1.

GOODWILL ACCOUNTING
M & A’s

In the accounting sense, Goodwill can be thought of as a "premium" for buying a business.
When one company buys another, the amount it pays is called the purchase price.
Accountants take the purchase price and subtract it by a company's book value. The
difference is called Goodwill.

For decades, when a company bought another company, it could use one of two accounting
methods: pooling of interest or purchase. When the pooling of interest method is used, the
balance sheets of the two businesses are combined and no goodwill is created. When the
purchase method is used, the acquiring company will put the premium they paid for the
other company on their balance sheet under the "Goodwill" category. Accounting rules
require the goodwill be amortized over the course of 40 years.

An Example of Balance Sheet Goodwill

What does that mean? Let's use McDonald's and Wendy's as an example since most people
are familiar with them.

McDonald's
Earnings:$1,977,300,000
Shares-Outstanding:1.29Billion
(You don't need McDonald's other information for this example)

Wendy's
BookValue:$1,082,424,000
BookValueperShare:$10.3482
SharesOutstanding:104.6Million
Earnings: $169,648,000

Say McDonald's decided to buy all of Wendy's stock using the purchase method. Wendy's
has a book value of $10.3482 per share, yet is trading at $32 per share. If McDonald's were
to pay the current market price, they would spend a total of $3,347,200,000 (104.6 million
shares x $36 per share). To keep this example simple, we are going to assume the
shareholders of Wendy's approved the merger for cash. McDonald's would mail a check to
the Wendy's shareholders, paying them $32 for each share they owned.

Since the book value of Wendy's is only $1,082,424,000, and McDonald's paid
$3,347,200,000, McDonald's paid a premium of $2,264,776,000. This is going to go onto
their balance sheet as Goodwill. It is required to be amortized against earnings for up to 40
years. This means that each year, 1/40 of the goodwill amount must be subtracted from
McDonald's earnings so that by the 40th year, there is no goodwill left on the balance sheet.

Now that McDonald's and Wendy's are one company, their earnings will be combined.
Assuming next year's results were identical, the company would earn $2,146,948,000, or
$1.66 per share1. Remember that goodwill must be amortized, meaning 1/40 the amount
must be deducted from next year's earnings. McDonald's must deduct $56,619,400 from
earnings next year as a charge against goodwill2. Now, McDonald's can only report earnings
of $2,090,328,600, or $1.62 per share (compared to the $1.66 they would have been able
to report before the goodwill charge). Goodwill reduced earnings by 4¢ per share.
If the pooling of interest method had been used, no goodwill would have been created, and
McDonald's would have reported EPS (earnings per share) of $1.66. Meaning that depending
on how the accounting was handled, the exact same transaction could have two vastly
different impacts on earnings per share.

Goodwill on the Balance Sheet Receives New Accounting Rules

It is no wonder that managements, in order to avoid this reduction in reportable earnings,

frequently opted to use the pooling of interest method when they complete a merger. Since
no goodwill is created, over-eager managers are able to pay outrageous prices for
acquisitions with little or no accountability on the balance sheet. Since it makes no sense to
have two different ways for accounting for a merger, the FASB (the folks in charge of
coming up with these accounting rules) decided they should eliminate the pooling of interest
method and force all transactions to be done via the purchase method. Executives and
politicians claimed this will significantly reduce the number of mergers since the new
standards would cause reportable earnings to drop as soon as a company had completed an
acquisition. As a concession, the FASB will no longer require goodwill to be written off
unless the assets became impaired (which means it becomes clear that the goodwill isn't
worth what the company paid for it).

Pay careful attention to the mergers a company has made in the past few years. Once you
are able to value a business, you will want to look at recent acquisitions to determine if they
were too expensive. If you find this to be the case, you will probably want to avoid the stock
(why would you want to invest in a company that was throwing your money around?).

Notes: 1.) Since McDonald's purchased Wendy's, the two companies' profits will be
combined. $1,977,300,000 + $169,648,000 = $2,146,948,000. To get the earnings per
share, you would simply divide it by the number of shares outstanding (1.29 billion). We're
assuming McDonald's bought Wendy's for cash. If stock had been used, the number of
shares would change, but for simplicity sake, we are going to assume this not to be the
case. 2.) Take the premium $2,264,776,000 and divide it by 40 years = this is the charge
against earnings each year 3.) Companies purchased before 1970 are not required to be
amortized off the balance sheet. They can stay there forever.

2. GOODWILL ACCOUNTING
M & A’s

Goodwill is an accounting term used to reflect the portion of the book value of a
business entity not directly attributable to its assets and liabilities; it normally
arises only in case of an acquisition. It reflects the ability of the entity to make
a higher profit than would be derived from selling the tangible assets. Goodwill
is considered an intangible asset.

Goodwill as a term was originally used to reflect the fact that an ongoing business had some
"intrinsic value" beyond its assets, such as the reputation the firm enjoyed with its clients.
Likewise, a buyer may agree to "overpay" because he sees potential synergy with his own
business. The accounting sense of goodwill followed as a plausible explanation of why a firm
sells for more than the value of its net assets.

Modern meaning

Goodwill in financial statements arises when a company is purchased for more than the fair
value of the identifiable assets of the company. The difference between the purchase price
and the sum of the fair value of the net assets is by definition the value of the "goodwill" of
the purchased company. The acquiring company must recognize goodwill as an asset in its
financial statements and present it as a separate line item on the balance sheet, according
to the current purchase accounting method. In this sense, goodwill serves as the balancing
sum that allows one firm to provide accounting information regarding its purchase of
another firm for a price substantially different from its book value. Goodwill can be negative,
arising where the net assets at the date of acquisition, fairly valued, exceed the cost of
acquisition. Negative goodwill is recognized as a liability.

For example, a software company may have net assets (consisting primarily of
miscellaneous equipment, and assuming no debt) valued at $1 million, but the company's
overall value (including brand, customers, intellectual capital) is valued at $10 million.
Anybody buying that company would book $10 million in total assets acquired, comprising
$1 million physical assets, and $9 million in goodwill. Goodwill has no predetermined value
prior to the acquisition; its magnitude depends on the two other variables by definition.

The carrying value of an asset with associated goodwill may subsequently be adjusted by
management, either by amortization or by means of occasional adjustments of the
estimated value of the associated assets (primarily based upon their ability to generate
cash-flow and profits). The exact treatment and other details, particularly amortization, will
depend on the accounting standards applied.

There is a distinction between two types of goodwill depending upon the type of business
enterprise: institutional goodwill and professional practice goodwill. Furthermore, goodwill in
a professional practice entity may be attributed to the practice itself and to the professional
practitioner.

It should also be noted that while goodwill is technically an intangible asset, goodwill and
intangible assets are usually listed as separate items on a company's balance sheet.

Basic goodwill formula

• Goodwill = Purchase Price – Fair Market Value of Net Assets

• Fair Market Value of Net Assets = Net Tangible Assets + Write-up of Net Assets
• Net Tangible Assets = Assets – Target's Existing Goodwill – Liabilities

As can be seen, a merger destroys the target's "old" goodwill and creates "new" goodwill to
appear in consolidated books. Net assets write-up is prepared through a qualified appraisal
in a process known as a Purchase Price Allocation.

History and purchase vs. pooling-of-interests

Previously, companies could structure many acquisition transactions to determine the choice
between two accounting methods to record a business combination: purchase accounting or
pooling-of-interests accounting. Pooling-of-interests method combined the book value of
assets and liabilities of the two companies to create the new balance sheet of the combined
companies. It therefore did not distinguish between who is buying whom. It also did not
record the price the acquiring company had to pay for the acquisition. U.S. Generally
Accepted Accounting Principles (FAS 141) no longer allows pooling-of-interests method.

Amortization and adjustments to carrying value

Goodwill is no longer amortized under U.S. GAAP (FAS 142). Companies objected to the
removal of the option to use pooling-of-interests, so amortization was removed by Financial
Accounting Standards Board as a concession. As of 2005-01-01, it is also forbidden under
International Accounting Standards. Goodwill can now only be impaired.

Instead of deducting the value of goodwill annually over a period of maximal 40 years,
companies are now required to value fair value of the reporting units, using present value of
future cash flow, and compare it to their carrying value (booked value of assets plus
goodwill minus liabilities.) If the fair value is less than carrying value (impaired), the
goodwill value needs to be reduced so the fair value is equal to carrying value. The
impairment loss is reported as a separate line item on the income statement, and new
adjusted value of goodwill is reported in the balance sheet. Since, in general, intellectual
property (IP) is part of goodwill—in its lay, not accounting sense—one of the most important
assets of knowledge-based companies does not appear at all on formal balance sheets. As
for these companies, it is the IP that generates profit, not the buildings or the cash they
hold; this may lead to a misleading valuation, discouraging investors who do not understand
the company's value.

When the business is in trouble, with the threat of insolvency, investors will deduct the
goodwill from any calculation of residual equity because it will likely have no resale value

3. 3. U.S. GAAP
Statements of Financial Accounting Standards (SFAS)

Rules of SFAS No. 142, June 2001

Statement of Financial Accounting Standards (SFAS) No. 142

a. Goodwill and Other Intangible Assets
b. Issued in June 2001
c. Supersedes APB Opinion No. 17, "Intangible Assets".

Acquired intangible assets

a. An acquired intangible asset
--> recognized based on its fair value.

Intangible assets not specifically identifiable

a. Internally developed intangible assets

--> not recognized as an asset on the balance sheet.
 --> rules of SFAS No. 142 are same as APB Opinion No. 17

b. Cost of internally developing intangible assets

(not specifically identifiable)
--> recognized as an expense when incurred.

Amortization of intangible assets

a. An intangible asset with a finite useful life

--> amortized over its useful life.

b. If the useful life is not limited

--> by legal, economic or other factors,
--> useful life is indefinite (not infinite).

c. Amount to be amortized
= cost - residual value

d. If the pattern of economic benefits can be determined

--> Amortization method should reflect such pattern.

e. If the pattern of economic benefits cannot be determined

--> Straight-line amortization

Goodwill

a. Goodwill is not amortized.

--> Goodwill is tested for impairment

b. Impaired
--> fair value < carrying amount

c. Test for impairment

--> on an annual basis

d. If certain events would reduce fair value below carrying amount,

--> test for impairment is done between annual tests.