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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 International Financial Reporting Standards (IFRS) are standards and interpretations adopted by the International Accounting Standards Board (IASB).

Many of the standards forming part of IFRS are known by the older name of International Accounting Standards (IAS).
 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 Impairment

1. A reduction in a company's stated capital.

2. The total capital that is less than the par value of the company's capital stock.

Notes:
1. This is usually reduced because of poorly estimated losses or gains.

2.
 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 Noun 1. amortisation - the reduction of the value of an asset by prorating its cost over a period of years
amortization

reduction, step-down, diminution, decrease - the act of decreasing or reducing something

2.
 method to an impairment-only approach on January 1,2005, when IAS See iPlanet Application Server.

1. (computer) IAS - The first modern computer. It had main registers, processing circuits, information paths within the central processing unit, and used Von Neumann's fetch-execute cycle.
22 was superseded by IFRS IFRS International Financial Reporting Standard(s)
IFRS Inter Frame Relay Service
IFRS Indiana Facilities Registry System
3.

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 SFAS Statement of Financial Accounting Standards
SFAS Special Forces Assessment and Selection
SFAS Student Financial Aid Services
SFAS Sport Fishing Association of Singapore
SFAS Safety Features Actuation System
SFAS Statewide Fixed Assets System
 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 AMORTISE, contracts. To alien lands in mortmain.  goodwill. This move improved their results considerably.

The French have an appropriate term for when the purchase price exceeds the lair-value net assets Net assets

The difference between total assets on the one hand and current liabilities and noncapitalized long-term liabilities on the other hand.


net assets

See owners' equity.
: 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 Takeover target

A company that is the object of a takeover attempt, friendly or hostile.


takeover target

See target company.
. 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 as·tro·nom·i·cal   also as·tro·nom·ic
adj.
1. Of or relating to astronomy.

2. Of enormous magnitude; immense: an astronomical increase in the deficit.
 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 pros·thet·ics
n.
The branch of medicine or surgery that deals with the production and application of artificial body parts.



pros
. When the transaction price rose to a ridiculous level, UK healthcare company Smith & Nephew withdrew and let its US competitor, Zimmer Holdings Zimmer Holdings Inc. NYSE: ZMH is the world leader in orthopedic implants. It is headquartered in Warsaw, Indiana. United States. Its products include knee, hip, shoulder and spinal implants along with fracture/trauma and orthopaedic surgical products. , 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 Operating profit (or loss)

Revenue from a firm's regular activities less costs and expenses and before income deductions.


operating profit

See operating income.
 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 irrespective of
prep.
Without consideration of; regardless of.

irrespective of
preposition despite 
 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 Transaction Costs

Costs incurred when buying or selling securities. These include brokers' commissions and spreads (the difference between the price the dealer paid for a security and the price they can sell it).
 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 The collection of assets belonging to a debtor to be applied to the discharge of his or her outstanding debts.

A type of proceeding pursuant to federal Bankruptcy
: no value.

Consider the example of a typically overpriced o·ver·price  
tr.v. o·ver·priced, o·ver·pric·ing, o·ver·pric·es
To put too high a price or value on.


overpriced
Adjective

costing more than it is thought to be worth

Adj.
 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 flotation
 or froth flotation

Most widely used process for extracting many minerals from their ores. The method separates and concentrates ores by altering their surfaces so that they are either repelled or attracted by water.
 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 hue and cry, formerly, in English law, pursuit of a criminal immediately after he had committed a felony. Whoever witnessed or discovered the crime was required to raise the hue and cry against the perpetrator (e.g.  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 orthopaedics Orthopedics  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 re·con·struc·tive  
adj.
1. Relating to or characterized by reconstruction.

2. Serving to rebuild, restore, or correct the appearance and function of defective, damaged, or misshaped body structures or parts:
 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 Intangible Asset

An asset that is not physical in nature.

Notes:
Examples are things like copyrights, patents, intellectual property, and goodwill. These are the opposite of tangible 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 Operating Ratio

A ratio that shows the efficiency of management by comparing operating expense to net sales:
 before and after the acquisition (profitability ratios Profitability ratios

Ratios that focus on how well a firm is performing. Profit margins measure performance with relation to sales. Rate of return ratios measure performance relative to some measure of size of the investment.
 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 FCMA Faith Centered Music Association
FCMA First Coast Manufacturers Association
FCMA Fishery Conservation and Management Act of 1976
FCMA Fellow Chartered Management Accountant
FCMA Full Circle Motorcycle Association (Sedalia, Missouri) 
 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)
No portion of this article can be reproduced without the express written permission from the copyright holder.
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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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