Is Goodwill an Asset

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Is Goodwill an Asset

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Title: Is Goodwill an Asset

1
Is Goodwill an Asset?

Do we care about goodwill, and whether it is an
asset?
When is goodwill likely to be an issue that
generates interest?

The accounting for purchased goodwill generates
greater interest whenever merger and acquisition
activity is robust..

And the recent FASB decision to disallow pooling
of interests means that goodwill will potentially
be an issue in all merger transactions.

How would you define goodwill? Consider the
definition you would use to operationalize
goodwill, and compare it to the conceptual
definition of goodwill...

The working definition of goodwill has the
difference between the purchase price and the
fair market value of the identifiable net assets
in a purchase transaction. In the past, we
accounted for this as an intangible asset and
amortized it over a period not to exceed 40
years. Is this adequate anymore? What is the
conceptual definition?

Conceptually, goodwill is the ability of a
business to earn a higher than average rate of
return on the identifiable net assets of the
company. The higher return implies additional,
unidentified, assets that are the drivers for
that return.

The conceptual definition and working definition
are not identical, and they imply some
differences in how components of the purchase
price might be identified and accounted for. It
is useful to evaluate the potential reasons for
a difference between the purchase price and the
fair market value of the assets.

If we can break the lump sum down into component
parts, we can evaluate potential accounting
treatments that would be implied by the
conceptual framework.

9
Nature of Goodwill

Im using the term goodwill here in a broad
sense, not necessarily consistent with how we
account for goodwill...
Top-down perspective Goodwill is a component or
subset of something larger
Bottom-up perspective Goodwill is the sum of
the components that comprise it.

10
Top-Down

Goodwill may be viewed as a component of the
acquirers investment and is based on the
acquirers expectation about future earnings from
the investment.
The issue is framed in terms of whether the
investment itself qualifies as an asset. If it
does, then the components are viewed as subsets
of the larger asset and accounted for as assets
themselves.

Goodwill is the leftover portion of the
investment, which is consistent with the
definition in APB 16, the excess of the cost of
the acquired company over the sum of the amount
assigned to identifiable assets acquired less
liabilities assumed.

And this is traditionally how we have thought
about goodwill and accounted for it.

But as the FASB considers the potential
definitions and accounting treatment of
goodwill, they found that breaking it into
different components may also be useful.

14
Bottom-up

If the price paid by the acquirer exceeds the
fair value of the net identifiable assets of the
acquiree, presumably some other resources were
acquired that have value to the acquirer. In
identifying the resources that may be components
of goodwill, it is useful to interpret goodwill
broadly to capture the largest potential set of
component parts.

This may not be consistent with how we finally
define goodwill or how we account for goodwill.

In its broadest conceptualization, goodwill may
be interpreted as the excess of purchase price
over book value.
This might be particularly useful if the fair
market value of the identifiable assets is hard
to determine.

What components can you identify that might
explain why the purchase price of a company is
higher than the book value of the net assets?
(Hint...the authors of a recent article on
goodwill identified 6 potential components.)

The following represent possible component
parts of goodwill
Excess of the fair values over the book values of
recognized net assets
(Is this part of part of goodwill under APB
16? Should it be? Or should we account for it
as something else?)

Fair values of other net assets not recognized by
acquiree - primarily identifiable intangibles
that may not have been recognized, possibly
because they did not meet recognition criteria
(IPRD)
(Is this part of goodwill under APB 16? Should
it be? Or should we account for it as something
else?)

Fair value of the going concern element of the
acquirees existing business the ability of the
acquiree as a stand alone business to earn a
higher rate of return on an organized collection
of net assets than would have been expected if
those assets had been acquired separately
(Synergies)

Fair value of synergies from combining the
acquirers and acquirees businesses and net
assets. This is unique to each business
combination.

Overvaluation of the consideration paid by the
acquirer - possible errors in valuing the
purchase consideration (i.e., in an all-stock
transaction, the current market price of the
shares issued may be higher than if those shares
were sold for cash and the cash was then used to
effect the combination). (Is this conceptually
goodwill? Is the price of shares fixed?

Overpayment or underpayment by the acquirer,
which may occur when the price is driven up in
the course of bidding for the acquiree, or when
the net assets were obtained through a distress
or fire sale (Tycos problem when they sold their
CIT Insurance group....maybe)

Components 1 and 2 both relate to the acquiree
and how the acquiree values its assets.

These are not conceptually part of goodwill.
Component 1 is not an asset in and of itself, but
instead reflects gains that were not recognized
by the acquiree on its net assets and is
therefore part of those assets, not goodwill.

Component 2 is also not part of goodwill, at
least not conceptually, but instead primarily
reflects intangibles that might be separately
identified and recognized as individual assets
rather than being included in goodwill

Components 5 and 6 relate to the acquirer but are
not conceptually part of goodwill. Component 5
is not an asset or even part of an asset, but
rather a measurement error.
Component 6 represents a gain or loss resulting
from measurement error and is not conceptually
goodwill.

Only Components 3 and 4 are conceptually part of
goodwill, and may be thought of as core
goodwill.
Component 3 might be thought of as preexisting
goodwill that was either internally generated by
the acquiree or acquired by it in previous
business combination. This might be called
going concern goodwill.

Component 4 did not exist before the combination,
but rather results from the combination itself,
and may be referred to as combination goodwill.

What are the conceptual differences between going
concern goodwill and combination goodwill?

31
Example

Big Bank, and institution experienced in
acquiring other banks and successfully
consolidating their operations with their own,
acquires Local Bank, an institution with many of
its branch banks located across the street from
Big Bank branches.

Big Bank acquired Local Bank primarily because
of the synergies from consolidation that
ultimately are expected to be reflected in
significant cost savings from Big Banks plan to
close redundant branch banks (some will be Big
Bank branches some will be Local Bank branches)

If Local Banks identifiable net assets have a
fair value of 10 million and Local Bank has a
market value of 14 on a stand-alone basis, its
going concern goodwill might be 4 million. If
Big Bank acquires it for 20 million, it might
be assumed that combination goodwill has a value
of 6 million.

Based on this analysis of the six components of
purchase price, the question of what goodwill
is--and is not--can be answered, at least
conceptually...
Goodwill is really components 3 and 4
But measurement issues make it difficult to
separate out components 1, 2, 5, and 6

Conceptually, how should we account for
components 1, 2, 5, and 6?

1--add to asset values to write up to FMV
2--establish asset values
5-6 measurment errors--what do you suggest, if
the amounts could be determined? If the amounts
cannot be determined?

37
Core Goodwill

CON 6 states that assets are probable future
economic benefits obtained or controlled by a
particular entity as a result of past transaction
or events. Assets have 3 essential
characteristics

Assets embody a probable future benefit that
involves a capacity, singly or in combination
with other assets, to contribute directly or
indirectly to future net cash inflows

A particular entity can obtain the benefit and
control others access to it, and

The transaction or other event giving rise to the
entitys right to or control of the benefit has
already occurred.

Core goodwill cannot be exchanged for something
else of value nor can it be used to settle the
entitys liabilities. However, it can be used to
produce net future cash inflows.

Core goodwill has the capacity in combination
with other assets to contribute indirectly to
future cash flows. The future benefit associated
with core goodwill may be less certain than the
benefit associated with other most other assets

CON 6 notes that the most obvious evidence of
future economic benefit is market price.

Because core goodwill does not have the capacity
singly to contribute directly to future net cash
inflows, it is not priced separately in the
marketplace, but rather is priced in combination
with other assets with which it contributes to
future cash flows

While core goodwill is not priced separately,
that does not preclude it from having future
economic benefit. CON 6 notes that anything
commonly bought and sold has future economic
benefit, including the items in a basket
purchase obtained in a business combination
(para. 173)

Control exists, because the acquirer owns a
controlling financial interest in the acquired
entitys equity.
And the past transaction is the acquisition.

So it would seem that core goodwill meets the
criteria to be recognized as an asset.

48
Separately Identifiable

Schuetze would exclude goodwill from his
definition of assets because he would require
that all assets that are not cash or contractual
claims to cash or services must be capable of
being sold separately for cash. AS a result,
exchangeability is an essential characteristic of
those assets.

UKs Accounting Standards Board in 1997 also took
the stand that Goodwill is not an asset. While
their definition of an asset is similar to that
of the FASB, they interpret control in a
different context. The ASB states items that
cannot be separately identified from the business
as a whole cannot be individually controlled by
the entity and hence are not assets.

The ASB states that goodwill is neither an asset
like other assets nor an immediate loss in value.
Rather, it forms the bridge between the cost of
the investment as shown in the acquirers own
financial statements and the values attributed to
the acquired assets and liabilities in the
consolidated financial statements.

Although purchased goodwill is not in itself
an asset, its inclusion amongst the assets of the
reporting entity, rather than as a deduction from
shareholders equity, recognized that goodwill is
part of a larger asset, the investment, for which
management remains accountable.

Meeting the definition of an asset is a necessary
but not sufficient condition for goodwill to be
recognized as an asset in the financial
statements. Measurabilty, relevance, and
reliability must also be met.

One question is the extent to which we can
measure the different components of the excess of
purchase price over the book value of the assets.

IT seems that different portions of the
components should be accounted for differently.

The net gains on the appreciation of the assets
above book value should be included in the asset
value and depreciated.

Core goodwill should be capitalized. Should it
be depreciated? Subject to impairment tests?
Maintained indefinitely?

The new standard on business combinations
indicates that core goodwill should be
capitalized and subject to an impairment test.
What do you think of this?

58
Intangibles

Component 2 was
Fair values of other net assets not recognized by
acquiree - primarily identifiable intangibles
that may not have been recognized, possibly
because they did not meet recognition criteria
(IPRD)

59
Research on Intangibles

The Financial Accounting Standards Committee of
the American Accounting Association is charged
with responding to requests by standard setters
on issues related to financial reporting.

They find that extant research supports the
following conclusions
Expenditures on RD and to a lesser extent
advertising, not currently recognized as assets,
contribute to firm value That is, capital market
research ascribes asset-like status to such
expenditures.

That means that market prices reflect a time
component to these expenditures.

This, in spite of the fact that the assets are
not reflected on the balance sheethow do we
determine that the market treats these
expenditures as assets?

The stock market reacts positively to firms
announcements relating to RD activities. Higher
than expected RD expenditures are positively
correlated with higher stock prices. Similarly,
the stock market values advertising expenditures.
The effects of advertising were largely confined
to firms producing durable goods.

That would indicate that the market perceives a
higher present value of future cash flows because
of these current expenditures.

By evaluating the length of time the stock sells
at a premium related to the announcement of the
expenditure, we can infer the life that the
market attributes to the expenditure.

Inferred lives of advertising expenditures were
generally short, in the range of 1-5 years.
The inferred lives of the RD investments ranged
from 5 to 10 years,

In special cases, such as in the wireless
communication industry, nonrecognition of
internally generated intangibles can potentially
obviate the relevance of conventional financial
statements.

What does this imply for the fair value of
acquired intangibles?
Can the values be measures reliably?

One might believe that management made estimates
of the values of identifiable intangibles in
arriving at a purchase price for the
acquisition...

So the assets could be valued through the eyes
of management.
Is this a fair market value? OR does it contain
measurement error?

IF it contains measurement error, is this a
problem?

Is your answer different if you are considering
the use of financial information to evaluate the
stewardship of management vs. the forward looking
estimate of the nature, timing, and uncertainty
of future cash flows?

Is it better to attempt to measure these
different components of goodwill and treat them
separately or to lump them all together in a
single intangible asset account, goodwill?

74
IPRD

Interpretation 4 of FAS 2 states that IPRD must
be measured and separated out from core goodwill
in a purchase combination.
What is IPRD?

The research and development acquired singly, as
a part of a group of assets, or in a business
combination accounted for using the purchase
method.

76
Example

Three grad students in Ames, Iowa, started a
biotech research company. They rented office
space in the ISU Research Park. They bought 3
state-of-the-art computers and programs worth
15,000, and 3 used desks and chairs. The grad
students spent three years developing computer
models of DNA molecules in an attempt to develop a

model of an insect-resistant corn seed.
After 3 years, they had a design for
genetically-engineered corn that they believed
would be worth testing.
They did not have the resources to actually
make the seed nor to test it in fields.

Because they did not have the resources to
carry the development work any farther, they
decided to look for a buyer for their company.

Does their work and their company have value?
To what extent? What is the value of their net
identifiable tangible assets?
Do they have any goodwill? (Remember our
definition(s) of goodwill)
What will the purchase price represent?

The entire value of the company is IPRD.
According to current accounting standards, the
entire amount of IPRD must be expensed when
acquired.

This requirement is to maintain consistency with
FAS 2, which requires all RD to be expensed as
incurred.
Does this make sense?
If IPRD were not expensed, what would be the
issues with capitalization?
Costs to complete, similar research projects that
were internally generated...

The SEC has taken issue with IPRD charges,
claiming that they have been abused.
What about the potential for abuse?
Are large charges likely?
What are the measurement issues?

Who makes the determination of the value of IPRD?

One of the problems has been who has the
expertise to value the different components of
IPRD. On occasion, the audit firm has evaluated
the deal and assigned values to the components of
the excess of the purchase price over the book
value of the assets.