In an earlier post, I described how SFAS 141R resulted in some incremental improvements to the accounting for business combinations. However, warts remain, and the purposes of this post is describe the ugliest and most painful of them all: the accounting for so-called ‘goodwill.’
Here’s a simple example to contemplate:
- Company P determines that Company S has a value of $1,100, and negotiates an acquisition for 100% of its outstanding shares for $1,000.
- S has the following assets:
- Plant and equipment with a fair value of $200.
- An assembled workforce with a fair value of $100.
- S has no liabilities eligible for accounting recognition.
- Company S will be run independently from Company P; thus, any synergies created by the acquisition are negligible.
The root of the problem is literally that debits (the assets acquired) do not equal credits (the purchase price). Business combination accounting is a collision of fantasy and reality: the fantasy is that accounting can fully reflect the economic impact of past events on an enterprise, and the reality is that it cannot be so. A balance sheet produced by even the most principled of accounting systems imaginable cannot possibly comprehend the entire set of economic assets and liabilities. One example on the asset side would be that S has been put together in such a way as to rapidly and inexpensively expand or contract capacity as market conditions change. In other words, S holds ‘real options’, and the shareholders of S would want P to pay for them. On the liability side, not all obligations are legal, amounts are highly uncertain, and the probability of payment may be low.
The FASB’s solution to the debit and credit problem is to plug the shortfall in debits and to weave a fantasy around it. The plug is euphoniously dubbed ‘goodwill’ — to be classified on the balance sheet as an asset and tested for impairment at least once each year. In the above example, the amount reported as goodwill would be $800 (=$1,000 – $200).
Whipped Cream on the Balance Sheet
As described above, the amount reported as goodwill is, at its best, a conglomeration of assets offset by liabilities. Nowhere else in accounting would there be permitted such a hodgepodge, and by no other means other than a narrowly defined ‘business combination’ may it — whatever it is — be recognized. But even granting that offsetting assets with unrelated liabilities may be permissible, of what use to investors is the assignment of a number to something that, by definition, is beyond description? (Ironically, even though the value of S’s assembled workforce may be measurable and significant, separate recognition of this asset is streng verboten and kept a dark secret from investors.)
As I have reported in my earlier post, Walter Schuetze (former SEC Chief Accountant and FASB member) derisively characterizes reported goodwill as "the lump left over." Actually, I think he was being generous. FAS 141R contains some significant exceptions to fair valuation of assets acquired and liabilities assumed. Thus, the unknown difference between recorded amounts and their fair values are shoveled into the goodwill muddle. As if that weren’t enough, the math of the goodwill calculation blithely compares apples with oranges: prices paid with values received. "Lump", "goodwill" or whatever name you can think of implies that the number is associated with actual attributes, but what we are dealing with here is nothing more than just a number–an arbitrary number.
So, dear readers, I hope you are not disillusioned to realize that ‘goodwill’ is invariably anything but. If it must be recognized at all, let’s drop the obvious pretension and call it what it is: in this example, "excess of purchase price over recognized amounts of identified assets acquired and liabilities assumed." However, dropping the pretension is not as easy as it seems. If a muddle is to be reported as an asset, it must be subject to an impairment test; and without a dressy name that belies the muddle that is ‘goodwill’, there can be no pretense for the charade of an impairment test that is FAS 142.
The Goodwill Impairment Mess
Recognition of goodwill may seem but a curious anomaly until you get to the impairment test specified in FAS 142. It’s a real money pit: goodwill has to be assigned to "reporting units" (a new concept rife with opportunities for manipulation); the fair value of each reporting unit has to be assessed at least once a year (another opportunity for manipulation); and the real mayhem begins if, heaven forbid, you are required to estimate the "implied fair value of goodwill" (another new concept rife with opportunities for manipulation). The only good that comes out of goodwill impairment testing are the jobs created for valuation consultants, accountants and attorneys.
A Proposed Solution
In olden days, the British permitted a charge to contributed capital for the amount that would otherwise have been recognized as goodwill. While imperfect, it may well be the only reasonable solution to the problem; for as I have shown above, there can be no perfect solution. If you can’t describe what something is, than what possible good can come from purporting to measure it?
By the way, even though business combinations rules have been somewhat converged by the issuance of FAS 141R and a revised IFRS 3, goodwill impairment remains one of the most significant differences between IFRS and U.S. GAAP. The two approaches are fundamentally at odds, but it should be said that IFRS’s impairment rules are much less worse. But that’s not the most important point I want to make. Whatever the merits of the two approaches, by eliminating goodwill and the inevitably screwball impairment tests, standard setters would not only be improving financial reporting, they could also say that they have resolved one of the thorniest convergence issues.