Qualiport

[ August 7, 2000 ]

Goodwill Guide II

By Maynard Paton (TMFMayn)

Carburton Street, London -- On Friday, I started to tackle the phrase "adjusted for goodwill", a commonly used term within company analysis. The feature covered the significance of goodwill when calculating the key shareholder ratio, return on equity, under the old SSAP 22 accounting standard.

As forewarned in Friday's article, the accounting standards covering goodwill changed in late 1998. The new standard, FRS 10, had two main benefits for investors, namely:

i) to bring goodwill created by any acquisition to the forefront of the company's accounts. Under SSAP 22, any goodwill acquired was detailed within the accounting small print. Under FRS 10, goodwill is given a much higher profile. It is now capitalised as an intangible asset on the balance sheet and subsequently amortised through the profit and loss account over a number of years;

ii) to bring UK accounting into line with international standards, notably those of the United States.

Headaches

Unfortunately, FRS 10 still gives investors headaches when determining return on equity calculations, namely:

i) allowing companies to leave alone goodwill that had been previously written off under SSAP 22, so creating two different ongoing treatments of goodwill;

ii) introducing a further set of adjustments that investors need to perform to arrive at accurate return on equity calculations.

What needs to be made clear at this point is that the changing of accounting standard, from SSAP 22 to FRS 10, affects neither the profitability nor valuation of a company. FRS 10 is simply a different, but higher profile, way of presenting the same accounting information.

Transition to FRS 10

Using SSAP 22, this is how the balance sheet example ended on Friday.

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

Under the transitional arrangements preceding FRS10, companies had two options. Either capitalise any goodwill historically written off back on to the balance sheet, which would see the balance sheet change thus:

Balance Sheet

Assets            £m   Shareholders' Funds     £m

Goodwill           3   Share Capital           27
Factory           10   Profit and loss reserve 10
Machinery         16   Total                   37
Acquired Assets    4
Stock              2
Cash               2
Total assets      37

Or leave alone the goodwill written off and to instead "merge" the goodwill reserve with the retained profit and loss reserve, as shown below:

Balance Sheet

Assets            £m    Shareholders' Funds     £m

Factory           10    Share Capital           27
Machinery         16    Profit and loss reserve  7
Acquired Assets    4    Total                   34
Stock              2
Cash               2
Total assets      34

Unfortunately, most companies took the second route during the transition to FRS10. Thankfully, the cumulative amount of goodwill written off still has to be recorded in the accounting notes if the second option was taken.

Starting the third year

Let's continue the example from Friday. Fresh from my previous acquisition, I'm keen to make another purchase. At the start of the third year, I inject another £10m into my business and immediately buy a company that has assets of just £2m. During the transition to FRS 10, I chose not to reinstate goodwill previously written off back on to the balance sheet. So here's how the balance sheet would look immediately after the latest acquisition under FRS10.

Balance Sheet

Assets            £m   Shareholders' Funds     £m

Goodwill           8   Share Capital           37
Factory           10   Profit and loss reserve  7
Machinery         16   Total                   44
Acquired Assets    6
Stock              2
Cash               2
Total assets      44

The £10m injection is added to shareholders' capital, while £2m of acquired assets and the £8m of goodwill are placed within the balance sheet.

FRS 10 dictates that goodwill acquired should be written off in equal instalments via the profit and loss account over a period not exceeding 20 years. This introduces a theoretical dilemma for investors.

On the one hand, the goodwill acquired has borne a cost to shareholders and that cost should impact profits. But on the other hand, goodwill acquired should in reality never decrease in value. In fact, it should increase in value if properly "managed" by the company. The arguments still rage on this point.

Amortisation

The effect of goodwill amortisation can be dramatic on the profit and loss account. Continuing the example, I make a £10m operating profit in the third year, tax is applied at 30% and the £8m goodwill acquired is amortised equally over ten years.

Profit and Loss Account
                          £m

Operating profit         10.0
Goodwill amortisation    (0.8)
Pre-tax profit            9.2
Tax                      (3.0)
Earnings                  6.2

Instead of reporting £7m after tax under SSAP 22, earnings reported using FRS 10 are £6.2m, an 11% decline. As an investor, I'd now be certainly aware of the "cost" of acquiring the £8m goodwill.

Note that goodwill amortisation is not a tax-deductible charge. Neither is it a cash charge, as the cash was spent whenever the business was bought. The amortisation simply represents the acquired cost of the goodwill spread over several years.

Given that the amortisation charge is not a true charge, but merely a part-reflection of a past expense, I actually end up with £7m profit in the year. I plough that £7m back into additional machinery during the year. Capitalised goodwill falls to £7.2m after its amortisation and the retained profit and loss reserve is boosted by the £6.2m FRS 10 figure. Here's how the balance sheet would look after the third year.

Balance Sheet

Assets            £m     Shareholders' Funds      £m

Goodwill           7.2   Share Capital            37
Factory           10     Profit and loss reserve  13.2
Machinery         23     Total                    50.2
Acquired Assets    6
Stock              2
Cash               2
Total assets      50.2

Back to ROE

Let's get back to return on equity calculations. In reality the second acquisition created £8m of goodwill, yet is shown as £7.2m after one year. So although under FRS 10 will "depreciate" the goodwill acquired, investors shouldn't lose sight of the total cost originally borne.

Thus, it makes sense to encompass the pre-amortisation goodwill figure within any return on equity calculation. And with the total goodwill cost being included in the denominator, the numerator (post-tax profit) should exclude any goodwill amortisation charges.

In other words, given the current FRS 10 presentation and the legacy of SSAP 22, return on average equity (ROAE) should be calculated as:

       Post-tax profits excluding goodwill amortisation
       ------------------------------------------------
               ( Shareholders' funds + 
             goodwill written off (SSAP 22) - 
             goodwill currently capitalised (FRS 10) + 
       historic cost of goodwill capitalised (FRS 10) )

(With shareholders' funds and the three goodwill figures being the average amounts recorded throughout the year in question).

So for my example company, the calculation at the end of year three is:

                          £6.2m + £0.8m
-------------------------------------------------------------
( (£50.2m + £3m - £7.2m + £8m)+(£34m + £3m - £0 + £0m) ) / 2 

          £7m
   =    ------         = 15.4%
        £45.5m

Summary

There are some points to note. In today's and Friday's feature, the acquisitions were bought at the start of each year. That eased the calculations, with each purchase giving a full year's contribution.

Of course, acquisitions can take place at any time during a company's financial year. In this case, investors have to annualise any acquired profits. This annualisation aligns the profit contribution to the full equity consideration.

Investors also have to take into account that acquisitions are frequently based upon synergies that may take a few years to come to fruition. Again, this depresses short-term ROE figures, the company increasing today's equity base while waiting for tomorrow's consequential profit.

Certainly, there is much debate over the accounting for goodwill. Although not perfect, I recognise that any accounting directive is not going to please "all of the people, all of the time". Simply, I've presented the methodology that the Qualiport uses when interpreting reinvestment returns where goodwill is involved.

However, perhaps the best answer to the interpretation of goodwill is to focus on businesses that have no requirement for acquisitions in the first place. The stock market always gives a greater rating towards those companies growing organically rather than those growing by acquisition.

And perhaps it was concentrating on companies exhibiting substantial organic growth that prompted Warren Buffett to suggest "you can live a full and rewarding life without ever thinking about goodwill and its amortisation".

Where Next?

Revisit the first part of the Qualiport's Goodwill Guide