A Goodwill Accounting

1. GOODWILL ACCOUNTING M & A’s In the accounting sense, Goodwill can be thought of as a "premium" for buying a business. When one company buys another, the amount it pays is called the purchase price. Accountants take the purchase price and subtract it by a company's book value. The difference is called Goodwill. For decades, when a company bought another company, it could use one of two accounting methods: pooling of interest or purchase. When the pooling of interest method is used, the balance sheets of the two businesses are combined and no goodwill is created. When the purchase method is used, the acquiring company will put the premium they paid for the other company on their balance sheet under the "Goodwill" category. Accounting rules require the goodwill be amortized over the course of 40 years. An Example of Balance Sheet Goodwill What does that mean? Let's use McDonald's and Wendy's as an example since most people are familiar with them. McDonald's Earnings:$1,977,300,000 Shares-Outstanding:1.29Billion (You don't need McDonald's other information for this example) Wendy's BookValue:$1,082,424,000 BookValueperShare:$10.3482 SharesOutstanding:104.6Million Earnings: $169,648,000 Say McDonald's decided to buy all of Wendy's stock using the purchase method. Wendy's has a book value of $10.3482 per share, yet is trading at $32 per share. If McDonald's were to pay the current market price, they would spend a total of $3,347,200,000 (104.6 million shares x $36 per share). To keep this example simple, we are going to assume the shareholders of Wendy's approved the merger for cash. McDonald's would mail a check to the Wendy's shareholders, paying them $32 for each share they owned. Since the book value of Wendy's is only $1,082,424,000, and McDonald's paid $3,347,200,000, McDonald's paid a premium of $2,264,776,000. This is going to go onto their balance sheet as Goodwill. It is required to be amortized against earnings for up to 40 years. This means that each year, 1/40 of the goodwill amount must be subtracted from McDonald's earnings so that by the 40th year, there is no goodwill left on the balance sheet. Now that McDonald's and Wendy's are one company, their earnings will be combined. Assuming next year's results were identical, the company would earn $2,146,948,000, or $1.66 per share1. Remember that goodwill must be amortized, meaning 1/40 the amount must be deducted from next year's earnings. McDonald's must deduct $56,619,400 from earnings next year as a charge against goodwill2. Now, McDonald's can only report earnings of $2,090,328,600, or $1.62 per share (compared to the $1.66 they would have been able to report before the goodwill charge). Goodwill reduced earnings by 4¢ per share.

If the pooling of interest method had been used, no goodwill would have been created, and McDonald's would have reported EPS (earnings per share) of $1.66. Meaning that depending on how the accounting was handled, the exact same transaction could have two vastly different impacts on earnings per share. Goodwill on the Balance Sheet Receives New Accounting Rules It is no wonder that managements, in order to avoid this reduction in reportable earnings, frequently opted to use the pooling of interest method when they complete a merger. Since no goodwill is created, over-eager managers are able to pay outrageous prices for acquisitions with little or no accountability on the balance sheet. Since it makes no sense to have two different ways for accounting for a merger, the FASB (the folks in charge of coming up with these accounting rules) decided they should eliminate the pooling of interest method and force all transactions to be done via the purchase method. Executives and politicians claimed this will significantly reduce the number of mergers since the new standards would cause reportable earnings to drop as soon as a company had completed an acquisition. As a concession, the FASB will no longer require goodwill to be written off unless the assets became impaired (which means it becomes clear that the goodwill isn't worth what the company paid for it). Pay careful attention to the mergers a company has made in the past few years. Once you are able to value a business, you will want to look at recent acquisitions to determine if they were too expensive. If you find this to be the case, you will probably want to avoid the stock (why would you want to invest in a company that was throwing your money around?). Notes: 1.) Since McDonald's purchased Wendy's, the two companies' profits will be combined. $1,977,300,000 + $169,648,000 = $2,146,948,000. To get the earnings per share, you would simply divide it by the number of shares outstanding (1.29 billion). We're assuming McDonald's bought Wendy's for cash. If stock had been used, the number of shares would change, but for simplicity sake, we are going to assume this not to be the case. 2.) Take the premium $2,264,776,000 and divide it by 40 years = this is the charge against earnings each year 3.) Companies purchased before 1970 are not required to be amortized off the balance sheet. They can stay there forever.

2. GOODWILL ACCOUNTING M & A’s

Goodwill is an accounting term used to reflect the portion of the book value of a business entity not directly attributable to its assets and liabilities; it normally arises only in case of an acquisition. It reflects the ability of the entity to make a higher profit than would be derived from selling the tangible assets. Goodwill is considered an intangible asset. Goodwill as a term was originally used to reflect the fact that an ongoing business had some "intrinsic value" beyond its assets, such as the reputation the firm enjoyed with its clients. Likewise, a buyer may agree to "overpay" because he sees potential synergy with his own

business. The accounting sense of goodwill followed as a plausible explanation of why a firm sells for more than the value of its net assets. Modern meaning Goodwill in financial statements arises when a company is purchased for more than the fair value of the identifiable assets of the company. The difference between the purchase price and the sum of the fair value of the net assets is by definition the value of the "goodwill" of the purchased company. The acquiring company must recognize goodwill as an asset in its financial statements and present it as a separate line item on the balance sheet, according to the current purchase accounting method. In this sense, goodwill serves as the balancing sum that allows one firm to provide accounting information regarding its purchase of another firm for a price substantially different from its book value. Goodwill can be negative, arising where the net assets at the date of acquisition, fairly valued, exceed the cost of acquisition. Negative goodwill is recognized as a liability. For example, a software company may have net assets (consisting primarily of miscellaneous equipment, and assuming no debt) valued at $1 million, but the company's overall value (including brand, customers, intellectual capital) is valued at $10 million. Anybody buying that company would book $10 million in total assets acquired, comprising $1 million physical assets, and $9 million in goodwill. Goodwill has no predetermined value prior to the acquisition; its magnitude depends on the two other variables by definition. The carrying value of an asset with associated goodwill may subsequently be adjusted by management, either by amortization or by means of occasional adjustments of the estimated value of the associated assets (primarily based upon their ability to generate cash-flow and profits). The exact treatment and other details, particularly amortization, will depend on the accounting standards applied. There is a distinction between two types of goodwill depending upon the type of business enterprise: institutional goodwill and professional practice goodwill. Furthermore, goodwill in a professional practice entity may be attributed to the practice itself and to the professional practitioner. It should also be noted that while goodwill is technically an intangible asset, goodwill and intangible assets are usually listed as separate items on a company's balance sheet. Basic goodwill formula • • •

Goodwill = Purchase Price – Fair Market Value of Net Assets Fair Market Value of Net Assets = Net Tangible Assets + Write-up of Net Assets Net Tangible Assets = Assets – Target's Existing Goodwill – Liabilities

As can be seen, a merger destroys the target's "old" goodwill and creates "new" goodwill to appear in consolidated books. Net assets write-up is prepared through a qualified appraisal in a process known as a Purchase Price Allocation. History and purchase vs. pooling-of-interests Previously, companies could structure many acquisition transactions to determine the choice between two accounting methods to record a business combination: purchase accounting or

pooling-of-interests accounting. Pooling-of-interests method combined the book value of assets and liabilities of the two companies to create the new balance sheet of the combined companies. It therefore did not distinguish between who is buying whom. It also did not record the price the acquiring company had to pay for the acquisition. U.S. Generally Accepted Accounting Principles (FAS 141) no longer allows pooling-of-interests method. Amortization and adjustments to carrying value Goodwill is no longer amortized under U.S. GAAP (FAS 142). Companies objected to the removal of the option to use pooling-of-interests, so amortization was removed by Financial Accounting Standards Board as a concession. As of 2005-01-01, it is also forbidden under International Accounting Standards. Goodwill can now only be impaired. Instead of deducting the value of goodwill annually over a period of maximal 40 years, companies are now required to value fair value of the reporting units, using present value of future cash flow, and compare it to their carrying value (booked value of assets plus goodwill minus liabilities.) If the fair value is less than carrying value (impaired), the goodwill value needs to be reduced so the fair value is equal to carrying value. The impairment loss is reported as a separate line item on the income statement, and new adjusted value of goodwill is reported in the balance sheet. Since, in general, intellectual property (IP) is part of goodwill—in its lay, not accounting sense—one of the most important assets of knowledge-based companies does not appear at all on formal balance sheets. As for these companies, it is the IP that generates profit, not the buildings or the cash they hold; this may lead to a misleading valuation, discouraging investors who do not understand the company's value. When the business is in trouble, with the threat of insolvency, investors will deduct the goodwill from any calculation of residual equity because it will likely have no resale value

3. 3. U.S. GAAP Statements of Financial Accounting Standards (SFAS)

Rules of SFAS No. 142, June 2001 Statement of Financial Accounting Standards (SFAS) No. 142 a. Goodwill and Other Intangible Assets b. Issued in June 2001 c. Supersedes APB Opinion No. 17, "Intangible Assets". Acquired intangible assets a. An acquired intangible asset --> recognized based on its fair value. Intangible assets not specifically identifiable a. Internally developed intangible assets --> not recognized as an asset on the balance sheet.

--> rules of SFAS No. 142 are same as APB Opinion No. 17 b. Cost of internally developing intangible assets (not specifically identifiable) --> recognized as an expense when incurred. Amortization of intangible assets a. An intangible asset with a finite useful life --> amortized over its useful life. b. If the useful life is not limited --> by legal, economic or other factors, --> useful life is indefinite (not infinite). c. Amount to be amortized = cost - residual value d. If the pattern of economic benefits can be determined --> Amortization method should reflect such pattern. e. If the pattern of economic benefits cannot be determined --> Straight-line amortization Goodwill a. Goodwill is not amortized. --> Goodwill is tested for impairment b. Impaired --> fair value < carrying amount c. Test for impairment --> on an annual basis d. If certain events would reduce fair value below carrying amount, --> test for impairment is done between annual tests.