10:00 a.m., Wednesday, June 14, 2000
Thank you for the opportunity to participate in the roundtable discussion on June 14 and express my views regarding the FASB's proposal on business combinations. I hope that my testimony to the Committee on March 2 and follow-up letter of April 3 was insightful to the members of the Committee and the FASB.
In advance of my testimony, I am providing some of my thoughts on the focal topic of the round table discussion. I look forward to further elaboration on June 14.
What is the nature of goodwill and how should it be measured?
Goodwill represents the difference between the total value of an enterprise, measured at a specific point in time, and the value of the enterprise's readily identifiable net assets. Put another way, goodwill represents the difference between the value of the assumed future cash flows of an enterprise and the value of its readily identifiable net assets. At its core, goodwill represents the ability of the enterprise's collective assets to earn cash flows in the future. Enterprises earn future cash flows by utilizing their collective assets productively in the marketplace. Goodwill is affected by management's actions in leveraging the assets of the enterprise strategically in order to continuously compete and win in the marketplace. Solid management; employee intellect; a strong human resource function that strives to maintain current human intellect and attract new intellect to the organization; strong quality systems that ensure consistent and high quality products; a strong marketing and sales organization that continues to develop and expand markets and relationships; and, a strong research and development focus that continues to bring innovative products to the market are all, both i) the essence of what goodwill is, and ii) critical to its maintenance and enhancement in value. The way that acquired goodwill is valued for accounting purposes depends on the accounting method used.
Under the purchase method of accounting, goodwill is valued by taking the difference between the purchase price of an acquired enterprise (valued as of the closing date) and the value of its readily identifiable assets. This goodwill is then amortized over an arbitrary period of time. The accounting concept is that goodwill is consumed over the amortization period. This may be quite contrary to the underlying economics, where the amount of goodwill is actually increasing at the same time that the accounting records reflect a deterioration or consumption of goodwill.
Under the pooling of interests method of accounting, the value of goodwill is not recorded in the financial statements. The financial statements are reflected at a carryover basis. Most of the drivers of goodwill creation and preservation mentioned above are expensed as incurred in the GAAP financial statements. Hence, there is no accounting asset on the predecessor financial statements. In a pooling, the treatment of goodwill is consistent between the Parent and the Subsidiary. I believe that the accounting that results is the most appropriate.
For public companies, goodwill is valued every day in the public capital markets. The goodwill value for the total enterprise is the difference between the enterprise's market capitalization and its net assets. Although this measure of goodwill can be volatile and dependent on market conditions, I believe that this is the best measure of goodwill available. It represents the public market's view of the enterprise's ability to leverage its assets (tangible, intangible and intellectual) to collectively earn cash flow in the future. Goodwill is a forward-looking concept, not one of past history. That is the reason why I think putting a historical cost value on goodwill and reflecting that value in GAAP financial statements is flawed.
Goodwill for a subset of an enterprise or a private company requires valuation, and ultimately a buyer to determine its value. Determining the value of goodwill on an ongoing basis is difficult if not impossible.
In summary, I believe that goodwill should not be recorded in historical cost financial statements. The amount of goodwill of a public company is valued in the public capital markets and reflected in a company's market capitalization. I do not see the value in showing a company's market capitalization on the face of its balance sheet. If disclosure of such information is deemed relevant to investors, such disclosure should occur in the President's Letter to Shareholders, Management Discussion and Analysis, or the Footnotes to the Financial Statements.
Can goodwill appreciate in value, and, if so, how should the appreciation of goodwill be measured and accounted for?
The value of a company and hence its goodwill can appreciate or depreciate. As stated above, the management of the business and market conditions affect the value of goodwill. For public companies, I believe that goodwill should be valued as it is today – by the markets. I do not believe that we need to account for goodwill in the financial statements. As I have testified before the Committee previously, the markets are sophisticated and understand the future prospects of enterprises. Companies are very accountable for every share that they issue. If shares issued do not earn at or above the company's "core shares," then the public markets will punish the company's stock price. Shareholders and the company's board of directors will hold the company's management very accountable. The same is true for cash investments. Ultimately, a company must provide returns at or above its cost of capital, or its stock price, and management will be punished.
Can events that trigger a diminution in the value of goodwill be identified?
Events that cause a decrease in goodwill can occur over a period of time, as the result of a series of events, or be the result of a specific event. The decease in goodwill can be temporary or permanent. The public capital markets and management continuously make judgments about the future prospects of a company. If those prospects have deteriorated, the markets reflect that decrease in the company's valuation. The events that cause goodwill to deteriorate can be market based or based on an ineptness of management to implement and execute a solid strategy.
The determination of whether acquired goodwill has been permanently impaired is difficult and requires judgment. There are also issues related to the level at which anticipated cash flows should be measured, and, if that measurement at a detailed level is even possible subsequent to the integration of an acquired enterprise.
If it can be determined that the value of goodwill asset has been impaired, how should the impairment of goodwill be measured and accounted for?
I believe that the deterioration of goodwill should be accounted for as it is today under a pooling – by the public capital markets. The decrease in goodwill is reflected in the company's market capitalization.
In summary, I do not see the need to reflect goodwill acquired or developed in the financial statements. The goodwill is "recorded," but it is recorded in the company's market capitalization. By recording acquired goodwill in the financial statements, valued at a point in time, I believe that you are going to "clutter" the balance sheet with information that is not any more relevant than information that is already available in the capital markets. The information is also not consistent between internally generated and acquired goodwill. I do not think this information will be of much incremental value to investors. If management made a great acquisition decision, it is rewarded through enhanced earnings, cash flows and valuation. If management made a poor acquisition decision or failed to execute upon an opportunity, it will be held accountable with depressed earnings, cash flow, and market capitalization.
If the issue is accountability, managements are very accountable. If the issue is transparency and disclosure, I support and applaud enhanced disclosures. I have attached a copy of my follow-up letter of April 3 to the committee that states some of my ideas on disclosure.
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