Goodwill Is Great, But It’s Not An Asset

          There are a couple definitions of goodwill. The first is “friendly disposition; benevolence; kindness (dictionary.com).” The second relating to commerce, from Webster is “the capitalized value of the excess of estimated future profits of a business over the rate of return on capital considered normal in the related industry.” I’m very fond of the thing described by the first definition, and I’m not much of a fan at all of the thing described by the second definition. Unfortunately, as I am an accountant by trade, and since I usually spend my time talking about things I don’t like, in this forum anyway, today we are going to talk about the second one.

           For your benefit, here is just a little background on goodwill in the accounting sense of the word to help expand the meaning of the definition. Goodwill is only recorded when a company purchases another company for an amount that is greater than what the fair market value of the company is decided to be. It is called goodwill because it feels like an amount given freely as it is in excess of what the market would demand for such a purchase. Previously, these amounts were recorded as an asset and then depreciated (expense recorded over time a period of time) over an estimated useful life. Now the generally accepted convention in the US is to continue to record it as an asset, and evaluate it on a regular basis for impairment, writing down the value, but never writing up, based on updated value forecasts.

          When first learning about the concept of goodwill I didn’t really have an issue, because I was just learning convention and kept being fed answers to goodwill questions like “that’s just how it is.” But after four years auditing I have begun to take up issue with the concept. Because for all the reasons we had to debate what an asset was and what a liability was, and why we had to break apart anything called an investment and anything that was appraised on a fair value basis to ensure that nothing was being recorded to the balance sheet that exceeded fair value, for some reason I found that none of the rules applied to goodwill. That goodwill was an amount in excess of fair market value, but this time for some reason it was still treated as an asset, and for some reason that was ok.

          I was stumped by the impairment test. I’ve always understood an asset to be impaired if its recorded value is higher than its fair market value. Isn’t the fair market value of goodwill always $0? If the market had valued the acquisition at the actual price paid, goodwill wouldn’t exist. So everything that comprises goodwill is in practice and in definition in excess of fair market value, therefore based on the traditional definition of impairment all goodwill should be impaired as soon as the purchase transaction occurs. There are other definitions of impairment that usually base impairment on the same estimates that created the goodwill in the first place. Unfortunately that number is created by the buying company when determining what amount they should pay to acquire the other. Now I’m not saying that the calculation that management created will never be proven accurate, it’s more that we should not rely on the purchaser to determine the value of the asset they now own. But the people who perceive this value are the officers, actuaries, accountants, and analysts of the purchasing company. Is that a group we should really trust to give an honest perceived value? They, of course, want to justify their decision and defer recording any loss, and goodwill makes them look better in that regard. 

          We then rely on accountants and auditors to prove them wrong. Accounting should be as objective as possible and when management is creating a valuation and has an incentive to be biased is this an estimate we should really trust. In general to say that a company will have a future benefit from this goodwill is very subjective and in many cases uncertain. So why is the convention unlike the rest of accounting, where if we are uncertain about what will happen in the future we take the conservative approach? I know there are auditors and specialists who value this stuff and test for impairment, I was one, but I also know these accountants often don’t know as much about the business that are being valued and therefore it is difficult to find hard ground to stand on to contest this valuation, and I also know that auditors often tend to be agreeable to management at the end of the day.

          I also have problems with the definition of an asset as it relates to goodwill. I know I’m giving enough definitions here to sound like a forgettable middle-school commencement speech, but here is the definition from the International Financial Reporting Standards accounting framework “An asset is a resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise." The one piece there that sticks out is that it is something that is controlled by the purchasing company that now lists goodwill on its balance sheet. In what way can they control it? They can’t do anything with it. They can’t sell it. They can’t trade it for anything, or mortgage it, or insure it. Even the other intangible assets like domain names, customer lists, patents can all be sold separately from the rest of the company. Therefore I believe that goodwill does not even meet the basic definition of an asset by the commonly accepted definition. Yet, inconsistent with the rest of accounting guidelines, it is treated as one.  

           

          This inappropriate treatment of over-payments increases the chances that users will misinterpret financial statements. If you go to a used car dealership, and don’t do enough research to where you end up paying $10,000 for a car whose market value is only $5,000 does that mean that your car is worth $10,000? Just because you were foolish enough to pay for it? Maybe it had a perceived value to you because you were fond of the metallic mint green paint color, or maybe it gave you a feeling of nostalgia for you because that was the same model your grandfather used to drive you around in when you were five years old. But that does not mean that you can then immediately sell this car to anyone else for $10,000. You will only be able to sell it for $5,000. So even if the purchaser perceives a value, that value in all other accounting circumstances anyway cannot be recorded until the market agrees, until some real event takes place and the amount can be realized. If we record the excess as goodwill we’re basically saying that the purchase transaction created $5,000 of new assets in the world, when really all that happened was a change in ownership title. Look at the math, before the transaction the buyer had $10,000 of assets in cash, and the seller had a car whose market value was $5,000 a total of $15,000 existing in this world. After they switch ownership of these assets, the seller of the car now has $10,000 in cash, and the buyer has assets of $10,000, a car worth $5,000 and goodwill of $5,000, a grand total of $20,000. Nothing new was created, no service was provided, and yet there is $5,000 of new assets in the world. That, I feel can get very dangerous when determining what our total economy is worth especially when you consider that this affect is amplified each time another company acquisition transaction where goodwill is involved gets completed.  

          That extra $5,000 in the previous example and goodwill in general is a perceived asset. Here is where perceived value can get you into trouble. What about the case where one company overpaid to acquire a company simply so that the competitor wouldn’t get it, like CVS Pharmacy did with the Longs Drugs acquisition a couple of years ago? Should that goodwill be considered an asset? Maybe CVS decided that if Walgreens purchased Longs that their business would no longer be sustainable, and thus they were willing to spend whatever it took to not lose that bidding war, even if it became a poor short-run financial decision or if they were paying more than they expected to receive. In that case at least part of the goodwill acquired is even beyond what the purchasing company believes the acquisition to be worth. Maybe you could say there is value in that at least they would not incur the future revenue losses that could be propagated by Walgreens winning the acquisition bid. While the acquisition might even still be a good business strategy with the long-term company viability it should still be recognized that right now it was an overpayment. And that overpayment should be recorded as a current period loss.  Otherwise we can keep going more and more abstract and start calling market dominance, or competitive advantage an asset. Usually, these things are not proved to provide actual returns, or are difficult to value with any reliability which is consistent with the fundamental accounting guideline of conservatism, until actual earned revenue from business transactions begins. 

           My overall point is that you can make up and endless number of reasons as to why you think an asset you own is worth more than what the market says it’s worth, and who wouldn't want to do that? But only if you’re right you will reap the benefits in the future. But those benefits should not be recognized until the market agrees with you.

           One thing that I learned in college during a ridiculously stupid conversation/argument (which I totally lost) with the Assistant College Administrative Officer about housing rules and whether flags and banners should be allowed to be displayed out of dorm windows, was that before contesting any rule, it’s best to first understand why that rule exists. It was very valuable advice that has done wonders for my (self-perceived) ability to understand problems and situations. With this advice in mind, I tried to research reasons that it is beneficial to record goodwill as an asset. Here's what I came up with. 

          The real purpose of goodwill is so that the stock price doesn’t drop when they buy up another company… because those investors don’t want to lose their money in a market dip as the company makes an acquisition of another. But if there is no reason that this should be treated any differently than any other acquisition of assets. There is not a good reason for different rules to be in place for this one business transaction, the corporate buyout. Let the market decide what the fair value of these assets should be. If people think that this loss was artificial, that the company will make the money back after the new acquisition gets going and the new-found synergy between the buyer and the acquired starts to pay dividends… great. But not until that happens. For those investors who believe that the acquisition is not a good idea will be able to see that effect in the financial statements and make their assessment.

          The idea of goodwill is that the purchasing company remains unchanged based on the transaction, which simply isn’t true. This was a decision made by management, which depending on the materiality of the acquisition could be a huge change to the company. I don’t know how much Instagram was worth when Facebook purchased it for $1B but I know that it did not have $1B worth of assets on its balance sheet nor did most people in the business world feel that it was worth close to that sum. Yet still, Facebook’s balance sheet did not change as it saw $1B go out the door (most of it was actually company stock), it was allowed to say that $1B of investments in Instagram came back in. I think this clearly results in inappropriate and misleading financial statements.

           Others before me have contemplated goodwill. There is even a concept called non-purchased goodwill that roughly states that a company can do well in building a customer base and loyalty (items whose value is already accounted for in other intangible assets such as trademarks and customer lists I feel) and that additional value is something that the company can actually experience. And others have even given reason as to why this internally created non-purchase goodwill is not called an asset.  “Merger premia and national differences in accounting for goodwill’, Journal of International Financial Management and Accounting, Vol. 3, Issue 3, pp.219-240.

(1) The accountants adopt conservative view, together with the fear that internally generated goodwill may turn out to be a fictitious asset in order to make the balance sheet look better.

(2) Certain accounting rules such as historical cost, objectivity and verifiability are extremely difficult to apply in accounting for non-purchased goodwill in practice.

(3) It is difficult to revalue non-purchased goodwill annually. Some assumptions have been made to carry out the test, such as the estimation of future profits and of what should be a reasonable rate of return for a particular business.

(4) The business costs which attribute to the value of goodwill are difficult to measure. For instance, it is difficult to bifurcate which part of the cost of R&D or advertising expenditure contributed to the sales that in turn generated goodwill.

          All of these are great accounting arguments. However, it is my opinion that they apply equally to purchased and non-purchased goodwill. Even if goodwill comes from a purchase transaction the goodwill is ultimately created by the acquiring company. If it weren’t for the above market price that the acquiring company paid to complete the acquisition there would be no goodwill, so the goodwill was created by the high purchase price consented by the purchaser. Thus the goodwill is internally generated by the acquiring company.  

           So what do you do as the company CFO? In my opinion, any amount paid for an acquisition in excess of the fair market value, should be recorded as a loss, a decrease to net income, in the period the acquisition was made, because that’s when the cash went out the door. Perhaps more cash will come in later because of all the great attributes you acquired, but until that turns into cash how is it going to help the company, how is it going to help the investor. 

           The primary argument against immediately recognizing amounts expended in excess of the fair value of the acquired company as a current period loss is that “this treatment may lead to negligible or negative amounts of shareholder’s equity as it reduces the balance sheet total of the acquirer.” (Holgate, P, A. 1990, ‘Goodwill, Acquisitions & Mergers’, London) to which I say good. If an acquisition of intangible assets which have not yet proven they have market worth results in negligible levels of equity, then I think that the resulting equity balance would accurately reflect the risk the company is taking by making the acquisition and the users of the financial statements will have to consider that when deciding to invest, to continuing to invest, or not, which is the purpose these financial statements exist in the first place. 

           My issue however, is really not even with the balance sheet, because Goodwill is clearly distinguished on the balance sheet and if you, like me, believe that goodwill should not exist in financial statements, it is actually pretty easy to just look at the balance sheet and reduce assets and equity by the amount of goodwill. My issue is that the way it is currently treated does not properly affect the income statement or statement of cash flows because money which went out the door is understated. In the goodwill model it gives the impression that the company received something back as it is recorded as an inflow from investing activities in the cash flow, and it is left out of expenses on the balance sheet, thus overstating net income for the year. The anticipated income has not really happened, yet it gets effectively realized in the income statement as there is no loss or expense recorded with this transaction.

          Conceptually does anyone actually believe that these businesses are doing anything out of goodwill? Talk to people doing M&A’s that isn’t what they think about. Donations to charity for community relations purposes is one thing, but that has its own accounting treatment (as a current period expense funny enough) and benefits in the form of reduced tax liability. But it is completely contradictory to the fiduciary duty of the officers of the for-profit company to suggest that they are buying something at a certain price due to the goodwill of their or the company’s heart. I make the same argument about campaign contributions from corporations being considered “free speech” when any officer should probably be removed from the company for using company funds to express how the organization “feels.” The reason the officer isn’t removed is that either A. They are an individual who has majority control of company and are using what are essentially their personal funds to express their view, just in a way that is more strategic for tax purposes by having the company pay it. Or B. those contributions are really an investment hoping that there will be favorable regulation or legislation that will come out of supporting a bill, proposition, position, or candidate. However, since things may not work out that way, even if their horse won the election, they cannot record any benefit until that benefit is recognized. So in the same way, this investment in the acquisition is supposed to have a future benefit, the benefit has not yet been recognized. Otherwise there would be cash on the balance sheet, or an increase to the fair market value of another asset, or a reduced liability or expense, or revenue on the balance sheet to show for it.

          It’s generally agreed in the accounting world that goodwill is hard to value, and that’s what makes it a tricky topic. I’ll tell you what though, if you get rid of it entirely the question becomes pretty simple, and it would agree with all the other principles established in the accounting world, and financial statements would be more useful to investors and other users. It ends the debate and removes the subjectivity, which should be one of the primary motives of financial reporting.