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Something Bad About Goodwill

It has done no such thing. Two years down the road, mergers and acquisitions are being treated in annual accounts almost as though the new approach had not happened.

The idea was that investors should know what assets have been acquired in a deal. Why exactly was a premium paid over the net asset value (NAV) of the target company? What was bought? Historically, this margin was simply allocated to goodwill and goodwill was just the arithmetical difference between what was paid and the value of the net assets. To observe the new standard, the intangible assets have to be identified and valued as well as the tangibles; a procedure that for many years was just too much for the accountants. “Let's stick to what we know”, they cried. “Describe goodwill as an asset and we can use it in a tax effective manner; no matter that it has absolutely no meaning or substance”.

IFRS 3 was designed to change this. Similar to the American SFAS 141 (introduced a few years earlier), it demands greater explanation. Rather than goodwill itself being an asset, it is now what is left over once the intangibles have been identified, measured and deducted from the price premium. Goodwill is the bit that cannot be explained, and its accounting treatment attests to this. It may no longer be amortised; this is the preserve of real, not imagined assets. Goodwill appears in the books for what it is; a residual. Each year it must be tested for impairment (tested to ensure the value in the balance sheet is not greater than what it would fetch in the market – its replacement value).

Impairment alone causes a problem. If goodwill is the residue of value once tangible and intangible assets have been valued and deducted, how will it be tested? It can only be worth more than its replacement value if the identified assets have fallen in value (and it has therefore increased) or the value of the entity has increased in some way but the other assets have not. That sounds somewhat convoluted, but surely the only way that goodwill may be tested is to see what has happened to the value of the identifiable assets or the overall value of the entity. Goodwill itself has no intrinsic value. You only know what has happened to goodwill when you measure the inputs that bring it about.

Nothing good about goodwill

On the face of it the sole purpose of goodwill is to mop up what is left over when the proper accounting has been completed. But that is not how it is being treated. London based brand valuation company, Intangible Business, has tracked merger and acquisition activity for the years following the introduction of the new standard. They found that over half the purchase price was accounted for by goodwill; 17% by tangibles and the balance of 30% by identifiable intangibles.

When Barclays Bank plc reported the acquisition of Absa in its 2006 annual financial statements, the value it placed on the brand, in terms of IFRS 3, was a risible £172 million. Barclays bought 57% of Absa in a deal worth about £2 billion, which placed a value on the Absa company of £3, 5 billion. Absa's net assets (NAV) at the time were in the books at £1,7 billion, so the (equivalent) premium paid was £1,8 billion of which the brand represented, according to the IFRS 3 inspired post purchase calculations, just under 13% (grossed up to 100%). By reference to established databases of completed brand valuations, the brand should be worth at least 50% of the market premium. So, for reasons best known to itself, Barclays have undervalued the brand asset that it bought by about one quarter, preferring to ascribe the excess over NAV to goodwill.

The Barclays purchase of Absa was probably one of the first deals to be subjected to the requirements of IFRS 3, but the frugal treatment of the Absa brand appears to reflect current common wisdom and practice. The mystery is why?

Writing down intangibles

The essence of IFRS 3 was an acknowledgement that goodwill conveys little information to the investing public; that it is not an asset; and that companies involved in deals such as these must make a genuine attempt to place values on the intangibles that underpin the price they paid.

Tim Ambler is a senior fellow at the London Business School and has made a considerable name for himself in the area of marketing metrics. He was quoted in a recent edition of the Financial Director journal (January, 2007) as saying that “the balance sheet is getting less and less interesting because it explains an ever smaller part of a company's market capitalisation”. He goes on to point out that intangible assets account for between 30% and 70% of a typical company's value. And yet his research indicates that boards of directors typically spend only 10% of their time on the source of their revenue – the marketplace - and 90% on what to spend their money. That being the case, the reluctance to attribute full value to acquired brands (and other intangibles) makes sense.

It might make sense, but may not be sensible.

What makes intangibles so valuable that they drive a huge portion of company worth is that they tend to be the sustainable competitive advantages that, for example, drive economic profit. When a company earns after-tax profits that exceed its cost of capital, there must be a reason or the rules of economics would kick in and competition would drive prices down to commodity level. No firm in the category would be able to make more than its cost of capital. In modern business, this rarely is the case. Firms routinely make and sustain economic profit, and this often is reflected in the market premium placed on firms by the investment community.

By extension, the reason why businesses are prepared to pay large premiums over NAV for target firms is because they have intangible assets that lessen the risk that future income streams will not be maintained. Brands do that, as do established supply lines, customer lists, special business systems and innovative research and development.

Sense and sensibility

This is why IFRS 3 makes so much sense. Investors need to know why a company is worth what has been paid for it and, splitting out the intangibles from the market premium, is designed to do just this. Assuming the intangibles do not fully explain the premium paid, there will be a residual that is goodwill, but it should be small, perhaps not more than 10% of the premium. In fact, identifying and valuing the intangibles, adding them to the tangible assets and making an allowance for goodwill, is a rough and ready way of valuing the business from the bottom up.

When goodwill is accepted as an asset, it is impossible to know what to do to increase the value of the firm. It is after all the difference between the identifiable assets and the overall worth of the entity. If you know what the intangibles are and what role they played in the price paid for the firm, you have a benchmark against which to judge future values.

Executive vice-president of leading market research firm Millward Brown, brand valuation expert, Joanna Seddon, had this to say in the edition of Financial Director referred to above: “The reason for defining the value of brands and other intangibles is not to find a number but to identify the best way to manage the business, to get better statistics, to invest better and to grow the value that marketing adds to the business”.

I would dispute her view on the number, because that is what is needed for IFRS 3, but I agree totally with the balance of her statement. When goodwill is broken down and the contributing intangible assets are identified and measured, management has material to work with. It understands why the firm was worth the price paid and it is able to use this knowledge in its strategic planning. That is impossible with an arithmetic difference.

Quo vadis?

There is a message in what appears to be happening. Fifteen years (that is how long it took for the accounting profession to contemplate and agree the changes that brought about IFRS 3) spent arguing the merits of intangibles has brought about an ambiguous result. On the one hand, the accountants can claim that they have acknowledged that shareholder wealth arises from assets other than those you can “drop on the floor”, but right now they are unprepared to ascribe to this class of asset any significant value.

This flies in the face of a statement published by FASB, and to which IASB members presumably also subscribe, that: “(Investors need) better information about intangible assets because those assets are an increasingly important economic resource for many entities and are an increasing proportion of the assets acquired in many business combinations”.

We don't need at this stage to speculate on why values of intangible are so low and goodwill is still so fashionable. The accountants that prepare the post-deal accounts and the managers that instruct them must appreciate the uselessness of the passé accounting residue, and the informational and management benefits of proper and full disclosure.

As Joanna Seddon has pointed out, credible valuations of intangibles provide managerial tools that are inestimable in their ability to provide improved strategic direction, and to manage the enhancement of shareholder value.

Roger Sinclair - PhD Wits. Professor Emeritus in the School of Economic and Business Science (SEBS) Wits, MD of BrandMetrics.

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