should it be charged off to the equity section immediately? Last time, [participant I-8] said to leave goodwill as an asset because it leads him to ask other questions. [TI 12/9, p. 51]
Participant I-8
You create other distortions when you write goodwill off to equity because it appears that the company's return on equity is phenomenal when in fact it is not. [TI 12/9, p. 51]
Participant I-12
Or it appears that the company is going out of business when in fact it's not. That is what I have seen in the banking arena, with the consolidation phase currently going on. The regulators substract the goodwill from the capital account and then the capital account looks pretty bad. [TI 12/9, p. 51]
Committee/Staff/Observer
If you follow pooling of interest accounting, don't you get the same high return on equity that you get if you write off the goodwill? [Also included in 8(b)] [TI 12/9, p. 51]
Participant I-8
You combine the equity of both entities. [Also included in 8(b)] [TI 12/9, p. 51]
Participant I-11
The goodwill arises because you paid more than book value. [Also included in 8(b)] [TI 12/9, p. 51]
Committee/Staff/Observer
So you raise equity first and record the goodwill, equity is higher, then you write off the goodwill and come back to something that's closer to the equity you have under pooling of interest accounting. [Also included in 8(b)] [TI 12/9, p. 52]
Participant I-8
I don't see it that way. I have an entity with a history of return on equity which I can look at and analyse, and I have the other entity, and they now combine and there might be a difference in combination, but I haven't lost anything in terms of my ability to analyze how profitable those entities were in the past and come to some conclusion about the future. [Also included in 8(b)] [TI 12/9, p. 52]
Participant I-7
The 40 years is a different issue. I don't think there is anybody who follows a manufacturing company that does not add back goodwill expense to earnings. [TI 12/9, p. 52]
Committee/Staff/Observer
So you agree you do add back amortization. [TI 12/9, p. 53]
Participant I-7
Yes. [TI 12/9, p. 53]
Participant I-12
As I mentioned before, my problem is that some banks are taking something that is really a loan loss and classify it as goodwill and write it off over 40 years instead of today. It's not a goodwill question so much as a loophole question. On the goodwill issue, I have no problem in my analysis with the way goodwill is accounted for now. I have a problem with when the regulatory authorities treat goodwill differently; then, I need to know what the amount is. And there is plenty of financial companies where you cannot find goodwill on the balance sheet or in the disclosure. [TI 12/9, p. 53]
Committee/Staff/Observer
Let me move to the 40 years question. What about the fact that we have a very arbitrary period of 40 years mandated in the standards? [TI 12/9, p. 53]
Participant I-6
I think it's too long; I don't know anything that has a 40 year life. [TI 12/9, p. 53]
Participant I-5
If goodwill got there because the company is well managed, you should assume it's going to keep growing. Intellectually, if you believe goodwill is an asset, you shouldn't write it off, you should compound it. If you believe goodwill on the balance sheet is a real asset, it should not depreciate, it should appreciate. [TI 12/9, p. 53]
Participant I-6
Are you saying that, if it's a true asset, leave it there until it's worthless and then get rid of it? [TI 12/9, p. 53]
Participant I-4
The problem is that one views goodwill as a pejorative thing and the fact is, not only is it normally not that, but attempting to write it off over an arbitrary period of 40 years just makes it even worse. I try to add back the number to cash flow and normally think that when I'm doing it, I'm not doing any real justice to it. The fact is that I probably should be adding back much more to the cash flow. [TI 12/9, p. 54]
Participant I-5
It's a very easy thing to get goodwill off the balance sheet and the income statement, which is what I would do automatically so I don't really care how it's treated. [TI 12/9, p. 54]
Committee/Staff/Observer
You're saying adjust it out of the balance sheet completely? But you just said we ought to be writing it up? [TI 12/9, p. 54]
Participant I-5
I said if you believe that it's an asset, then by extension you should believe that it appreciates. I don't believe it should be in the balance sheet, period. [TI 12/9, p. 54]
Participant I-6
From my experience, goodwill often turns out to be a line item used to justify for overpaying for companies. Conceptually, I agree with the notion; the reality, from experience, is that it's overpaid. [TI 12/9, p. 54]
Participant I-8
I don't agree with that in all cases. For example, in the case of software companies that have no assets, I don't have any problem in taking the amortization as a noncash charge. I don't know that there's anything to be tinkered with from my standpoint. [TI 12/9, p. 54]
Participant I-4
I think the way goodwill is accounted for now doesn't really help the situation from an investor's perspective. But I have to admit that I'm hard pressed to think that there is any other easy way to describe it. [TI 12/9, p. 54]
Participant I-9
Emotionally, I don't like goodwill and I always substract it out initially. Intellectually, I think you have to leave it in. The reason I don't like it is that it introduces something that I know I'm always wrong about; I'm either understating it or overstating it. If you pay too much for a company, then you ought to write it off. On the other hand, if you bought the [name deleted] trademark for $1 million, you got a great thing and the earnings from that purchase should offset the goodwill over time. I guess I would compromise and go to a 10-15 year write-off of the goodwill. I think the 40 year part is all wrong. [TI 12/9, p. 55]
Participant I-4
But if we buy a business that is well run and we're good managers, goodwill will grow. [TI 12/9, p. 55]
Participant I-9
But it should show up in the income statement over time if you made a good deal. [TI 12/9, p. 55]
Committee/Staff/Observer
Why are you comfortable with the goodwill that is recognized when you buy [name deleted] but you're not concerned with the fact that the goodwill is not on [their] books today? [TI 12/9, p. 55]
Participant I-4
It's in [name deleted] stock price, it's in the valuation. [TI 12/9, p. 55]
Participant I-11
The accounting of the balance sheet is based on historical cost and if a company is successful over time, the economic value of the assets tend to increase. If you reprice it at another point in time, then you got to find some way to reprice that difference and we call it goodwill. Then you go forward again with an historically-priced goodwill which may or may not have the same value in the future. It seems to me that a value to it is that it serves as a red flag for analysts to determine whether an acquiring company is making a good investment or is overpaying. [TI 12/9, p. 55]
Participant I-12
A rational acquiror would pay an acquiree the net present value of the future cash flows of that business. That net present value may be more or less than stated book value. Theoretically, over time, the revenues would eventually reflect the cash flows embedded in the net present value. From my own perspective, I don't have any problem with the current accounting methodology on goodwill; what I have a problem with is that I want to be sure it's disclosed and available to me for analysis. [TI 12/9, p. 56]
Participant I-6
I have a basic problem. For example, [a company] buys a copper mining operation and has a huge goodwill associated with it. Then, [that company], being a British company, writes goodwill off immediately to equity. The company has no control over the selling price of the copper; it may be a great company and have a great name, but the copper that is produced by that company is going to sell at the same price as anybody else's copper. There is no such thing as goodwill with a mine. But the goodwill arises because the acquiree wrote the hole down because it wasn't making money and the market value based on the current commodity price gave rise to a disparity. Realistically, that mine should have been written back up to its asset value instead of calling it goodwill. [TI 12/9, p. 56]
Committee/Staff/Observer
In this example, the company should have debited the "hole in the ground", not goodwill for the value that could be ascribed to it by discounting future cash flows. [TI 12/9, p. 56]
Participant I-8
And I have the sense that we don't have a problem with goodwill accounting. I will ask you: what's the problem that you see with goodwill accounting? [TI 12/9, p. 56]
From our standpoint, we try to come to some conclusion about the valuation of a security and I would defy you to correlate valuation in the world with stated book value; you can't for a whole bunch of reasons. [TI 12/9, p. 57]
Participant I-4
There's a great deal of variation on the importance of goodwill. In a lot of cases, it's kind of irrelevant because we try to determine what values are by capitalizing cash flows. But in a lot of cases, for example for regional banks that are being bought and being value in the equity marketplace, then the establishment of goodwill is a very important thing. And the elimination of goodwill in the balance sheet is also a very important thing as to what the real value, either on an ongoing basis or in a transaction, really is. [TI 12/9, p. 57]
Participant I-6
On goodwill, if there was one modification made to it, it would be that I would not allow it to be written off over 5, 10, 15, 20, 40 years; if it's something of value, it should be there. I would see it as a permanent asset like a piece of land until it's really worthless and then written off in total. [TI 12/9, p. 57]
Participant I-5
If you reduce what we're doing to the basics, we're looking at what assets these companies have and try to put values on those assets. If you're taking into account how much goodwill is reported on the balance sheet and how much is being amortized, all you're doing is taking into account the decisions of some management at some time on what to pay for another company. If you had those two companies side by side before the purchase, you'd end up without the goodwill on the balance sheet and without the amortization of that goodwill. Is it easier for you to value a company after you know what someone else paid for it? Or is it easier for you to value that company without that added information? If it's the latter, it adds nothing to your analysis. [TI 12/9, p. 57-58]
Participant I-4
It also tends to make a buyer who buys a company on a pooling basis to look much more prescient than a person who does it on a purchase basis, which is not true in any sense other than an accounting sense. [TI 12/9, p. 58]
Committee/Staff/Observer
If somebody actually does pay for a group of assets, don't you want them to earn a profit on what they paid for it instead of what they were carried at in the books earlier? [TI 12/9, p. 58]
Participant I-4
Absolutely. [TI 12/9, p. 58]
Participant I-5
What is relevant as an investor, the return on the asset they paid for or the return on the price of the stock you buy? When I'm looking at a company, I'm not looking at a rate of return on their asset base, but rather what I'm paying for that asset base. And what I'm paying has nothing to do with what they paid. [TI 12/9, p. 58]
Committee/Staff/Observer
I'm anxiously looking forward to the staff summary of this discussion. How many believe we should leave the amortization period at 40 years? [No one answered.] How many believe we should not write anything off? [TI 12/9, p. 58]
Participant I-11
I think I have to say I believe that. [TI 12/9, p. 58]
Participant I-8
I agree. [TI 12/9, p. 59]
Committee/Staff/Observer
You would do nothing to it until the goodwill is disposed of? [TI 12/9, p. 59]
Participant I-8
Right. [TI 12/9, p. 59]
Committee/Staff/Observer
How many would write it off over a lesser period than 40 years? [2] [TI 12/9, p. 59]
Participant I-4
To the extent that it is equally irrelevant to do that as 40 or 0, I would agree. [TI 12/9, p. 59]
[Context] Meeting of the Creditor Discussion Group on February 2, 1993. Part of the meeting was devoted to the topic of display. During the discussion, a comment was made on goodwill.
Participant C-11
I have a subsidiary point to make on the indirect method. Often times, the item lumped together is depreciation and amortization. I think that there's a real absence often of good data, both in terms of what the amortization is, as opposed to depreciation of equipment. And also in a footnote context the time period for the amortization. Everyone knows that there are now new capital ratios that give different weighting allowances for goodwill of different types. And it's astonishing to me that still very well recognized companies do not disclose goodwill at all in the published financials. So I think a lot more weight has to be put on differentiating those items than has been the case. [Also included in 5(a) and 5(c)] [TC 2/2, p. 26]
[Context] Meeting of the Creditor Discussion Group on February 2, 1993. Part of the meeting was devoted to the topic of alternative accounting procedures.
Committee/Staff/Observer
[Participant C-15], do you care whether it's a purchase versus a pooling? [Also included in 8(b)] [TC 2/2, p. 39]
Participant C-15
Very much so. With purchase accounting, going forward makes our analysis somewhat difficult, because the value of the assets are stepped up and make it a lot more difficult to identify what, if any, goodwill was actually generated. But I think that, in effect, that there is goodwill there, just a matter of how it's recognized. And again, the lack of comparability is an issue of one accounting method chosen versus another. [Also included in 8(b)] [TC 2/2, p. 39]
[Context] Meeting of the Creditor Discussion Group on February 2, 1993. Part of the meeting was devoted to the topic of goodwill.
Committee/Staff/Observer
Let us assume that your choice was purchase. The question is, how do we deal with this thing we call goodwill? There has been a lot of criticism about whether or not our current method of amortizing in to ongoing earnings over a period up to 40 years is the right answer. Some have argued that we ought to shorten the period up. Some have argued that it ought not to go through the earnings statement at all, that it ought to be direct charge to equity. There are even those who argue that the way the United States does its goodwill accounting puts its companies at a competitive disadvantage vis-a-vis other people going to the market who have more liberal ways of getting rid of goodwill When you see goodwill, what do you do? Is the method we currently use that smoothes it in over a period of time one a problem and needs a change? And if it needs a change, what would you recommend? Or is it not a problem, or it's a problem but I can handle it and I don't have another answer? [TC 2/2, p. 42]
Participant C-5
I wouldn't say it's a tremendous problem, but I will tell you that we automatically adjust for it. I was going to ask the question, is this a broader question than just goodwill; does it include other intangibles as well? [TC 2/2, p. 43]
Committee/Staff/Observer
If we could keep it at goodwill for the moment. [TC 2/2, p. 43]
Participant C-5
We just make an automatic adjustment, both to the income statement for cash flow analysis purposes, as well as to the balance sheet for leverage and tangible net worth calculations. So we're, in effect, converting to automatic write off. [TC 2/2, p. 43]
Committee/Staff/Observer
The whole amount or just portions of it? [TC 2/2, p. 43]
Participant C-5
It's 100% write down. And that's the general evaluation criteria that we use. [TC 2/2, p. 43]
Participant C-15
I think that we essentially take the same approach. But then I think we're trying to go one step further. Because sometimes when goodwill is generated in an acquisition, there is something tangible that's being generated. Can they earn a return on that investment? That's the general approach that we would take. It's easy to identify, also. It's a separate line item, you can see what the amortization period is and so on. [TC 2/2, p. 43]
Participant C-13
We adjust for it, we just write it off. [TC 2/2, p. 43]
Participant C-17
Goodwill may have value it's just that we don't know what it is; you look at the cash flows and see how well will this company supports your loan. [TC 2/2, p. 43]
Participant C-11
I write it off. There are problems with other intangibles also, for example, mortgage servicing. I'm going to have very different points of view of the value of servicing if a company has an awful lot of that, and a lot of the amortization relates to that. We've had a problem just this last year, there were a lot of companies that had to write off some of these service intangibles. [Also included in 7(b)] [TC 2/2, p. 43-44]
Participant C-5
Rather than look at goodwill, in order to make that adjustment, we will typically do a sort of mark to market calculation of any of the multiple type things and then look at our leverage on a business value basis. Because those goodwills invariably suffer particularly if there's been a series of acquisitions and one's a three year old goodwill, one's a four year old goodwill, there's no relativity to market value. There is value in those franchises and half of our analysis goes right down to figure out franchise value. [TC 2/2, p. 44]
Committee/Staff/Observer
What if accountants just removed it for you so it was out of your way, and it wasn't there in the first place? Does it matter to you whether it's ever recorded in the first place? Or should it be just excluded from the balance sheet to begin with? [TC 2/2, p. 44]
Participant C-11
I think it matters because, for some reason, all of a sudden, you have a reduction in equity. I think you want to know why that happened. [TC 2/2, p. 44]
Participant C-15
If it was written off all at once, you wouldn't know what happened; three years from now, you'd say, gee, I got a $4 billion deficit net worth. [TC 2/2, p. 44]
Participant C-14
Yes, just wipe it off, I agree. [TC 2/2, p. 44]
Participant C-17
I'd be looking at a retained earnings account and say they lost 4 billion bucks. [TC 2/2, p. 44]
Committee/Staff/Observer
But it'll be in your changes of capital; you still pick it up on a prior period as a change of capital. [TC 2/2, p. 44]
Participant C-15
There is some value to the goodwill; if it's all written off, instead of over a period of time, you may be overstating your earnings going forward. [TC 2/2, p. 45]
Participant C-11
I think you have a conceptual problem, too, with a low book value for a company with very strong cash flow earnings. There is analytical content there where the write-off may be pretty harsh. [TC 2/2, p. 45]
Participant C-5
There is also, though, a return on assets type of issue that, yes, you're paying up, you're reducing your return on assets. But ultimately, you're buying an asset that will give you an effective return for a period of time. And your net worth is over-stated for return on assets. I will tell you where we make the adjustment is in the leverage calculation. There are other financial analytic ratios where we don't. We don't do a return on tangible assets. We just do the quick and dirties, which are cash flow and leverage. [Also included in 1(c)] [TC 2/2, p. 45]
Participant C-17
Your ROA calculation, if you wrote goodwill off would look a whole lot better. [TC 2/2, p. 45]
Participant C-14
It seems inconsistent that either you use or you don't. [TC 2/2, p. 45]
Participant C-5
But I'm telling you where I don't use it, I take it out of my leverage calculation. I don't adjust my assets. [TC 2/2, p. 45]
Participant C-15
That's how you would determine if the goodwill is worth anything or not. [TC 2/2, p. 45]
Participant C-13
I would say we do much the same thing that [participant C-5] does, that we're excluding good will, but we're looking at the net worth calculations. Also, we're looking at cash flow calculations. On the other hand, although not exclusively, because we do look at returns of tangible equity. But as a general rule, we're looking at returns on book equity, returns on book assets. [Also included in 1(c)] [TC 2/2, p. 46]
Committee/Staff/Observer
I would say that I'm at the point of extreme confusion about why you would want it in financial statements so you could take it out. What you're saying is you don't always take it out? [TC 2/2, p. 46]
Participant C-5
But I'm not too sure that's because we shouldn't take it or just out of carelessness; you can't remember every place to take it out. [TC 2/2, p. 46]
Committee/Staff/Observer
Why do you take it out? [TC 2/2, p. 46]
Participant C-13
From the point of view of earnings, this is not a cash charge, so you take it out, so that you can establish cash flow. [TC 2/2, p. 46]
[Context] Responses to the postmeeting questionnaire to the February 2, 1993 Creditor Discussion Group meeting.
QUESTION 10-Goodwill Purchased in a Business Combination
Under current purchase accounting, participants seemed to be in agreement that adjustments are usually made to eliminate goodwill amortization from earnings analyses. In some cases, net worth or total assets were also adjusted to eliminate goodwill. What was not clear was whether participants found value in having goodwill remain in the financial statements instead of eliminating goodwill at the acquisition date and removing the need to adjust for it.
Indicate your preferences with 1 being the most preferred, 2 the next preferred and so on to 3 being the least preferred.
1-3,2-2,3-7 Goodwill should be eliminated when a purchase is first recorded. If eliminated: (check one)
Participant C-3: Why have goodwill but at the same time, not fair value existing assets?
9 Goodwill should be charged directly to equity, OR
1 Goodwill should be charged to earnings in the period of the purchase
1-5,2-5,3-2 Goodwill should not be eliminated, because: (check as many as are appropriate)
9 The "excess" paid for a company is useful analytical information that should be preserved
2 The progress of the buyer's recovery of purchase price is important information
8 Although it is frequently eliminated in analysis, having the amount in one location is better than burying it in equity
4 The unrecovered cost should be included in ratios such as return on total assets and return on equity
1-4,2-5,3-2 Goodwill should not be eliminated, but the maximum amortization period should be greatly reduced to (please check one) _ 5 years, _ 10 years, _ 15 years, _ 20 years. 3 2 3
Participant C-12: Note that goodwill often results from purchasing a like business, and goodwill often brings the basis of purchased assets in line with the accounting for assets acquired in the ordinary course of business (e.g., a bank's bond portfolio).
[PMQC 2/2, p. 18-19]
[Context] Responses to the postmeeting questionnaire of the December 9, 1992 and January 13, 1993 Investor Discussion Group meetings.
QUESTION 16 - Goodwill Purchased in a Business Combination
Goodwill differs from the other four subjects in this group in that only one method of accounting for purchased goodwill is now accepted in the United States:
The cost of purchased goodwill-the amount by which the price of the acquired company exceeds the net fair value of its assets and liabilities acquired-is capitalized as an asset at acquisition and amortized to expense over its expected useful life, often 40 years, the maximum permitted by APB Opinion No. 17, Intangible Assets
That method has been widely criticized, however, and four other methods have been proposed to replace it. Two of them would differ from present practice only with respect to amortizing the cost of goodwill after acquisition:
The first method would amortize the cost of goodwill to expense over a period much shorter than 40 years, perhaps as short as 5 to 10 years
The second would not amortize it over an assumed useful life but would recognize losses from decreases in goodwill when goodwill is lost or its value is impaired
The other two methods would not capitalize the cost of purchased goodwill as an asset:
The third method would deduct it directly from stockholders' equity at acquisition
The fourth would deduct it as a loss, separate from operating income, in measuring income of the period of acquisition
In the discussion of goodwill, participants seemed to agree that investors and analysts usually adjust net income to eliminate goodwill amortization. Some also adjust, or know of others who adjust, total assets or equity to eliminate goodwill. What was unclear was whether participants found utility in having goodwill remain in the financial statements instead of being eliminated and, thus, removing the need for investors to adjust for it.
With respect to the various ways of accounting for goodwill purchased in a business combination, please indicate your preference with 1 meaning most preferred, 2 meaning next preferred, and 3 meaning least preferred (use a number only once)
Most Next Least
preferred preferred preferred
Goodwill should be eliminated at 3 2
acquisition. If goodwill is
eliminated, it should be deducted
(please check one)
directly from stockholders' equity 5
at acquisition
as a loss in measuring
comprehensive income for the period
of acquisition
from net income or earnings in the
period of the purchase
Most Next Least
preferred preferred preferred
Goodwill should not be eliminated, 2 2 2
although it is frequently
eliminated in analysis, because
(please check as many as are
appropriate)
The "excess" paid for a company is 3
useful analytical information that
should be preserved
The progress of the buyer's 1
recovery of purchase price is
important information
The unrecovered cost should be 4
included in ratios such as return
on total assets and return on
equity
Participant I-12: Gives analysts a
choice, depending on their
analytical purpose.
To have the amount in one location 2
is better than burying it in
stockholders' equity
Goodwill should not be eliminated, 1 4 1
but the maximum amortization period
should be greatly reduced to
(please check one)
5 years 1
10 years 2
15 years,
20 years 1 1 1
[PMQI 12/9 and 1/13, p. 30-32]
[Context] The papers are a summary of a committee and staff members' discussions with selected sell-side analysts from Goldman Sachs.
[One analyst] would like more data on off balance sheet items and admits that she eliminates goodwill from the balance sheet. She does admit, however, that other intangibles may have some value. [Also included in 1(b), 5(b), and 7(b)] [GOLDMAN, p. 2]