Calculation of Goodwill in Acquisition?

Can someone verify for me how to calculate Goodwill in an LBO?

I think it's: Equity Purchase Price - Book Value of Equity = Goodwill.

And BVE = Retained Earnings.

But what if BVE is > than Equity Purchase Price? Then Goodwill is negative? That doesn't seem to make sense to me.

Please clarify where I'm going wrong.

What is Goodwill?

Goodwill makes up part of the premium that is paid in an acquisition of a company. If a company is purchased for more than it is worth on the books, the company is paying for intangible elements such as skilled employees, brand recognition and other similar items. It is important to note that items such as patents or trademarks are accounted for in different line item.

Some examples of Goodwill are:

  • Brand name
  • Customer loyalty
  • Proprietary production methods (i.e. the recipe formula for Coke).

Whenever a company is acquired for an amount higher than the book value, a write up of intangible assets and PP&E along with goodwill usually account for the difference.

Calculating Goodwill

New goodwill = Purchase Price (equity) - BV of Equity - Write Up in PP&E - Write Up in Intangibles + Deferred Tax Liabilities (from Write Up in PP&E) + Existing Goodwill

Purchase Price of Equity Less Than Book Value of Equity

If the company that is being purchased has a book value of equity greater than the value that the acquirer is paying for the company - you will create "negative goodwill" which creates a "gain on the acquisition."

blackcleo:
One of two things happen if you have negative goodwill:
  1. You must take an extraordinary gain to income
  2. You write down your non-current assets until there is no negative goodwill left

I worked on a project where a company with $5B on their balance sheet was acquired for $140M. We wrote down all their assets to equal the $140M.

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Comments (85)

 
Nov 4, 2009 - 12:44am

Purchase Price (equity)- BV of Equity + Transaction Costs - Write up in PP&E - Write up in intangibles + Deferred Tax Liabilities (from write up in PP&E) + Existing Goodwill

There wouldn't be impairment... it is technically 'negative goodwill', which in reality means you've made a gain on the acquisition, I don't know the exact accounting treatment but I think you reduce some of the acquired assets or record it as an extraordinary gain in net income, which flows to equity making up the differnece.

 
Nov 4, 2009 - 1:22am

Mergerarb is right - for negative goodwill you record it as a gain on the acquisition, which flows through SE.

To be clear, goodwill is the difference between what the buyer pays and the target's net assets at fair value (this differs slightly from mergerarb's algorithm in that it would include step ups of land, etc., which mergerarb didn't include explicitly, but the idea is correct).

However, you do not include transaction costs.

More precisely, under FASB 141R, the buyer values its acquisition at the fair value of the consideration transferred and include in this contingent consideration, but exclude direct business combination costs (which I interpret "transaction costs" to be).

Under 141, you would include direct combination costs but exclude contingent considerations, but that has been revised.

Also note that the DTLs arise because while GAAP mandates purchase accounting, the IRS does not. Thus, if the buyer elects to use pooling accounting on the IRS tax books, then there is no tax-deductible goodwill on the tax books, but there is on the GAAP books, creating the DTL. If, however, the buyer elects to use purchase accounting on the IRS books, there would be no DTL.

 
Jan 17, 2010 - 12:39am

Actually let me add to this question if i may. I have seen models calculate goodwill and shareholder equity two different ways and am wondering if it is interchangeable or if one is more correct. The first method of goodwill and equity is:

Goodwill = Purchase price equity - Current BV equity + Transaction costs + old goodwill
Equity = cancel out old equity and make equity the contribution by sponsor

The other method i have seen is:

Goodwill = Purchase price of equity - Current BV equity + old goodwill
Equity = cancel old equity and make equity the contribution by sponsor less transaction costs

One method makes the purchase price effectively increased by the goodwill, the other makes the cash contribution decreased. I can see the logic in both situations but the net effect on equity is different (allocating transaction costs to goodwill increases it, deducting it from sponsor contribution obviously decreases it), so i'm wondering if one is more appropriate. Intuition and several models i have seen tell me choice one is the winner, but I read a good book that utilized the second method and is written by two bankers so I am questioning which is right.

 
Jan 17, 2010 - 11:35am

It's the second option -- transaction costs are expensed immediately, and they are pulled from SHE. Transaction costs technically increase the amount of equity a sponsor must pay (as it is generally a "plug" from the S&U), but as I mentioned above, it is expensed at the close of the transaction.

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Best Response
Jan 20, 2010 - 3:48pm

The complex way of doing this for a stock sale ONLY, is as such:

Goodwill = Equity Purchase Price - Net Asset Value (Total Assets - Liabilities) - Fixed Asset Write Up - Intangible Write Up - DTL (Fixed Asset Write up + Intangible Write up * tax rate) - Old goodwill...

some people eliminate the DTA & DTLs but I personally have never done that...

transaction costs aren't taken into account in the goodwill, but the debt fees are capitalized and amortized of the life of each instrument and all other fees taken as reduction in Retained Earnings @ close...

The DTL captures the difference in write-up accounting treatments at close and is reduced over time by the fact that the tax depreciation is less as a result of not being written up.... on the other hand, if a MACRS or SYD is used on this un-written up basis and the book taxes are less than irs taxes, then you'd innately create a DTL and would by default increase it on the balance sheet... if DTL rises, that's an increase in cash, if it falls, that's a decrease of cash (as seen in the cashflow statement)

 
Jun 26, 2010 - 10:32pm

Greetings All,

My question is:

If Company A is acquiring Company B and goodwill is created. Company A and Company B both have 'EXISTING GOODWILL'. So the combined new entity's goodwill will comprise Company A exisitng goodwill and goodwill created from transaction.

And we do not add the goodwill Company B (being acquired). ?

Is this correct?

Thanks

 
Feb 5, 2013 - 12:17pm

Total preliminary purchase price - Acquired equity book value Elimination of existing goodwill = Preliminary Excess Purchase Price (PEPP)

Goodwill = PEPP - Preliminary Fair Value Adjustments (Sum of fair values of PP&E (Property Plant & Equipment) and Intangible assets - deferred taxes

Hope that helps...

"negative goodwill" is a Badwill.... that means the seller fucked it up! ;-)

 
Feb 5, 2013 - 2:01pm

Negative goodwill question (Originally Posted: 04/19/2007)

If the fed hikes, I think alot of us would be valuing distressed LBO companies for bargain buyers. Here are a few questions:

For distressed companies that have have negative cash flows and recurring negative working capital, (think bankruptcy bound companies like New Century, Delta, etc.), how would you account for the negative goodwill (or badwill) if a buyer snatches up the assets WAY below book value.

For example say Detla Air [net asset fair value = $10 bn] gets snapped up by Cerberus at a bargain price for $2bn, this creates a negative goodwill of $8bn on the books.

I know internationally IFRS requires that all negative goodwill be charged to the profit and loss account. What does this really mean?

Well, what about in the U.S.? I know SFAS 141/142 calls for negative goodwill deduction from all non-current assets on a pro-rata basis, but what happens if all the assets become zero, and we're left with $6bn negative goodwill with zero value assets on the books?

How do we reconcile the statements to reflect this negative goodwill?

I think I know the answer, but what's your take?

 
Feb 5, 2013 - 2:04pm

I'm not sure how your scenario ends up with $6B in negative goodwill. Two things happen if you have negative goodwill (1) you must take an extraordinary gain to income or (2) you write down your non-current assets until there is no negative goodwill left.

I worked on a project where a company with $5B on their balance sheet was acquired for $140M. We wrote down all their assets to equal the $140M.

 
Feb 5, 2013 - 2:05pm

You cannot have negative goodwill. You just write down the assets to whatever you pay for them.

However, theoretically, you could have positive goodwill even if you pay less than book value. For example, you could get a valuation of the assets at $1B in your Delta Air example, write down the assets to $1B and then have $1B in new goodwill.

In practice, you just write down the assets.

 
Feb 5, 2013 - 2:07pm

Alpine:
You cannot have negative goodwill. You just write down the assets to whatever you pay for them.

However, theoretically, you could have positive goodwill even if you pay less than book value. For example, you could get a valuation of the assets at $1B in your Delta Air example, write down the assets to $1B and then have $1B in new goodwill.

In practice, you just write down the assets.

Right but that is considered negative goodwill.

 
Feb 5, 2013 - 2:10pm

As has been said before, you first write up/down all assets to FMV. Then, you calculate your goodwill amount (purchase price - adjusted book value). If this is negative, you look at long-term assets (basically, not AR, cash, or inv, since these would result in you recognizing the gain immediatly) and allocate the negative goodwill across them proportionally (based on their relative % of total tangible assets). If, theoretically, you managed to completely wipe out the entire long-term asset balance, you'd have to recognize an extraordinary gain. However, that is incredibly unlikely to happen since someone is going to get sued by their shareholders (or if bankrupt, their debt holders) if they sell it for that low of a price. To get below the writedown of assets, it would basically mean that you're buying cash, secutiries, AR, and inv. (the short-term assets), for less than the FMV that you wrote them up (or down) to.

 
Feb 5, 2013 - 2:12pm

You're almost right. However, you say that that if you wipe out the entire long term asset balance you'd have to recognize an extraordinary gain. That's not true. An extraordinary gain is recorded when the "fair value" of the assets, as defined by GAAP, exceeds the purchase price. You are essentially writing up your retained earnings to make the balance sheet balance, hence the gain.

 
Feb 5, 2013 - 2:11pm

As has been said before, you first write up/down all assets to FMV. Then, you calculate your goodwill amount (purchase price - adjusted book value). If this is negative, you look at long-term assets (basically, not AR, cash, or inv, since these would result in you recognizing the gain immediatly) and allocate the negative goodwill across them proportionally (based on their relative % of total short-term assets). If, theoretically, you managed to completely wipe out the entire long-term asset balance, you'd have to recognize an extraordinary gain. However, that is incredibly unlikely to happen since someone is going to get sued by their shareholders (or if bankrupt, their debt holders) if they sell it for that low of a price. To get below the writedown of assets, it would basically mean that you're buying cash, secutiries, AR, and inv. (the short-term assets), for less than the FMV that you wrote them up (or down) to.

 
Feb 5, 2013 - 2:14pm

I have looked at a few distressed deals over the past 6 months and have had to familiarize myself with this topic.

In case anyone is looking for an answer to this question post FAS 141r (effective Dec 2008), the rules have changed.

The excess (purchase price - value of assets) must be immediately recognized by the acquirer in earnings as a gain that increases goodwill from a would-be negative value to zero, per FAS 141r.

 
Feb 5, 2013 - 2:15pm

Goodwill .... Net Income (Originally Posted: 06/23/2008)

So goodwill becomes an asset on the balance sheet once it becomes accounted for...now how does this exactly impact net income?...would it go up because of perceived synergies? or whats the right explanation? thanks

 
Feb 5, 2013 - 2:16pm

Goodwill comes into play when a fund or company purchases another. It is a way of recognizing the difference between a firms assets and the purchase price. For instance, if ABC buys XYZ for $50 per share of CS for a total of $50mil, yet the assets of XYZ only equal to $43mil, $7mil would be assigned to goodwill. It's not a tangible asset in the sense that it does not add to net income in a way that can be measured. It's strictly part of an accounting system used to track transactions. Net income on the other hand is based on incoming revenues and outgoing expendatures.

 
Feb 5, 2013 - 2:19pm

There is a notion that GWI should impact Net income. The reason you are "overpaying" for the company is because you feel you will achieve synergies, or turn assets better.

In other words, when evaluating profitability of an acquisition, GWI should be included in the denominator as it was a factor in your purchase price.


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Feb 5, 2013 - 2:20pm

accounting for goodwill- combined balance sheet (Originally Posted: 03/19/2009)

lets say you acquired a company with 50 million debt 50 million equity and you bought their equity with all cash for $110 million

what are the proper entries for the new combined balance sheet?

decrease cash 110 million. are you retiring the target company equity and just assume the debt?

would it be decrease cash 110 million, increase assets 100, goodwill 10?
where does their debt go ?

how does this combination work? any help is appreciated.

 
Feb 5, 2013 - 2:24pm

LondonE1:
what do you mean by "equity"?

are you retarded? does it look like he's talking about some complex capital structure involving 2 tranche preferred with warrants and class A & B common?

I think your new strategy from now on should be read and learn. When your financial acumen is advanced enough, then we would be more than happy to hear from you and by default read your idiotic and empty remarks. Until then, SHUT UP!

 
Feb 5, 2013 - 2:23pm

Reduce cash by 110
Add all accounts together, except for equity.
Debt is rolled over ie simply added to acquiror's debt.
Eliminate the $50m equity of target and replace w/ $110m new equity ie add 110m to acquiror's old equity value.

Goodwill is now the excess of the old equity and the new equity paid ie $60m plus existing goodwill on acquiror's BS.

It helps to proforma the BS for the target company only first and then roll it up into a proforma combined with adjustements for cash source of the acquiror.

Implied EV is $160m.

 
Feb 5, 2013 - 2:26pm

flgators519:
so you say reduce cash 110, increase assets/goodwill 160? (50 debt and 110 new equity?)

how does this balance?

no increase goodwill (assets by 60)... it is the excess equity price paid over BV equity (110-50=60)

160 is your EV for the target = 110 equity + 50 rolled over debt.

 
Feb 5, 2013 - 2:27pm

thanks for the help. yes i get the EV. im still having trouble seeing how the new balance sheet will balance.

so you decrease cash 110, you would need to increase assets 110 to get it to balance.

increase assets 100, and increase goodwill 60.
on the other side 50 debt and 110 equity.

wont the shares you bought for cash of the target just be retired. you stlil increase your new balance sheet 110 for equity?

 
Feb 5, 2013 - 2:28pm

DO NOT TOUCH THE ASSETS! you only increase the goodwill.

The true change from 50 of old equity to the new 110 of equity is 60 and this is what the goodwill is. You're rolling over the debt therefore it does not change (you haven't used debt financing, you rolled it over, therefore it carries over just like the other accounts), the only thing that has happened is that equity portion increased therefore it needs an offsetting account in assets of 60 to balance it out.

That's why i suggest doing the proforma on the target and restructuring the balance sheet as per the acquisition finance & details and then rolling it up into the acquiror.

What happens is the proforma target will balance and when you roll it up the assets will be greater by 110 as you haven't deducted the source ie the cash. One you eliminate 110 of cash it will balance..

 
Feb 5, 2013 - 2:32pm

1) Given the recent changes in how transaction/advisory fees are accounted (expensed vs. capitalized), how has calculation of goodwill changed? Offer value less tangible book value plus no fees? Also, how does the new transaction fee expensing work? Assuming that your proforma balance sheet reflects the decrease in cash, is the expense a non-cash expense in period one and then added back on the cash flow statement?

2) In the case that you have an asset write up, i believe that deferred tax liabilities are formed and added to the goodwill calculation - can someone expand upon why this is the case and how the DTL balance decreases over time?

 
Feb 5, 2013 - 2:33pm

To answer your question 2) the deferred tax loss is created in your model ONLY if you do not plan on calculating the tax depreciation schedule seperately. This in effect allows you to spread the DLT over the years and create the tax shield in effect for "cash" taxes... You'll notice that the DTL doesnt exist in an asset purchase because the write up of the assets for book purposes and tax purposes is the same, creating no difference in depreciation over the years therefore no DTL (this is all assuming that you're running STL type depr.)

If you plan on creating a book depreciation schedule, tax depreciation schedule and a tax schedule to calculate the DLT/A each year, you need not worry about it... I prefer this method as you can apply a MACRS 5 / 7 years depreciation schedule really squeezing your "cash" taxes to a minimum...

That is my experience with it, if anyone has any differing views, please challenge, I'm no tax expert...

 
Feb 5, 2013 - 2:36pm

Not getting goodwill (Originally Posted: 12/25/2009)

WSO Tech guide v2.0 says that you can treat goodwill like depreciation expense. That I get. My question is, if for whatever reason you had a goodwill impairment, it gives a tax shield and then you add it back in your calculation of FCF just like dep?

I'm seeing it as a non-cash and therefore treating it the exact same way as depreciation. Correct?

 
Feb 5, 2013 - 2:37pm

Sort of. For GAAP reporting purposes, the impairment will be treated as an expense -- some companies will put it below the line, some will put it above the line. The goodwill impairment is generally considered a one-time expense, and for modeling purposes, you're definitely going to want to get the goodwill impairment out of EBIT and EBITDA ("normalize" the metrics) if it's above the line.

Depending on the preferences of your group (read: MD), you may back out the goodwill impairment all together due to it's one-time nature, i.e. your net income will increase by the tax-effected impairment number.

For cash flow purposes, it will depend on the treatment it received in the P&L. If you back out the impairment completely, you will not recognize it in the CF because you'll be "double-counting." However, if you do keep the impairment below the line, you'll want to add back the impairment just like you would D&A due to its non-cash nature.

Hope this helps.

EDIT: Realized that I assumed you knew what above and below the line meant... The "line" is operating income/EBIT, and anything above is an expense included in EBIT, and anything below is not included in EBIT.

 
Feb 5, 2013 - 2:40pm

Goodwill is not in proforma SCF (Originally Posted: 06/02/2010)

Just wanted to confirm (esp as GW is non-cash)

If so, wanted to see the reason why proforma SCF does not have GW is because proforma opening BS and Y1 BS (which is equal to last year/period) will have the same/constant GW number, hence no change in GW in BS (hence no change in GW in SCF). Anyone confirm/provide light?

 
Feb 5, 2013 - 2:41pm

Greetings

My question is:

If Company A is acquiring Company B and goodwill is created. Company A and Company B both have 'EXISTING GOODWILL'. So the combined new entity's goodwill will comprise Company A exisitng goodwill and goodwill created from transaction.

And we "do not" add the goodwill the Company B (being acquired). ?

Is this correct?

Thanks

 
Feb 5, 2013 - 2:43pm

Goodwill on balance sheet after being bought (Originally Posted: 06/19/2011)

In the year of closing, should I treat the goodwill (purchase price - current asset value) as other income in the income statement, and then subtract that amount from net income in the cash flow statement?

What would be the journal entry for the balance sheet?
Debt Goodwill
Credit Other Income?

Thanks!

 
Feb 5, 2013 - 2:48pm

Calculating Goodwill for lbo models (Originally Posted: 08/19/2011)

Hi all,

I have a question regarding calculating goodwill for LBO Models. I am currently looking at 2 different LBO templates and they differ in their goodwill calculations. I was hoping some of you smarter monkeys can help me understand why.

Template #1:

Purchase Price (including fees) - Target Book Value = Excess Purchase Price

Allocation to PP&E and Intangibles based on a % assumption

Excess Purchase Price - Allocated Amount = Un-allocated Amount

Un-allocated Amount - Deferred Tax Liabilities = Goodwill

(If possible, I am also curious what kind of assumption you would make for the allocation %. What should your assumptions be based on?)

Template #2:

Purchase Price (excluding fees) - Target Book Value + Existing Goodwill = Total Goodwill Created

Thanks for all your inputs. Have a great day.

 
Feb 5, 2013 - 2:50pm

Goodwill (accounting question) (Originally Posted: 12/09/2012)

Hi guys

Just an accounting question here about Goodwill after an acquisition

"Until Dec 01, goodwill was amortized on the income statement and was usually tax deductable"

Does that mean that the change made to SFAS142 requiring goodwill to be tested for impairment would affect corporate tax?

Obviously it would affect net income and EPS, but would the method of goodwill amortization affect the tax that a company would pay.

Thanks for the help.

 
Feb 5, 2013 - 2:51pm

It would only affect corporate tax in the sense that Goodwill is no longer being amortized. Instead of an amortization expense being expensed each year on the I/S, companies will record a loss on impairment, is an impairment is determined. All this does is make the loss on Goodwill less frequent, only occurring when there is an actual loss of value, rather than expensing it each year. And since Goodwill technically has an infinite lifespan, it didn't make sense to amortize it, which is why they changed it.

 
Feb 5, 2013 - 2:54pm

This may be too in-depth for what you were asking since you are basing taxes on EBIT, but if anyone cares. This all assumes an asset acquisition or a stock acquisition with a section 338 election to treat the stock acquisition as an asset acquisition for tax purposes.

You are correct in thinking that all else equal EBIT after SFAS 142 is higher due to not being able to amortize goodwill. However, it is technically incorrect to assume that just because EBIT increases, taxes due will increase. Tax is calculated using a parallel accounting system that has differences with GAAP accounting. The amortization of goodwill resulting from an acquisition is one of those differences. Section 197 allows an amortization deduction for tax purposes for goodwill resulting from an asset acquisition even though goodwill is not allowed to be amortized for book purposes per SFAS 142. This situation is similar to differences in depreciation for tax and book purposes. For tax you will be allowed an amortization deduction and for book you will not therefore all else equal taxable income will be lower than book income resulting in a DTL.

The DTL will be reversed when you either impair the goodwill and take a write off for book purposes and deduct nothing for tax purposes or when you sell the assets from with the goodwill is related. When the assets are sold you will recognize a larger taxable gain than you recognize for book purposes due to the lower basis in the goodwill due to the amortization deductions, resulting in the reversal of the DTL.

 
Feb 5, 2013 - 2:55pm

@we_be_bad

Thanks for explaining that, what you're saying makes sense. I'm guessing the DTL would be registered in GAAP accounting on the balance sheet? And the only time that DTL is going to actually have any effect is in a sale as you have mentioned.

Also is the system you are talking about tax accounting vs. GAAP accounting? It's just a general question really, not related to the original topic, but is there any reconciliation between these two accounting systems (ie. is it possible to verify the amortization charged under tax accounting from looking at a 10k). Do DTL and DTA on a GAAP balance sheet correspond with some entries in tax accounting or are they similar.

That's the last question Im gonna ask. But thanks for your time here, your last post was very informative.

 
Feb 5, 2013 - 2:56pm

No problem, glad to help.

Yeah the DTL will be on the GAAP balance sheet, and once its there it stays until it reverses through the sale or impairment for books.

Yeah I was referring to tax vs GAAP accounting. You won't be able to see exactly how much amortization they deducted for tax without looking at their tax return. You can see in their 10k their DTA/DTLs broken down into each component representing the temporary differences between the tax and GAAP accounting. That breakdown is found in the tax footnote to the financial statements. If you look at MSFT's you'll see a DTL resulting from the differences in depreciation and amortization but that's all the granularity you are going to get publicly.

 
Feb 5, 2013 - 2:57pm

Acquisition Accounting II: Goodwill, more plug than asset (Originally Posted: 12/17/2012)

There is no asset on a company’s balance sheet that wreaks more havoc on valuation and good sense than goodwill. The first problem with goodwill is that it sounds good, and when something sounds good, people feel the urge to pay for it. The second problem is that, notwithstanding claims to the contrary, it is not an asset but a plug variable that measures everything and nothing at the same time.

A short history of acquisition accounting
To understand the treatment of goodwill in GAAP, it is worth taking a quick look at how acquisitions have been accounted for over time, at least in the United States. Until a decade ago, companies that acquired other companies could pick one of two approaches to “account” for the acquisition.

  • In the first, termed pooling, the acquiring firm was allowed to incorporate just the book value of the target firm’s assets into its balance sheet, and essentially ignore or hide the premium paid over this book value. Thus, there was no goodwill on the balance sheet, but to qualify for pooling, the acquiring firm was required to jump through hoops (some of which were very expensive); for instance, only acquisitions financed entirely with stock qualified for pooling. 
  • In the second, purchase accounting, the acquiring firm had to incorporate the market value of what it paid for the target firm on its balance sheet, and to show the difference between the market value and the book value as “goodwill” on its balance sheet. Under this old system, goodwill was amortized over a fixed period not to exceed 40 years, though this amortization was not tax deductible (at least in the United States).

In spite of the fact that goodwill was a purely accounting variable and that its “non tax deductibility” made it irrelevant for cash flows, the fear of the earnings hit from amortization led companies to go through contortions (and to pay more) to qualify for pooling. AT&T, for instance, paid an additional $325 million when it bought NCR, to qualify for pooling, making an awful deal even worse. The prevalence of two different acquisition accounting systems also made it difficult to compare the balance sheet numbers for acquisitive companies that used purchase as opposed to pooling. Finally, amortizing goodwill over 40 years for all acquirers essentially resulted in both good and bad acquisitions being treated the same way for accounting purposes.

To remedy these problems, the cs/BlobServer?blobkey=id&blobwhere=1175820927971&blobheader=application%2Fpdf&blobcol=urldata&blobtable=MungoBlobs">accounting rules were changed on June 30, 2001, with four key modifications. First, pooling was disallowed and all firms were required to use purchase accounting. Second, accounting rules were changed to give accountants more discretion, albeit within strict limits, to do a reassessment of the value of a target firm’s existing assets at the time of the acquisition. To the extent that a target firm had assets on its books that were recorded at below (or above) their “fair” value today, this accounting adjustment could lead to an adjusted book value (which is different from the actual book value). In addition, accountants were also allowed some leeway to bring in the values of “intangible assets” such as customer lists and technology patents into the book value of the target firm. Third, the goodwill was then computed to be the difference between the market value paid for the target company and the “adjusted” book value. Finally, rather than amortize this goodwill over 40 years, accountants were required to revalue the acquired company at regular intervals and impair the goodwill, if they felt that the target company had declined in value.

While these changes made sense at an intuitive level, there are two things worth emphasizing about them. First, for better or worse, it has been a lucrative jobs program for accountants & appraisers, since their services are now required both at the time of the acquisition (to reappraise the value of the existing assets) and each period thereafter (to assess target company values). Second, as is the case with most accounting rules, the rules have obscured the principles of what the changes were meant to accomplish: create more transparency for investors about acquisition costs and more accountability for bad acquisitions.

So, what does goodwill measure?
If goodwill is the difference between what an acquiring company pays and the “adjusted” value of its existing assets, what exactly goes into it? To answer that question, let me compare two visions of balance sheets (click to see graphic)

The balance sheet to the top is a conventional accounting balance sheet, with book values recorded based on what was originally paid for the existing assets, net of depreciation and debt & equity, reflecting the company’s history. The balance sheet at the bottom is a intrinsic value balance sheet, with assets broken down into investments already made and growth investments (based upon expectations for the future).

Within this framework, here is what happens after an acquisition. The accountants are called in to reestimate the value of the existing assets and replace the conventional accounting book value with the estimated value. Goodwill then becomes the difference between the price paid by the acquiring company and the reassessed value for existing assets. So, what else goes into the price that an acquirer may pay, besides the value of the existing assets? Here is my attempt to break it down (click to see graphic).

Thus, accounting goodwill is composed of both goodwill that has a rational basis (a fair value of growth assets, control, synergy) and goodwill that is built on sand. Why should you care? As a stockholder in the acquiring firm, you first want to separate out overpayment from the remaining reasons, since it is an immediate transfer of your wealth to the target company. You could, of course, wait for accountants to impair this portion of the goodwill but it not only happens too late to help investors, but it may also reflect unexpected disappointments on control, synergy and growth assets.

I have a simple proposal that I know has zero chance of being adopted that may give investors at least a heads up, with acquiring companies. At the time of the acquisition, I noted in an earlier post that the acquiring company’s stock price drops in about 55% of acquisitions. If you accept the argument that this is the market’s collective judgment of how much was overpaid, why not break goodwill down into two components: the “market correction” can be called foolhardy goodwill and the rest can be rational goodwill. Thus, if a company pays $12 billion for a company with an adjusted book value of $ 4 billion, and sees its market cap drop by $ 3 billion on the announcement, you should see $ 3 billion in foolhardy goodwill and $ 5 billion in rational goodwill on its balance sheet. While both types of goodwill may turn out to be wrong, in hindsight, and may need to be impaired, I would argue that firms  (their top managers and bankers) should be held much more accountable for failures on the former, because they chose to do the acquisition in the face of investor opposition.

The Goodwill Games: The Bottom Line

  • There is no correlation, positive or negative, between the magnitude of goodwill and the quality of a deal: Given the time and resources that accountants bring to the measurement and subsequent impairment of goodwill, you would think that their actions have substantial impacts on markets. In an accounting world, you should expect to see a differentiation across acquiring companies, based upon how much goodwill is created at the time of the deal. Presumably, if you accept the accounting interpretation of goodwill, deals that result in less goodwill should be better than deals that create more, with “better” measured as market reaction to the announcement of the deal or as performance after. As far as I know, I do not know of a single study that finds a correlation between the two. (If you do find any, please let me know….)
  • The presence of goodwill on the balance sheets of acquiring firms make it difficult to compare these firms to those that don't do acquisitions, because it exposes the inconsistency in accounting rules on the treatment of growth assets. A growth firm that grows entirely through internal investments will not show its growth assets on its balance sheet, until it makes those investments. If that growth firm is acquired by another firm, the goodwill that shows up on the company's balance sheets will include growth assets. Investors therefore have to wrestle with what to do about goodwill in both relative and DCF valuation: (a) If you use earnings multiples (PE, for instance) or book value multiples (Price to Book, EV to Invested Capital), comparing acquisitive firms to non-acquisitive firms can be skewed by the presence of goodwill. Since goodwill inflates the book values (of both equity and invested capital), acquisitive companies can look cheap on both price to book and EV to invested capital measures. Analysts and investors often respond by using only "tangible" book value, where goodwill is removed from the equation.  (b) In discounted cash flow valuation, a key ingredient that determines value is return on equity (or return on invested capital) and both can be pushed down for acquisitive firms, if goodwill is treated as part of book capital. Analysts again respond by eliminating goodwill from book value and invested capital for accounting return measures. That may tilt the scales too far in the other direction,  because it gives acquiring companies a free pass on acquisitions and makes them look better than they really are in terms on returns on invested capital. I would argue for an intermediate solution, where the foolhardy goodwill (see above) is left in invested capital and the control/synergy portions are phased in over a 3-5 year period. Firms that consistently over pay for acquisitions or fail to deliver on synergy or control will therefore be assigned lower returns  on invested capital and lower value.
  • The impairment of goodwill does have an effect on stock prices but it may have also damaged earnings quality. Since declining stock prices (for the acquiring firm or the peer group of the target) is a key trigger for an accounting impairment assessment, there is an open question as to whether the impairment is a surprise to investors. Looking at the studies over the last decade, there is evidence that even though goodwill impairment lags economic impairment by many years, stock prices still drop on the impairment of goodwill, with the price impact of goodwill impairment being greatest at small firms that have little analyst following. However, there are also many who contend that goodwill impairments have contributed to making earnings reports more difficult to decipher and thus reduced earnings quality. Finally, there is also evidence that the initial market reaction to the acquisition is a good predictor of the subsequent impairment of goodwill. Perhaps, my proposal to separate goodwill into foolhardy and rational goodwill is not so outlandish, after all...

In summary, then, the new rules on goodwill have not reduced the propensity of acquirers to overpay for target firms, have not made their financial statements more informative, and might have made it more difficult for investors to value serial acquirers. So, would it not make more sense to move back to a simpler, automated system for reporting on acquisitions, with less accounting judgment and more reporting of facts?

Posts on acquisitions
HP's deal from hell: The mark-it-up and write-it-down two step
Acquisition Archives: Winners and Losers
Acquisition Hubris: Over confident CEOs and Compliant Boards
Acquisition Advice: Big deal or good deal?
Acquisition Accounting I: Accretive (Dilutive) Deals can be bad (good) deals
Acquisition Accounting II: Goodwill, more plug than asset

Professor of Finance at Stern Damodaran's Blog -- See my other wso posts
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Feb 5, 2013 - 3:00pm

Purchase price allocation/Goodwill Impairment work? (Originally Posted: 07/12/2013)

Anyone have experience doing ppa and goodwill type work for financial reporting? Any insight is welcome

Do you like the work?
How does it compare to traditional valuation work?
Since it is compliance work does it constantly get bid down?
Are they difficult to learn or are they easy once you get the jist?
etc.

 
Feb 5, 2013 - 3:01pm

1. I enjoy the work but it just depends what you are looking to do.
2. I am assuming when you say traditional valuation work you are speaking about fair market value work? Estate and gift type stuff. PPAs are much more complicated, I would say goodwill work is similar in terms of difficulty.
3. I would say PPAs are not usually bid down because it requires a higher skill level and firms making acquisitions can typically higher a firm that is more reputable.
4. Depends. My office is great for teaching, we have several managers who are willing to teach and have time allocated to this. Could be different depending on your office. Team fit is important to me as well.

 
Feb 5, 2013 - 3:02pm

valuationGURU:

1. I enjoy the work but it just depends what you are looking to do.

2. I am assuming when you say traditional valuation work you are speaking about fair market value work? Estate and gift type stuff. PPAs are much more complicated, I would say goodwill work is similar in terms of difficulty.

3. I would say PPAs are not usually bid down because it requires a higher skill level and firms making acquisitions can typically higher a firm that is more reputable.

4. Depends. My office is great for teaching, we have several managers who are willing to teach and have time allocated to this. Could be different depending on your office. Team fit is important to me as well.

Hello valuationGURU - Great insight, really appreciate it.

Ya I did some research and there doesn't appear to be a ton of literature on the actual process of doing a PPA. Do you know of any good resources?

1. The work seems extremely analytical and somewhat abstract. That part definatley interests me.
2. Yes, I was refering to FMV, Statutory FV, etc. Anything where you value the invested capital, EV, or equity value in aggregate. PPA seems like a different animal to me. You already have the value i.e. total consideration paid and you have to value the different parts (intangibles) essentially.
3. I may have showed my ass with that comment. The only time we get called for a PPA is when someone is "shopping" for lowest price. It's not really our niche, and that is what happens in the market place. I am sure that is not the case for all shops.
4. Fit is huge for me as well. The reason I asked about this topic is because I was looking at a position that does a mix of mm m&a, gift & estate, fv for financial reporting work. Something just didn't feel right though, idk just a gut feeling about the culture/fit.

Any other insights you may have is welcome. what the day to day is like, things you wish you knew, likes/dislikes, etc.

Thanks again

 
Feb 5, 2013 - 3:03pm

It is very analytical and abstract. The need to value intangible assets is something most people are unaware of and do not have any experience in.

As far as resources are concerned, there are a few intangible asset valuation textbooks out there. I have not read any of them myself, and due to the every evolving world of valuation (in terms of regulations and standards and such), they are probably all outdated to a certain extent.

I think fair market value work is dying in general and is definitely a smaller piece of revenue for larger firms than fair value work. I suppose it could be bid down to a certain extent, but just don't consistently see that.

Fit is huge. It is something we stress at our work and something I stress to potential employees/interns. My previous employer was absolute hell. When you wake up every morning and you don't want to go to work because of the culture in place, you need to make a switch.

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