Qualiport

[ August 4, 2000 ]

Goodwill Guide

By Maynard Paton (TMFMayn)

Carburton Street, London -- Within many Qualiport company evaluations, you may have come across the phrase "adjusted for goodwill". Although many Qualiport features have included this comment, there's never been too much explanation given on these pages about the real importance of any "goodwill adjustment".

To address this issue, today's and Monday's articles will cover the relevance of goodwill to shareholders. They'll encompass the previous and current accounting practices and how investors should interpret goodwill and how to perform the necessary adjustments.

Back to basics

Before getting involved with goodwill, we need to go back to basics. Here's an example that highlights the importance to investors of the return on equity (ROE) measurement.

I've got £20m and a great business idea. I set up a company and spend £10m on a factory, £6m on machinery, £2m on raw materials and leave £2m in the bank.

Balance Sheet

Assets            £m        Shareholders' Funds    £m

Factory           10        Share Capital          20
Machinery          6        Total                  20
Stock              2
Cash               2
Total assets      20

Immediately after my purchases, this is how the balance sheet would appear. The £20m spent on various assets reflects the £20m of capital, or shareholders' funds, injected into the business.

After a year in business, I produce a £4m post-tax profit. Because the business is doing great, I spend all of the profit on extra machinery during the year. I also assume no depreciation occurs on my fixed assets and that stock levels remain constant.

First year in business

Here's how the balance sheet would look after the first year.

Balance Sheet

Assets            £m       Shareholders' Funds     £m

Factory           10       Share Capital           20
Machinery         10       Profit and loss reserve  4
Stock              2       Total                   24
Cash               2
Total assets      24

The extra £4m spent on machinery is equalled by the £4m added to shareholders' funds. The profit retained is essentially money owned by the shareholders and is recorded within the new profit and loss reserve.

The calculation of how effectively my (or the shareholders') money is being utilised within the business is measured by a return on equity calculation. Typically, this is measured by dividing the post-tax profit by the average of shareholders' equity employed throughout the year. So for the above example, the return on average shareholders' equity (ROAE) is £4m / ( (£20m + £24m) / 2 ), or 18.2%.

Had I instead injected £50m into a different business that only generated £4m in its first year, the ROAE would have been £4m / ( (£50m + £54m) / 2 ) = 7.7%.

Clearly, I would be better off in my first business. All things being equal, it's only going to take another £20m (or 5 years) of retained profits to double my initial £4m of profits. At my second business, an extra £50m (or 12.5 years) would be required.

Thus, the higher the ROAE calculation, the less money needed from shareholders to fund ever-greater profits. At the Qualiport, we're looking for superior companies to invest in. These companies are identified by exhibiting above average ROAEs, or more precisely, an above average incremental return on equity.

Accounting for Goodwill

Goodwill is typically created when one company buys another. The accounting term is technically defined as "the difference between the costs of an acquired entity and the aggregate of the fair value of the entity's identifiable assets and liabilities."

How goodwill is then subsequently accounted for usually distorts the important ROAE calculation, hence the Qualiport "adjustments" to give a more realistic picture.

However, to make things even more complicated for investors, the accounting practices concerning goodwill have recently changed. Those now looking at ROAE and goodwill have to interpret the effect of both the current accounting standard (Financial Reporting Standard 10, introduced late 1998) and its forerunner (Statement of Standard Accounting Practice 22) to gauge an accurate state of equity return performance.

SSAP 22

Firstly, we'll look at how acquired goodwill used to be accounted for, pre-FRS10.

Let's continue the above example. At the start of the second year, I go on the acquisition trail. I inject another £7m in to the business to fund a corporate purchase. I spend the £7m on a company that has assets of just £4m. Therefore, goodwill of £3m is "created".

SSAP 22 stated that goodwill should not normally be recognised as a corporate asset. Instead, goodwill should be written off against a company's reserves.

Here's how the balance sheet would look after the £7m acquisition.

Balance Sheet

Assets            £m       Shareholders' Funds     £m

Factory           10       Share Capital           27
Machinery         10       Profit and loss reserve  4
Acquired Assets    4       Goodwill                (3)
Stock              2       Total                   28
Cash               2
Total assets      28

The extra £7m is added to shareholders' capital and the acquired assets of £4m are placed in the balance sheet. This creates an imbalance between shareholders' funds (£31m) and assets (£28m). To even up both sides of the balance sheet, the £3m of goodwill is written off (as per SSAP 22) against the company's reserves. Sometimes it's directly written off against the profit and loss reserve, or instead, as in this example, a separate goodwill reserve is created.

Although the accounting presentation suggests that only £28m has been invested in the business, that being the total of shareholders' funds, in reality we know the amount is different. If we think back, £20m was originally invested, we have £4m of profit reinvested and an extra £7m was used to purchase the acquisition. That gives a total of £31m. Usually, this figure is deduced by adding back the goodwill written off back on to shareholders' funds, that is £3m plus £28m giving the £31m.

The second year

Let's continue the example. During the second year, the acquisition makes a post-tax profit of £1m, while the existing business produces a profit of £5m. The total profit of £6m is reinvested into the business to purchase additional machinery during the year.

Balance Sheet

Assets            £m       Shareholders' Funds     £m

Factory           10       Share Capital           27
Machinery         16       Profit and loss reserve 10
Acquired Assets    4       Goodwill                (3)
Stock              2       Total                   34
Cash               2
Total assets      34

And again, the additional profit is recorded under the machinery asset balance and the retained profit and loss reserve.

ROAE distortion

Calculating the return on average shareholders' equity, without taking into account the goodwill acquired, suggests an improvement in the utilisation of shareholders' funds.

Dividing the post-tax profits by the unadjusted average of shareholders' funds (£6m / (( £34m + £28m ) / 2) results in a figure of 19.4%, a figure higher than the first year's 18.2% measure. On the face of it, the acquisition looks to have improved shareholder returns.

But taking into account the goodwill reserve, a slightly different story emerges. Adding back the £3m of goodwill that was in existence at both the start and end of the second year, we get a 17.6% return (£6m / ((( £34m +£3m ) + ( £28m + £3m)) / 2)) on the adjusted average of shareholders' equity, indicating a small decline on the previous year.

In real life...

In reality, the effect of this accounting practice is far more extreme than indicated in the above example.

One example is Qualiport member PizzaExpress (LSE: PIZ). The company made a post-tax profit of £22.8m during 1999. According to the balance sheet, the restaurateurs had employed average shareholders' funds of £51.9m throughout the year. ROAE is thus a whopping 43.9%.

Turn to note 14 of their 1999 annual accounts and we find that "goodwill written off to reserves as at 30th June 1999 was £42.7m (1998: £44.4m)". Adding back the average goodwill carried throughout the year (£43.55m) to the average shareholders' funds (£51.9m) gives £94.45m. Using that as the denominator, the return on average adjusted equity comes to a more credible 24.1% (£22.8m / £94.45m).

Although PizzaExpress still reports a very impressive ROAE on the adjusted basis, there's obvious cause for investors to be careful when determining equity returns. The common mistake is to confuse a company with a seemingly impressive ROAE with one that has inefficiently used shareholders' money on an acquisition spree.

On Monday, I'll continue the investors' guide to goodwill. Specifically, I'll cover the revised accounting practice of FRS10, how investors should adjust their company performance ratios for the current practice and some of the slightly underhand presentations that goodwill accounting can provide. In the meantime, all feedback is welcome and can be directed to the Qualiport discussion board, in the Resources centre below.

Where Next?

Discover the importance of the incremental return on equity