We discuss the challenges of accounting for goodwill.
I lead on valuation and accounting issues across all sectors, reviewing recommendations, challenging the rationale for existing holdings and developing valuation frameworks. I believe that financial reports, if interpreted carefully, can reveal a lot about both a company’s strengths and weaknesses, and the quality of management. The goal of my forensic reviews is to distil all the numbers into a few differentiated investment questions which can help enhance our multi-dimensional research, and lead to high-quality investment discussions with our fundamental analysts and with companies.
- There is a lot of confusion and debate about what goodwill represents and how it should be accounted for. Currently, goodwill is tested annually for impairment, but the US Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) are considering reintroducing the amortization of goodwill.
- Those who think goodwill represents an indefinite-lived asset think the current impairment-only model makes sense. However, for those who think goodwill represents a finite-lived asset, amortization makes sense.
- I argue that goodwill should be split into three component parts: an indefinite-lived asset which should be tested for impairment, a finite-lived asset which should be amortized, and the part which is not an asset at all which should be written off immediately. At first glance this might seem challenging for companies to apply, but I think it would provide investors with much better information, justifying the effort.
Prince Hamlet opens his famous soliloquy with “To be, or not to be” before contemplating the difficult choice between the unknowns of death and the unfairness of life. Although arguably less dramatic, the US FASB and the IASB are posing another uncomfortable and difficult question: whether to amortize, or not to amortize, goodwill.
What Is Goodwill?
Accounting standards define goodwill as the difference between the fair value of the consideration paid and the fair value of the net assets acquired. Goodwill is the accounting entry which balances the books, but what exactly does it represent?
Lord Macnaghten offered his definition of goodwill 1901, in a UK House of Lords case between The Commissioners of Inland Revenue and Muller and Company’s Margarine Limited.
“It is a thing very easy to describe, very difficult to define. It is the benefit and advantage of the good name, reputation, and connection of a business. It is the attractive force which brings in custom. It is the one thing which distinguishes an old-established business from a new business at its first start …. goodwill is worth nothing unless it has power of attraction sufficient to bring customers home to the source from which it emanates. Goodwill is composed of a variety of elements. It differs in its composition in different trades and in different businesses in the same trade. One element may preponderate here and another element there.”
I propose classifying goodwill into three component parts: an indefinite-lived asset, a finite-lived asset and what’s not an asset at all.
An Indefinite-Lived Asset
The best example is the accumulated know-how in the business. So long as the business continues to prosper, the accumulated know-how should maintain its value. However, if lots of key employees leave or if the market opportunity suddenly declines, the value of this know-how is diminished.
It makes sense to test this type of goodwill for impairment if there are material events which suggest its value is permanently diminished.
A Finite-Lived Asset
The most common example is the amount paid for expected cost synergies. I came across a company which excelled at running industrial plants. It specialized in buying underperforming companies, which it was confident it could run better and, in most cases, it was able to double the margin over a few years.
It makes sense to amortize this type of goodwill over its useful economic life, typically a few years. The balance sheet would reflect a wasting asset and the income statement would reflect both the cost synergies and the premium paid for these synergies.
Not an Asset at All
This is the amount management overpaid for the acquisition.
It makes sense for this type of goodwill to be written off immediately. This is the theory, but how would it work in practice? If an auditor were to ask management how much it overspent on an acquisition, it is unlikely to give a reliable answer, even though studies have shown that most acquisitions destroy value. However, if both the acquirer and target are listed on stock markets, the overpayment can be estimated as the amount which the combined market capitalization of the acquirer and target fell when the deal was announced.
The status quo, to test all goodwill for impairment only, flatters the income statement as it reflects cost synergies but not the premium paid for those synergies.
To amortize all goodwill would be nonsensical: why would you amortize an indefinite-lived asset? If the standard setters were to adopt this approach I suspect management, and investors, would ignore the amortization, excluding it from adjusted profit definitions.
In my opinion, goodwill should be split into three parts, each treated differently. This would help investors understand the premium paid: was it mostly for cost synergies or for the benefits of buying an established business? It would also improve the relevance of GAAP (Generally Accepted Accounting Principles) profitability and net assets because only the appropriate amount of goodwill would be amortized.
PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. Any reference to a specific security, country or sector should not be construed as a recommendation to buy or sell this security, country or sector. Please note that strategy holdings and positioning are subject to change without notice. For additional Important Information, click on the link below.
For Institutional Clients Only. Issued by Newton Investment Management North America LLC ("NIMNA" or the "Firm"). NIMNA is a registered investment adviser with the US Securities and Exchange Commission ("SEC") and subsidiary of The Bank of New York Mellon Corporation ("BNY Mellon"). The Firm was established in 2021, comprised of equity and multi-asset teams from an affiliate, Mellon Investments Corporation. The Firm is part of the group of affiliated companies that individually or collectively provide investment advisory services under the brand "Newton" or "Newton Investment Management". Newton currently includes NIMNA and Newton Investment Management Ltd ("NIM") and Newton Investment Management Japan Limited ("NIMJ").
Material in this publication is for general information only. The opinions expressed in this document are those of Newton and should not be construed as investment advice or recommendations for any purchase or sale of any specific security or commodity. Certain information contained herein is based on outside sources believed to be reliable, but its accuracy is not guaranteed.
Statements are current as of the date of the material only. Any forward-looking statements speak only as of the date they are made, and are subject to numerous assumptions, risks, and uncertainties, which change over time. Actual results could differ materially from those anticipated in forward-looking statements. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment and past performance is no indication of future performance.
Information about the indices shown here is provided to allow for comparison of the performance of the strategy to that of certain well-known and widely recognized indices. There is no representation that such index is an appropriate benchmark for such comparison.
This material (or any portion thereof) may not be copied or distributed without Newton’s prior written approval.