Accounting for goodwill

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p29-36 Tech_FM May 05 v2

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TECHNICAL MATTERS Accounting for goodwill

This issue Accounting for goodwill The OFR Equity investment CPM

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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 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 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for goodwill changed from an amortisation method to an impairment-only approach on January 1, 2005, when IAS22 was superseded by IFRS3. Under US Gaap, the definition of goodwill is the same – ie, it’s the excess of the purchase price over the fair value of the net identifiable assets acquired – although SFAS142 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

Illustration: Julian Mosedale

changed to using US Gaap after this date to avoid the negative effect of having to amortise goodwill. This move improved their results considerably. The French have an appropriate term for when the purchase price exceeds the fair-value net assets: écart 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

The prices Vivendi paid exceeded fair-value net assets by astronomical sums, resulting in the charging of huge goodwill amortisation amounts

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. 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 fair-value net assets by astronomical 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. When the transaction price rose to a ridiculous level, UK healthcare company Smith & Nephew withdrew and let its US competitor, Zimmer FIN A NCIA L May 2005 M A N A GEM EN T

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