Roundtable Meeting and Discussion of "Accounting for Goodwill"

Statement of
Calvin Johnson
Professor of Law
University of Texas School of Law

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

Introduction: The Pooling Method is Per se Misleading.

The purchase method restates the value of assets to their current fair market value. Fair market value of assets generates reliable, relevant accounting data whenever unrelated parties combine their interests. Arm's length bargaining between unrelated parties as to what fraction each shall hold of the combined business provides reliable accounting data as to value. As the Accounting Principles Board said,

"[A] business combination is a significant economic event which results from bargaining between independent parties. Each party bargains on the basis of his assessment of the current status and future prospects of each constituent as a separate enterprise and as a contributor to the proposed combined enterprise. The agreed terms of combination recognize primarily the bargained value... Accounting Principles Board Opinion No. 16, 19 (1970).

Fair market value of assets provides relevant accounting data: Investors must make decisions as to whether to buy or sell stock or other business interests by looking to current costs. Historical cost, as of some unidentified point possibly decades ago, provides no relevant or material data for the benefit of investment decisions and should be abandoned whenever reliable more current data is available.

The pooling method of accounting is per se misleading, if anyone believes it, because arm's length bargaining takes away the extraordinary bargains that the pooling method falsely claims. Assume, for instance, a simplified hypo of a company, Company C, started in Founder's garage with $10,000 capital, which distributes all profits annually. Company C, for simplicity, has no debt. Founder's company then grows to the point that it generates $1 million. cash dividends per year. Under the historical cost convention, the founder has a return on capital of $l mil/ $10,000 or 10,000% annually, which is indeed a quite an extraordinary investment return. Now assume an acquiring company comes along and determines that a 10% discount rate is appropriate for the risks, and so pays Founder $l0 million for the business by issuing the founder $10 million worth of acquiring company stock. Stock for the issuer is just a proxy for the net present value of the future cash the purchaser will distributions. Fair market value is nothing but a proxy for that cash. The Founder may have a cost of only $10,000 for the capital inputs into the business, but the acquirer has a cost of $10 million. The acquiring company does not have 10,000% return. The $1 million net income the business generates is just a normal 10% return on the acquirer's $l0 million investment made in the form of stock.

The pooling method of accounting would allow the acquirer to step into the shoes of the Founder and report that the acquirer has only $10,000 cost for the business assets of Company C as a whole. That method is misleading. Founder's initial $10,000 investment does not matter to the acquirer. The acquirer has paid $l0 million in stock for Company C. It needs to report to its shareholders a 10% profit, not a $10,000% annual profit from Founder's business. If it uses up its investment or costs, it needs to report to its shareholders that it has used up the true $10 million of capital, not just $10,000. Incompetent managers will be able to show a profit to their shareholders, quite misleadingly, if they can state their costs at the original $10,000, even when they are losing money badly if they must accurately state their costs at the current $10,000,000.

The pooling method of accounting is so misleading that it needs to repealed whenever there is enough arm's length bargaining to indicate the fair market value of the business assets. An incorporation of an old and cold partnership, with no change in proportional interests, might not provide arm's length bargaining to give reliable figures for value. If there is any material change in interests, however, then assets should be stepped up to new value. Setting initial asset values at current higher fair market value is consistent with the tradition of accounting conservatism, because subsequent credits (reductions) of the fair market value accounts will show the subsequent business as consuming more valuable assets. Standards might also state that assets should not be stated above fair market value, with a warning in audit standards to be wary of stated fair market value when bargains appear collusive or when it is in the interests of the parties over state value collusively.

Bargaining between two equal size business entities will ordinarily provide non-collusive arm's bargaining generating reliable and relevant accounting data. There is thus no case for a special exception to purchase accounting for cases where the two entities are of roughly equal size. In 1954, the Senate Finance Committee rejected the distinction between equal-constituent and unequal-constituent mergers in defining tax- free reorganizations and indeed there is no viable distinction between equal-constituent and unequal-constituent mergers. In both cases, the asset accounts need to be restated to their current bargain-set value.

Specific Questions

1. What is the nature of goodwill and how should it be measured?

Goodwill is the extra value paid for a firm that can not be attributed to any specific assets. For example, Company C founded in the garage with $10,000 may rent everything and have no balance sheet assets. The acquirer was willing to pay $10 million for it because it generated $1 million cash a year, just like $10 million in the bank. Going concerns almost always have goodwill because they are worth more than the sum of their specific assets. A business company is living organism, able to recruit and train people, buy materials, add value, sell and distribute the product. If Company C rents its office and all equipment, then substantially all of its $10 million value might be good will. In the next century as we move increasing to wealth in the form of information, many more companies will have nothing but goodwill.

Current accounting refuses to treat self-developed good will as an accounting asset. In the abstract Company C was worth $10 million to Founder as well as to the acquiring company, but generally accepted accounting principles ("GAAP") only recognizes the $10 million as an asset when there is an arm's length purchase. Consistently, GAAP treats research and development is treated as lost when made and having no value, even for the Micosofts, Intuits, Nikes, Coca-colas and Amazons that have intangible assets worth billions. GAAP refusal to recognize the value of research and development and other intangibles means that many companies have a net worth, as appraised by the stock market, that is 20-30 times higher than the net worth as appraised by GAAP. GAAP refusal to countenance self-developed intangibles as accounting assets means that GAAP books bear no relationship to accurate economic descriptions for the most energetic sectors of the economy. But accountants feel that they have no choice but to retreat from more accurate descriptions because they have no reliable tools for auditing intangibles and determining their value. GAAP respects the value of intangibles only when there is a third party negotiation in an acquisition that validates the value of the intangible. The good will is then measured anchored on the sound base of the price that the acquirer and acquired shareholders negotiate at arm's length

2. Does Goodwill Depreciate?

Some assets, such as factories and cars, inevitably become worthless over time. Some assets, such as land, location or corporate stock, may fluctuate in value but do not inevitably expire over time. Current GAAP requires that goodwill be treated as if it expired over 40 years, and one-fortieth (2-1/2%) of the cost of the goodwill asset must be charged against earnings in every year. AICPA Accounting Principles Board, Opinion No. 17, Intangible Assets 9 (1970). FASB is considering increasing the write-off to as much as 5% of the cost year, by mandating a 20 year life.

The FASB requirement that goodwill be amortized, I conclude, is probably required by practical considerations, although not by high theory. Goodwill does not inevitably disappear. There are two economically-equivalent forms for acquiring a business: purchase of stock or purchase of assets. GAAP treats the cost of stock as nondepreciating, even though the fluctuations in value of stock can be extraordinary. If business assets rather than stock are purchased, however, GAAP the cost of business beyond that attributable to any specific expiring assets, is the goodwill asset, amortized over 40 years. GAAP indeed forces amortization even for acquired businesses that are getting more valuable and not expiring.

Mandatory amortization of good will over a period of not more than 40 years was proposed by the SEC in 1970 because it could not be confident that management would write off goodwill that had in fact expired. If Founder leaves Company C and earnings drop from $l million a year to $100,000, then Company C is like only $1 million in the bank, not $10 million and $9 million of the acquiring company's cost has disappeared. The SEC worried that management would not always write down the value of the intangible assets when earnings in fact deteriorated and that a mandatory write off of 2-1/2% per year was necessary to rein in management discretion. The SEC also proposed the mandatory write off in order to curb accounting incentives for corporate takeovers. Hamer Budge (SEC Commissioner), Accounting Questions in Corporate Acquisitions, security market agencies, Hearings before the SUBCOMM. on Commerce & Finance, H. Interstate & Foreign Commerce Comm., 91st Cong., 1st Sess. at 18 (Feb. 25, 1969).

3. Can goodwill appreciate in value, and, if so, how should the appreciation of goodwill be measured and accounted for?

In the abstract, a balance sheet reflects value, just as the balance of one's bank account reflects the bank account's value. Both should give a prediction of what income will come in next year. But booking the appreciation in the value of any assets is inconsistent with the historical cost convention, which has been a fundamental premise of GAAP since the Depression. Some assets have an ascertainable fair market value, determined within an acceptable range, from reliable market quotes or from calculation of the net present value of future cash, reliably measured. GAAP is moving toward recognizing appreciation for assets with ascertainable value. It ought to be moving even more toward recognizing assets that have ascertainable value, in order to make GAAP accounting more accurate as an economic description.

But goodwill is the last asset that will be pulled out from the historical cost convention. Valuation of goodwill requires valuation of the entire company, not just saleable or manageable assets within the company. Accountants have never understood their professional skills to be valuation of the whole company, although accounting data is meant to be a useful manipulation of data to help that valuation.. Basing accounting on the valuation of the entire company by recognizing the appreciation of internally developed goodwill would be a revolution, with unknown consequences for the accountants.

4. Can events that trigger a diminution in the value of goodwill be identified? If it can be determined that the value of the goodwill asset has been impaired, how should the impairment of goodwill be measured and accounted for?

If Company C is no longer like a $10 million bank account, because its earnings drop below $1 million, then some part of the debit balance of the goodwill asset on the acquirer's balance sheet should be credited to current earnings, that is, treated as a loss reducing current earnings. Under current fundament concepts, by-passing the income statement is a breach of the fundamental principles of accounting because it hides bad news.

Sometimes the diminution in the value of the goodwill can be identified and sometimes it can not. One can rely on the market sometimes. If the market capitalization is lower than the accounting net worth, then that means that the smart market has determined some of the companies accounting assets have in fact expired. The market price overall is the summation of the vectors of greedy outsiders who put their money where their valuation is, and we can rely on their opinions as a basis for good accounting. If the GAAP net worth equals market capitalization, we have achieved Nirvana of having accounting accurately describe the company. A rule that the firm must take losses to write down assets so that accounting and market worth are the same can provide some control on assets stated at more than there real worth. Use of market valuations works only for firms traded on a broad public market that is fully informed of all useful investment information.

It is possible to use accounting earnings as a measure of overall firm capital: if we assume 10% return, for example, then we can assume that the assets have expired when the earnings drop. If Company C earnings drop from $l million to $100,000, then Company C should be required to take a loss of $9 mil. On the basis of this year's earnings, Company C has become like $l million bank account rather than a $10 million bank account. The write off does not need to be symmetrical: accounting conservatism has always implied that assets should be written down in circumstances in which they would not be written up.

The SEC and FASB can exhort the acquirer's accountants to break out the $10 million cost of Company C into specific assets. Much of the value of Company C, for example, might reside in the Founder and be lost when he retires. Still it is not at all clear that the exhortations without sound-theory rules will have any effect.

Relying on appraisers or accountants to identify short lived or lost intangibles is not promising. In the years before the enactment of section 197 of the Code (which for the first time allowed acquired intangibles to be depreciated for tax purposes), there was a cottage industry of accountants and appraisers who would give expensive reports to the acquiring firm to justify the firms saying for tax purposes that it had acquired intangible assets that had a very short useful life. On taxpayer returns, intangibles acquired in corporate takeovers was reported as having an economic life of only 8.8 years. U.S. General Accounting Office, Tax Policy: Issues and Proposals Regarding Tax Treatment of Intangible Assets (Aug. 1991). That history is dreary and discouraging. Corporations were reporting very short lives to save tax, relying on purchased opinions. The purchased opinions were largely manufactured briefs, not accurate, but expensive. For GAAP, management motives would be not to report short lives, but long lives and the history of tax reporting implies that management will be self-interested. The management could get its way by buying very expensive wasteful appraisals. Giving management discretion to manipulate earnings by buying expensive reports is not that promising a solution.

Current tax law, adopted to be neutral, treats acquired intangibles as expiring over 15 years. Internal Revenue Code 197. Conformity between tax and GAAP would imply that all intangible assets should be written off over 15 years. There is a discipline in conformity management wants a short life for tax and long, even infinite life for GAAP. Forcing conformity might mean that the forces pushing for short and long reach equipoise, so accurate description has a chance of governing both GAPP and tax accounting.

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