How good is goodwill - you decide!

Accountancy SA,  May 2003  by Fontanot, Paul

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How many times have you flipped to the back of a company's annual report and found yourself blankly staring at the pages of numbers and tables? You know that these should be important to your investing decision, but you're not quite sure what they mean or where to begin. Certain investors have always known that financial statements are the key to every company. Financial statements can warn of potential problems, and when used correctly, they help determine what a business is really 'worth'. An investor who understands financial statements will never have to ask, "Is this company a good investment?"

The balance sheet is just one component of the financial statements and is often described as a 'snapshot' of the financial position of a business at a given point in time. It provides a picture of the collection of assets and resources of a company, as well as the company's liabilities and the equity at a particular date.

All assets on the balance sheet are deferred expenses and will eventually be realised through usage or sale and in the process will be expensed in the income statement, affecting the earnings of a company.

SO, WHY PAY A PREMIUM? I In the accounting sense, goodwill can be thought of as a 'premium' for buying a business. Accountants take the purchase price and compare it to a company's book value. The difference is called goodwill.

One characteristic of goodwill that has emerged over the past century is that it is inseparable from the business. It cannot be sold without selling the associated business. If you can sell what you are calling goodwill, then it is something other than goodwill. It may be contract rights, a client list, distribution channels, or any number of other things and should be labelled as such, instead of being lumped into the goodwill account.

More common in press releases recently are pro forma earnings. These are often referred to as 'earnings before all the bad stuff'. The original reasoning behind this was to take out any unusual, one-time charges in order to allow investors to make a better comparison with earnings from previous years. This was primarily used after mergers and takeovers, but they seem to have been overused lately, as nearly every company that loses money blames it on 'one-time' charges. Of course any company that continues to release pro forma earnings quarter after quarter indicates to me that these are not in fact 'one-time charges', but merely poor management.

One of the most important intangible assets on a company's balance sheet that can have a material effect on earnings is goodwill.

The treatment of goodwill has changed over the years. In South Africa, before the introduction of the accounting standard AC129, which deals with the treatment of goodwill, goodwill was accounted for in a number of different ways, for instance:

* Goodwill was written off directly against reserves, usually referred to 'reserve accounting'.

* Goodwill would be carried at cost less accumulated amortisation and impairments. Amortisation and impairments would be expensed in the income statement.

* Goodwill would be carried at cost less accumulated impairments. In such situations goodwill would not be amortised, but would only be written down if an impairment was considered to exist.

Sections 83 and 84 of the Companies Act, which dealt with the reduction of share capital, were repealed in 1999 and therefore goodwill can no longer be charged to the equity of the company.

One problem with the capitalisation of goodwill is determining the proper amount to capitalise, and over what period to amortise it. Support for amortisation is based on the matching concept of relating costs to benefits. Main arguments for amortisation are the abuse of non-amortisation and the unreliability of earnings without some attempt to recognise the impact. Another rationale for this approach alleges that overpayment for the assets of an acquired company, represents the expectation of super future earnings. Since these earnings may eventually end up in shareholders' equity, they can be offset against the excess acquisition payment.

The capitalisation of goodwill without amortisation may allow the most advantageous financial reporting figures. A company gets to record an asset instead of a decrease in shareholders' equity and net income is not periodically reduced. This allows higher assets, shareholders' equity, and net income amounts on the financial statements relative to any other method of accounting for goodwill. However, this could result in more abuse than any other method.

Before any method can be considered, one needs to make reference to the definition of an asset, whereby it is "...a resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise." (AC000 - Framework for the preparation of financial statements as issued November 1990)

How can you tell if a company's goodwill is damaged and heading for a write-down? All you need is a company's balance sheet and its market capitalisation - the share price times the number of shares outstanding/issued.