QUALIPORT
The Simple Guide To Goodwill

By Maynard Paton (TMFMayn)
March 29, 2005

Goodwill features in the accounts of most companies. It is created when one firm buys another and 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."

The accounting concept of goodwill was overhauled a few years ago and, with the forthcoming introduction of International Financial Reporting Standards (IFRS), is about to undergo another upheaval.

This article is a simplified primer on goodwill and Statement of Standard Accounting Practice 22 (the old method of accounting for goodwill), Financial Reporting Standard 10 (the current method), and International Accounting Standard 38 (the new method).

More details on SSAP 22 can be found here and more on FRS 10 can be found here. Excellent books that go into IFRS and goodwill in depth include Company Valuation Under IFRS and Interpreting Company Reports And Accounts.

Old rules (SSAP 22)

Imagine Company A with this simplified balance sheet:

Assets	£m	Shareholders' funds	£m
Operating assets	20	Share capital	10
Cash	20	Profit and loss reserve	30
	40		40

Company A then buys Company B for £15m cash. The fair value of B's net assets is £5m. Goodwill is therefore £10m.

Under SSAP 22, A's balance sheet would change to this:

Assets	£m	Shareholders' funds	£m
Operating assets	25	Share capital	10
Cash	5	Profit and loss reserve	20
	30		30

As SSAP 22 did not recognise goodwill as an asset, the £10m of goodwill acquired had to be written off against A's reserves (specifically, the profit and loss reserve) to even up both sides of the balance sheet.

However, listed companies still have to reveal the cumulative amount of goodwill written off in the past under SSAP 22 -- although the figure is typically buried deep within the accounting small print (usually near the note detailing the firm's share capital and reserves).

Under SSAP 22, reported earnings were not affected by goodwill. Read more.

Current rules (FRS 10)

FRS 10 was introduced in late 1998 and replaced the goodwill accounting of SSAP 22. Rather than write off goodwill, FRS 10 dictated goodwill should instead be capitalised on the balance sheet and (in an attempt to spotlight the cost of the acquisition) charged against profits (or 'amortised') over a number of years (usually 20).

Going back to Company A's purchase of Company B, here's how A's accounts would look under FRS 10 post-acquisition:

Assets	£m	Shareholders' funds	£m
Goodwill	10	Share capital	10
Operating assets	25	Profit and loss reserve	30
Cash	5
	40		40

Say Company A and Company B made profits of £4m and £1m respectively under SSAP 24. But under FRS 10 -- with A deciding to amortise goodwill over 20 years -- total annual earnings after the acquisition would be £4.5m (£4m + £1m - amortisation of £0.5m (£10m goodwill/20 years)).

Here's how the balance sheet would look one year following the acquisition under FRS10:

Assets	£m	Shareholders' funds	£m
Goodwill	9.5	Share capital	10
Operating assets	25	Profit and loss reserve	34.5
Cash	10
	44.5		44.5

The profit and loss reserve increases by £4.5m, in line with reported earnings. Goodwill reduces by £0.5m to £9.5m following the amortisation charge. Assuming pre-amortisation earnings are represented fully by cash, the cash balance rises from £5m to £10m. Note that it's a £5m increase (not £4.5m), since the amortisation charge is not a cash one (the cash was spent at the time of acquisition!).

As the years roll on, pinpointing a cumulative goodwill amortised figure can be tricky. However, the note in the accounts detailing intangible assets ought to highlight the amount. Read more.

New rules (IAS 38)

And so to the new rules. To be implemented for accounting periods starting on or after 1 January 2005, IFRS considers goodwill to have an indefinite life and IAS 38 instructs companies not to amortise it. Instead, goodwill will be subject to an annual 'impairment review'.

Again using Company A's purchase of Company B, here's how A's accounts would look under IFRS:

Assets	£m	Shareholders' funds	£m
Goodwill	10	Share capital	10
Operating assets	25	Profit and loss reserve	30
Cash	5
	40		40

If Company B suffers no problems, then there is no further adjustment to the goodwill entry.

But say Company B is a disaster and overall profits from the group reduce to zero, which prompt the board to write down the acquired goodwill to £2m. It all produces this balance sheet:

Assets	£m	Shareholders' funds	£m
Goodwill	2	Share capital	10
Operating assets	25	Profit and loss reserve	22
Cash	5
	32		32

In theory, the IFRS impairment reviews should be no different from the existing rules concerning goodwill write offs (applied in recent years by many telecom, media and technology outfits that paid too much for rivals in the dotcom boom). Undoubtedly these impairments will be flagged as 'exceptional' charges against earnings by the companies concerned.

Summary

Despite the various accounting methods, goodwill remains a true economic cost to shareholders. It reflects cash spent at a certain point in time, which companies may have invested wisely or foolishly.

The impending introduction of IFRS should improve the evaluation of goodwill and acquisitions. Firstly, reported profits will no longer be affected by goodwill amortisation. This charge was largely a bookkeeping exercise that had little to do with business reality (in fact, goodwill purchased via an acquisition should grow over time, not diminish!). Second, goodwill will now remain untouched on the balance sheet proper (barring write-downs), giving investors a far clearer indication of how much has been spent in the past buying subsidiaries.

However, there remains one big problem: few -- if any -- companies will retrospectively apply IFRS and reinstate previously amortised or written-off goodwill back onto the balance sheet. For fans of return on equity (ROE) calculations (or similar), shareholders' equity will still have to be adjusted for goodwill written off under SSAP 22, goodwill amortised under FRS 10 as well as goodwill impaired under IFRS (and before)! Read more | more.

Given these ongoing headaches, no doubt it was concentrating on companies exhibiting substantial organic growth that prompted legendary investor Warren Buffett to suggest "you can live a full and rewarding life without ever thinking about goodwill..."!

More: Company Valuation Under IFRS | Interpreting Company Reports And Accounts | Goodwill and SSAP 22 | Goodwill and FRS 10

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Holding	Number of shares	Closing price 24/03/05 (p)	Value (£)
Associated British Ports	681	486	3,309.66
Emap	372	833	3,098.76
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Johnston Press	1,608	544.5	8,755.56
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