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Goodwill accounting: time for an overhaul.

The U.S. treatment of goodwill is at odds with the practices of many major industrialized nations.

On August 8, 1989, Marvin Davis offered $240 per share ($5.4 billion) for United Airlines (UAL) when the stock was trading for $164.50. On September 1, the pilots' union and UAL management offered $300 per share ($6.75 billion). Following the "mini" market crash on October 13, 1989, UAL stock dropped from $285 to $223; the union-management offer was reduced to $225 to $240 per share ($5.1 billion to $5.4 billion) on October 23, 1989. This offer subsequently fell to an estimated $185 per share ($4.1 billion) on March 20, 1990, and negotiations were terminated soon after.

Was this normal give-and-take in merger deliberations? Consider the following: Although UAL's share price varied significantly, the market value of its net tangible assets changed very little during the eight-month negotiation period. What supposedly did change, according to Accounting Principles Board Opinion no. 16, Business Combinations, was the value assignable to the intangible asset "goodwill." The goodwill amount at March 20, 1990, would have been $2.72 billion (the difference between the high and low offer prices) lower than the amount recordable on September 1, 1989.

Could UAL's goodwill really have changed that much in eight months? Does valuation of a company's goodwill depend solely on the vagaries of the stock market? According to APB Opinion no. 16, the answer to both questions automatically is yes. Compounding this capricious valuation procedure, APB Opinion no. 17, Intangible Assets, provides negligible guidance on how to allocate goodwill to the periods benefiting from it. It simply specifies it be amortized over a period not exceeding 40 years.

These two APB opinions, now over 20 years old, are among the most controversial accounting pronouncements ever issued. Both were implemented amid a storm of dissension at the end of a wave of mergers in the 1960s. Opinion no. 16 sought to curb flagrant abuses commonplace when the pooling-of-interests method was used to account for mergers. (See "APB 16: Time to Reconsider," by Michael Davis, JofA, Oct. 91, page 99.) The goodwill capitalization and amortization guidelines of Opinions nos. 16 and 17 provide the impetus for this article's look at the current state of business combination rules in the United States.


There are two reasons why goodwill is due for an overhaul.

1. It is now a far larger component of companies' acquisition price than it was when the rules were implemented in 1970. As a result, goodwill has a more negative impact on net income. For example, 90% of the $12.9 billion Philip Morris paid for Kraft Inc. in 1988 was attributable to goodwill. In the 1989 Time Warner merger, 80% of the $14 billion paid was for goodwill. The annual goodwill writeoff, even over the maximum 40-year period, totaled $275 billion, resulting in a reported net loss for Time Warner of $217 million in 1990; losses are expected to continue for several years.

2. Lack of tax deductibility under U.S. income tax rules puts domestic bidders at a potential disadvantage in the international merger marketplace; other countries permit goodwill to be carried as a permanent asset or allow tax deductibility of goodwill ri teoffs.

Is the Financial Accounting Standards Board concerned? Apparently not, even though it was aware of the problems as far back as 1973. When the FASB replaced the APB in that year, responses to its request for views on previous APB opinions indicated nos. 16 and 17 were of greatest concern. In 1974, the FASB began the process of reevaluating the pooling rules. In 1975, it expanded the scope of its efforts to encompass all business combination issues, including goodwill. In 1976, it issued a Discussion Memorandum, Accounting for Business Combinations and Purchased Intangibles. And then? In the intervening 16 years, nothing.

In contrast, many national and international standard-setting bodies are working diligently to find satisfactory solutions. Rule makers in both Great Britain and Australia proposed treatments of goodwill substantially different from those currently allowed. The International Accounting Standards Committee also issued an exposure draft on this subject.


Goodwill is but one element of intangible assets. Valuation and amortization of intangibles have been troublesome, whether dealing with concrete and legally definable forms (such as patents, licensing agreements and copyrights), ethereal factors (such as business reputation), unique market position, a well-trained work force or the value of brand names.

All these items meet the general definition of an asset found in FASB Concepts Statement no. 6, Elements of Financial Statements: "probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events." Due to measurement difficulties, many intangibles are never shown on the balance sheet. Even patents and copyrights are excluded unless purchased from another party; internal development costs are expensed because they come under the research and development rules of FASB Concepts Statement no. 2, Accounting for Research and Development Costs.

Goodwill probably is the most intangible of intangibles because it is difficult to determine just exactly what it is. In practice it has evolved to include everything contributing to an existing business's advantage over a new one or anything that enhances a company's earning potential. Current measurement techniques, however, are considered to be inadequate to establish a verifiable value for most elements of goodwill.

In spite of the many formulas available to estimate superior earning power--and these often are used to determine what price to bid for a target company--the actual amount recorded on the balance sheet is a "plug," or residual number. The plug is the difference between the total price paid for a company and the fair market value (FMV) of its identifiable net assets, including intangible assets for which an FMV reasonably can be measured. The potential goodwill to be recorded in a successful leveraged buyout of UAL varied by $2.72 billion, due not to differences in excess-earnings valuation models but to the rollercoaster ride in UAL's stock price.


While there is general agreement goodwill is an asset, four related questions generate substantial diversity of opinion:

* Should goodwill, both purchase and internally generated, be capitalized?

* Should separate elements of goodwill be identified and valued?

* How and over what period should goodwill be amortized?

* Should goodwill amortization be tax deductible?

Industrialized countries are deliberating these issues; international agreement on the first three would be an enormous step toward harmonization of accounting standards. A consistent approach to the last issue is more problematic; the political aspects of national tax policies often are determined independent of reasoned accounting theory. Yet each country's different tax treatment of goodwill amortization ultimately creates the unlevel playing field in the global merger arena.

Capitalization. This approach's proponents argue that if goodwill is as important an asset as many believe, it belongs on the balance sheet regardless of its origin. From a fair-presentation and full-disclosure perspective, this position has substantial merit. One way to estimate internally generated goodwill is for a company to subtract the net assets' market value from total market capitalization, as represented by share price. This is the same procedure used for purchased goodwill, except it likely understates goodwill, since most acquirers pay a premium over the current share price. On the other hand, share price provides a fair appraisal of the company's goodwill as an independent entity, excluding elements that may benefit a specific acquiring company and are worth paying for above the share price, such as product diversification, quick entry into certain markets and synergistic savings from eliminating duplicated administrative and accounting functions.

Opponents of capitalizing internally generated goodwill take the position this type of goodwill take the position this type of goodwill fails the measurability criterion of Concepts Statement no. 5, because it is not currently "measurable with sufficient reliability." Using different terminology, United Kingdom standard setters give their positions in Exposure Draft 47, Accounting for Goodwill: "Internally generated goodwill should not be recognized and included in the balance sheet. In a cost-based accounting model it does not pass the criteria for recognition in the balance sheet because neither its cost nor the transaction which gives rise to it can be identified."

It also is argued valuation of internally generated goodwill is based on "softer" numbers--there is no bargained arm's-length exchange--and is dependent on an ever moving target, the company's current share price. However, purchased-goodwill valuation also is conditioned on current share price and stock market changes.

Data from the failed UAL LBO illustrate this shortcoming. The highest bid of $300 per share would have resulted in approximately $3 billion purchased goodwill, all of which evaporated when negotiations terminated 7 months later. In addition, 7 months after the buyout failed, UAL stock was trading at $84.25, an $80.25 decrease from the $164.50 prebuyout price. This suggests internally generated goodwill declined by $1.8 billion. Taken together, $4.8 billion disappeared in only 14 months. Moreover, this happened at a time when UAL was gaining market share.

Identification and separate valuation. Several studies have to identify specific factors underlying goodwill (see exhibit 1, page 77). Numerous goodwill elements are identifiable and common across studies. Moreover, many individual factors, such as brand names, favorable tax conditions and product diversification, appear to have direct links to excess earning power. In the United Kingdom, some companies capitalize brand names and publishing titles (such as newspaper titles). In Australia, some companies go a step further and capitalize property rights, radio and television licenses, rent rolls and trademarks, whether purchased or internally developed, although capitalization of internally developed intangibles is not mandated due to acknowledged measurement reliability problems. If measurement difficulties can be overcome in the United States, separately identifying and valuing goodwill elements would significantly enhance the usefulness of financial statements.

Amortization. Some would prefer to eliminate goodwill entirely by charging it to stockholders' equity. Throughout its evolution, goodwill always has been viewed as an asset. Because a company's intangible resources often are what separate it from the competition, it seems incomprehensible to remove from the balance sheet an item that results from an arm's-length transaction and must have some future value, or the acquiring company would be throwing away valuable resources.

At the other extreme, some argue goodwill should not be amortized at all, because, properly maintained, it will last indefinitely. If this is correct, mandating amortization forces companies to incur a double hit on their income statements: the out-of-pocket expense of maintaining the value of goodwill as well as the required amortization charge.

Before Opinion no. 17, goodwill was carried at historical cost and amortized only if there was evidence of a diminution in value, something many companies were reluctant to acknowledge. Moreover, measuring the decline was problematic. The APB, responding to pressure to provide authoritative guidance, tried to solve the goodwill amortization problem by minimizing it: Opinion no. 17 required amortization but allowed the lengthy 40-year writeoff period so the impact on earnings in any given year would be immaterial.

While required amortization satisfied some critics, certain industries voiced concern. In broadcasting, for example, a station's major asset is its broadcasting license. Such licenses are almost certain to increase in value because of market entry restrictions. The magnitude of goodwill is more significant in non-capital-intensive industries, since there are fewer intangible assets to write up.

These concerns revolve around the following two issues:

* Does a 40-year amortization period effectively mitigate the impact, as intended by Opinion no. 17?

* Does the amount of amortization shown on the income statement really matter? Exhibit 2, page 78, shows that both goodwill and its related writeoff have a much larger impact on financial statements than during the period when Opinion no. 17 was enacted. Exhibits 3 and 4, page 80 and above, show the yearly amounts for two exhibit 2 items, average intangibles per company and amortization as a percentage of current-year net income. Large goodwill increases and the related income-statement impact have occurred primarily in the last few years. Although the impact on income might appear modest, it actually went from zero before Opinion no. 17, when amortization was not required, to nearly 8% in 1989, and averaged 5.2% from 1985 to 1989. Moreover, these data likely understate the income-statement impact because they do not include mergers, such as Time Warner, where goodwill amortization resulted in a net loss.

Since goodwill amortization is more significant today than in 1970, the issue of "does it matter" becomes more relevant. Since amortization is not tax deductible, it has no direct cash-flow impact. In essence, it is an "all bark, no bite" concern: Although amortization penalizes reported earnings, numerous studies have shown the market is able to see through such nonsubstantive financial statement influences easily.

Yet the amortization-impact concern refuses to die and often is cited as part of the reason U.S. companies are at a disadvantage in international mergers. Whether this argument has any merit, one thing is clear: U.S.-generated goodwill is no different from goodwill generated anywhere else. It ought to be treated uniformly around the globe, if only for comparability purposes. Needless confusion among financial data users and bickering between standard-setting bodies could be eliminated by agreement on either immediate writeoff, permanent capitalization or some periodic amortization method. All involved parties then would enjoy the same benefits or suffer the same drawbacks.

Tax deductibility of goodwill amortization. Ultimately, this is the issue goodwill arguments turn on, and yet it is virtually outside the accountant's control. Allowing a deduction for goodwill amortization is the purview of tax policy, not accounting theory. Just as different countries allow tangible assets to be depreciated over different useful lives, so too can goodwill deductibility differ. There has been much speculation that immediate writeoff of goodwill in Great Britain has allowed companies there to bid more for U.S. companies in merger negotiations although it is not tax deductible. In Germany, Japan and Canada, however, full or partial deduction is allowed, yielding a true cash-flow-based advantage.

Harmonization on this issue is unlikely, yet because managers have learned to live with the impact of varying tax policies on other accounting issues, it's likely the same would be true with uniform accounting treatment of goodwill but differing tax treatment.


Clearly, it's time for the FASB to wake up and ready business combination rules for the globalized economy of the 21st century. While the goodwill issue may be difficult to resolve, U.S. goodwill is no different from goodwill anywhere else. The growing magnitude of the amounts involved, the capricious way in which it's valued and amortized and the radically different treatments allowed in other countries demand harmonization to improve and ensure comparability in financial statements.
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Title Annotation:determination of corporate asset value by securities value
Author:Davis, Michael
Publication:Journal of Accountancy
Date:Jun 1, 1992
Previous Article:Opportunities in litigation services.
Next Article:Compliance: no exception for government contractors.

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