Roundtable Meeting and Discussion of "Accounting for Goodwill"

An Overview of "Accounting for Business Combinations: A Workable Solution"
Trevor S. Harris
Managing Director, Morgan Stanley Dean Witter
Professor of Accounting, Columbia Business School

10:00 a.m., Wednesday, June 14, 2000

Executive Summary:

Summary of Residual Income Valuation Model

The fundamental concept underlying all valuation models is that an entity's value (to its shareholders) is the sum of all cash flows to and from the shareholders, discounted by some rate to adjust for the time value of money and risk.

The simplest version of this valuation framework is a dividend discount model [DDM] that utilizes the actual cash flows to shareholders. 1 However, such models are impractical because dividend payment patterns are arbitrary, and in any period the best companies only return a small percentage of their earnings (or free cash) as a dividend to the owners. Consider the case of Berkshire Hathaway, run by Warren Buffett, arguably the most successful investor of our time. The company has not paid a dividend during Mr. Buffett's ownership, yet it is highly valued by its shareholders. A DDM for Berkshire Hathaway would give a strange and largely meaningless result.

The DDM is based on discounting the cash flows to shareholders. Traditional corporate finance models have adopted the framework to develop discounted cash flow [DCF] models for a company. However, in practice, these models suffer from three main concerns:

i. Measurement of relevant cash flows is difficult,

ii. Selecting a discount rate is quite arbitrary, and

iii. For most companies more than half (and often 80-90%) of the computed value is in a terminal value number which is subjective.

While DCF models are commonly used, they can be easily manipulated to provide a wide range of values for companies that are expected to operate indefinitely. As a result, it is understandable that auditors and regulators are uncomfortable relying on such valuation models to assess whether goodwill is impaired. This concern is exacerbated by the fact that a DCF valuation is difficult to link with accounting measures of shareholder's equity and goodwill.

A practical solution to the problem has evolved in the late 1990's with the revival of an old concept from management accounting known as residual income. The basic concept is that an investment that earns a return above the required (discount) rate generates positive residual income (adds to the economic value of the investment) and so is worth more than the original cash invested. The concept was popularized and re-introduced into management incentive programs by a variety of consulting firms, including Stern Stewart Inc., who branded their version as EVAŽ or Economic Value Added.

Simultaneously academic researchers showed that, with an accounting system that equates changes in shareholders equity to income and dividends, it is not difficult to link the DDM to the actual accounting numbers and derive a value for the firm.2

Simply stated the value of a firm is the sum of its net asset value (invested capital) and the discounted value of expected "excess" profitability (residual income). The valuation approach can be directly linked to the reported measures of earnings and equity and so can be used to explicitly identify the premium or goodwill (excess future profitability) that is paid for in an acquisition. Moving forward, the achievement of these goals and realizations of income can be evaluated so that a natural benchmark exists for assessing impairment of goodwill with greater reliability than a traditional DCF approach.

The economic logic and simplicity of the residual income valuation approach has lead to its adoption for a wide range of uses and users. For example, sell-side analysts use it for their valuations (e.g. CS First Boston and Goldman Sachs report EVA measures and several Morgan Stanley Dean Witter analysts use residual income). Investment firms such as CREF, Oppenheimer and Putnam use variants of the model, and many corporations have adopted the model for internal performance measurements. Corporate users include BankAmerica, The Coca-Cola Company, Eli Lilly, Monsanto and Sprint. Residual income valuation is also commonly found in the most popular financial statement analysis textbooks.

One feature that makes a residual income valuation model appealing as a reliable benchmark for testing impairment of goodwill is that residual income is easily related into traditional profitability ratios, including profit margins, asset turnovers and leverage. Consequently, auditors can gain comfort as to the achievability of the target levels of performance required to justify the goodwill acquired.

In sum, a residual income valuation approach, while not flawless, has a strong conceptual foundation as well as proven practical application, and it provides an explicit link to the goodwill recorded on acquisition. This link allows for both an understanding of the expected profitability implied in the acquisition price and a reliable post-acquisition impairment test.

Overview of Impairment Test

Goodwill is impaired if the company's rate of profitability is permanently below the growth rates that were incorporated into the original acquisition value.

1 - For simplicity, we can think of share repurchases as equivalent to dividends.

2 - See Ohlson, J.A. "Earnings, Book Values and Dividends in Equity Valuation." Contemporary Accounting Research, (1995). Vol. 11. pp. 661-87.

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