Goodwill

It is very unusual for one company to acquire another for exactly its book value. Generally speaking, there is a difference between the acquisition price, which may be paid in cash or in shares, and the portion of the target company’s shareholders’ equity attributable to the parent company. In most cases, this difference is positive as the price paid exceeds the target’s book value.

What does this difference represent?

In other words, why should a company agree to pay out more for another company than its book value? There are several possible explanations:

• the assets recorded on the acquired company’s balance sheet are worth more than their historical cost. This situation may result from the prudence principle, which means that unrealised capital losses have to be taken into account, but not unrealised capital gains;
• it is perfectly conceivable that assets, such as patents, licences and market share, that the company has accumulated over the years without wishing to or even being able to account for them, may not appear on the balance sheet. This situation is especially true if the company is highly profitable;
• the merger between the two companies may create synergies, either in the form of cost reductions and/or revenue enhancement. The buyer is likely to partly reflect them in the price offered to the seller;
• the buyer may be ready to pay a high price for a target just to prevent a new player from buying it, entering the market and putting the current level of the buyer’s profitability under pressure;
• finally, the buyer may quite simply have overpaid for the deal.

How is goodwill accounted for?

Goodwill is shown under intangible fixed assets of the new group’s balance sheet at an amount equal to the difference between the acquisition price and the share of the new subsidiary’s equity adjusted for unrealised capital gains net of unrealised capital losses on assets and liabilities. Assets, liabilities and equity of the new subsidiary are transferred to the group’s balance sheet at their estimated value rather than their book value. In this case, the intangible assets acquired are recorded on the group’s balance sheet even if they did not originally appear on the acquired company’s balance sheet; i.e., brands, patents, licences, landing slots, data bases, etc.

The difference between the purchase cost and the fair market value of the assets and liabilities acquired with a company is called goodwill.

Goodwill is assessed each year to verify whether its value is at least equal to its net book value as shown on the group’s balance sheet. This assessment is done by means of impairment tests. If the market value of goodwill is below its book value, goodwill is written down to its fair market value and a corresponding impairment loss is recorded in the income statement.

This method is known as the purchase method. This is the method prescribed by US GAAP since December 2001 and IAS from 1 January 2006.

The pooling of interest method was abolished by the US authorities in December 2001 and will be abolished by the IASB from 2006. It allowed the assets and liabilities of the newly acquired company to be included in the group’s accounts at their book value without any goodwill being recorded.

To illustrate the purchase method, let’s analyse now how Pfizer, the US pharmaceutical group, accounted for the acquisition of its rival, Pharmacia.

How financial analysts should treat goodwill?

From a financial standpoint, it is sensible to regard goodwill as an asset like any other that may suffer sudden falls in value that need to be recognised by means of an impairment charge.

Can it be argued that goodwill impairment losses do not reflect any decrease in the company’s wealth because there is no outflow of cash? We do not think so. Granted, goodwill impairment losses are a noncash item, but it would be wrong to say that only decisions giving rise to cash flows affect a company’s value. For instance, setting a maximum limit on voting rights or attributing ten voting rights to certain categories of share does not have any cash impact, but definitely reduces the value of shareholders’ equity.

Recognising the impairment of goodwill related to a past acquisition is tantamount to admitting that the price paid was too high. But what if the acquisition was paid for in shares? This makes no difference whatsoever, irrespective of whether the buyer’s shares were overvalued at the same time. Had the company carried out a share issue rather than overpaying for an acquisition, it would have been able to capitalise on its lofty share price to the great benefit of existing shareholders. The cash raised through the share issue would have been used to make acquisitions at much more reasonable prices once the wave of euphoria had subsided. This is precisely the strategy adopted by Bouygues. It raised C¼1.5bn of new equity in March 2000 at a very high share price, refused to participate in the UMTS auctions and used its cash pile only in 2002 to buy out minority interests in its telecom subsidiary at a far lower level than the rumoured price in 2000.

It is essential to remember that shareholders in a company that pays for a deal in shares suffer dilution in their interest. They accept this dilution because they take the view that the size of the cake will grow at a faster rate (e.g., by 30%) than the number of guests invited to the party (e.g., by over 25%). Should it transpire that the cake grows at merely 10% rather than the expected 30% because the purchased assets prove to be worth less than anticipated, the number of guests at the party will unfortunately stay the same. Accordingly, the size of each guest’s slice of the cake falls by 12% (110/125
1), so shareholders’ wealth has certainly diminished. Finally, testing each year whether the capital employed of each company segment is greater than its book value so as to determine whether the purchased goodwill needs to be written down is implicitly tantamount to recording internally generated goodwill that gradually replaces the purchased goodwill. As we know, goodwill has a limited lifespan in view of the competition prevailing in the business world.