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Accounting for goodwill: why are firms willing to pay so much for takeovers when the goodwill burden is so onerous? Kenneth Dogra examines the asset that dare not speak its name.

What is goodwill? Under international financial reporting standards it's defined as the excess of the cost of acquisition over a group's interest in the fair value of the identifiable assets and liabilities of a subsidiary, associate or jointly controlled entity at the date of acquisition. Goodwill is recognised as an asset. Annual impairment tests must be conducted and any loss in value of the assets acquired is written off via the profit and loss account. Accounting for goodwill changed from an amortisation method to an impairment-only approach on January 1,2005, when IAS22 was superseded by IFRS3.

Under US Gaap, the definition of goodwill is the same--ie, it's the excess of the purchase price over the lair value of the net identifiable assets acquired--although SFAS 142 changed accounting for goodwill from an amortisation method to an impairment-only approach as long ago as July 1, 2001. A number of international groups changed to using US Gaap after this date to avoid the negative effect of having to amortise goodwill. This move improved their results considerably.

The French have an appropriate term for when the purchase price exceeds the lair-value net assets: ecart d'acquisition, or difference on acquisition.

All this leads us to the conclusion that, when a business takes over another entity, it needs to find a method by which it can avoid reducing the net assets of the group by the excess over the fair-value net assets of the firm it has purchased. So we call this difference an asset that's not really identifiable.

Acquisitions are complex, high-risk processes. Unless there is a logic to a takeover that leads to a planned approach to growth, its chances of failure are high. For financial managers who have been involved in acquisitions, the crucial point in all negotiations is price. Sellers tend to have an inflated opinion of their companies and seek high prices, especially when the world economy is booming. But, with a planned approach to growth, buyers can identify certain synergies that look interesting on paper and carry a certain value. They can use a number of financial models to calculate the value of a takeover target. The most common technique used is the discounted cash flow method. This relies on the input of realistic cash flow forecasts, discounted to give net present value, for a period in the future.

The consequent numbers game fuels the negotiations--and the urge to win. In larger transactions involving quoted companies a second bidder may appear and push up the offer price, and the board of the target company has a duty to get the best price for its shareholders. Recent examples include Vivendi International's acquisitions in the telecoms industry, where the prices it paid exceeded lair-value net assets by astronomical sums, resulting in the charging of huge goodwill amortisation amounts to the profit and loss account.

Other companies are more aware of the goodwill burden and, much to their credit, walk away from a transaction when the price is too high. A striking example of this came in 2003 with the bidding war to acquire Centerpulse, a Swiss manufacturer of medical prosthetics. When the transaction price rose to a ridiculous level, UK healthcare company Smith & Nephew withdrew and let its US competitor, Zimmer Holdings, complete the purchase. See the case study on the opposite page to find out whether it was a case of the old IAS versus US Gaap or simply good business sense.

Many groups' profits after tax and earnings per share have been affected by excessive goodwill write-offs. As a result, they are reporting operating profit before goodwill amortisation and impairment. It has been suggested that investors and analysts look at cash flow, where there is no goodwill amortisation effect. But there is still a strain on the financial resources of a group where debt has to be repaid if it borrowed for acquisitions and increased interest expense, irrespective of the accounting engineering it has introduced.

The goodwill factor consists of the following characteristics:

* An asset on the balance sheet that cannot be identified as such (which is why it's called an intangible).

* Transaction costs lumped in with goodwill--and anything else, if you can get away with it.

* Amortisation and impairment charges to the profit and loss account.

* In a liquidation: no value.

Consider the example of a typically overpriced acquisition in panel 1. Assuming a borrowing rate of 3 per cent, the purchaser will incur an extra 27m [pounds sterling] in interest payments in the first year. On the assumption that the loan is to be repaid over seven years, a further 128.7m [pounds sterling] will need to be found, hopefully out of cash flow. This type of situation can lead to corporate manipulation in respect of financial reporting when profits and cash flow are insufficient.

In order to curb such overspending companies could consider changing how they account for acquisitions by writing off any difference between the purchase price and fair-value net assets together with transaction costs to a special section in the profit and loss account under the heading "Acquisition costs". This could be stated as in panel 2. Such an approach would make boards more accountable for the decisions they make when expanding their companies by acquisition.

Goodwill at the date of the change in the accounting treatment for acquisitions could be written off to reserves. Similarly, the surplus against net assets on a flotation could be netted off against the share premium generated and not left on the balance sheet as goodwill.

The standard setters and the accounting profession have acquiesced to the hue and cry of industry and the financial community in the past. Isn't it time that we brought some reality into financial reporting for investors?
PANEL 1
A TYPICALLY OVERPRICED ACQUISITION

 Transaction Balance sheet
 (m [pounds sterling]) (m [pounds sterling])

Fair-value net assets 400.5
Transaction costs 89.5
Difference 410.0
Purchase price 900.0
Fair-value net assets 400.5
Goodwill 499.5
Debt 900.0

PANEL 2
A NEW APPROACH TO
ACQUISITION COSTS

Sales
Gross profit
Operating costs
Operating profit
Non-operating costs
Financial expense net
Acquisition costs (detail given in note to the accounts)
Pre-tax profit
Taxation
Profit after tax

Note to the accounts

Acquisition costs
Difference between purchase price and fair value of
the net assets of X Ltd
Transaction costs
Total


CASE STUDY: ZIMMER HOLDING'S ACQUISITION OF CENTERPULSE

In October 2003 US company Zimmer Holdings acquired Centerpulse, a Swiss-based manufacturer of orthopaedic medical devices. The attractions for Zimmer were as follows:

* Becoming the biggest orthopaedics company in the world.

* Fulfilling key priorities by strengthening its European market position and entering the rapidly growing market for spinal devices.

* Adding established products and a more comprehensive research effort in orthobiologics to its portfolio.

* Increasing its presence in the reconstructive dental market.

When the deal was signed on October 2, Zimmer paid a consideration of $3,453.4m. The sum comprised a purchase consideration of $3,410.9m plus acquisition costs of $42.5m. This was paid for in cash ($1,187.1m) and shares ($2,223.8m).

The fair-value net assets at October 2, 2003 were as follows:
 $m
Current assets 796.8
Property, plant and equipment 169.9
Trademarks and trade names 243.0
Intangible assets subject to amortisation:
Core technology 116.0
Developed technology 309.0
Trademarks and trade names 31.0
Customer relationships 34.0
In-process research and development 11.2
Deferred taxes 537.4
Other assets 83.9
 Less liabilities:
 Short-term debt 306.3
 Deferred taxes 250.3
 Other current liabilities 274.6
 Integration liability 75.7
 Long-term liabilities 176.6
 Net assets 1,248.7


The key elements of the purchase consideration can, therefore, be analysed as follows:
Net assets acquired $1,248.7m
Acquisition costs $42.5m
Excess $2,162.2m
Total purchase consideration $3,453.4m


It appears that included under the intangible assets heading is what could be classified as a deferred expenditure in respect of R&D and marketing costs of $490.0m. Would this result in impairment costs in future? The goodwill would be $2,162.2m + $42.5m = $2,204.7m, representing 63.8 per cent of the purchase consideration. It's no wonder that Smith & Nephew, Zimmer's rival bidder, dropped out.

It's interesting to examine Zimmer's 2003 annual report to see its operating ratios before and after the acquisition (profitability ratios exclude adjustments in 2003 concerning the acquisition):
 2003 2002

Gross profit/sales 72.8% 74.9%
Operating profit/sales 24.3% 29.2%
Net profit/sales 20% 18.8%
Days in receivables 93.4 days 57.1 days
Days in suppliers 90.2 days 63.3 days
Debt/equity * 130.2% 42.3%
Free cash flow/sales 16.8% 13.4%
Break-even % of sales 61.9 62.1
Break-even of sales $1,176m $853m


Although there are improvements in some areas, do they justify a purchase price of $3.4bn? Zimmer's future results will provide the answer.

* Excluding goodwill

Kenneth Dogra FCMA is managing partner at the Amerac Consultancy (www.amerac.ch). He is ago the author of Reflections for the Unsuspecting Shareholder, which can be obtained, price 15 [pounds streling], from Amerac Publications, c/o The Better Book Company, Warblington, Havant, Hants PO9 2XH.
COPYRIGHT 2005 Chartered Institute of Management Accountants (CIMA)
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Title Annotation:TECHNICAL MATTERS
Author:Dogra, Kenneth
Publication:Financial Management (UK)
Geographic Code:1USA
Date:May 1, 2005
Words:1538
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