Question

1. Is the allocation of acquisition cost to goodwill subjective? Discuss.

2. How does the allocation of acquisition cost to goodwill affect profit and cash flows in subsequent years? For your critical analysis, you could compare the effect of the accounting treatment of goodwill in subsequent years with the effect of the accounting treatment of property, plant and equipment (or intangibles with finite useful lives) in subsequent years.

Answer 1

1)

THE VALUE OF THE CONSIDERATION GIVEN IN A TRANSACTION MUST BE ALLOCATED TO THE ACQUIRED ASSETS AND LIABILITIES, WITH THE RESIDUAL VALUE BEING ALLOCATED TO GOODWILL.

A PORTION OF THE CONSIDERATION IS CONTINGENT UPON ACHIEVING CERTAIN MILESTONES (I.E. EARN-OUTS), THEN AN ANALYSIS MUST BE PERFORMED TO DETERMINE THE VALUE OF THAT CONSIDERATION.

FTER THE VALUE OF THE CONSIDERATION IS DETERMINED, THEN THAT VALUE MUST BE ALLOCATED AMONG ALL TANGIBLE AND INTANGIBLE ASSETS AND LIABILITIES WITH THE RESIDUAL VALUE BEING ALLOCATED TO GOODWILL. EXAMPLES OF TANGIBLE ASSETS INCLUDE PROPERTY, PLANT AND EQUIPMENT. INTANGIBLE ASSETS INCLUDE SOFTWARE, LICENSING AGREEMENTS, PATENTS, ASSEMBLED WORKFORCE, NON-COMPETE AGREEMENTS, CUSTOMER RELATIONSHIPS, TRADEMARKS, TRADENAMES, COPYRIGHTS AND MORE. THE APPRAISER NEEDS TO DETERMINE THE VALUE OF EACH ASSET CATEGORY AND TO ALLOCATE THE OVERALL VALUE OF THE CONSIDERATION TO THOSE ASSETS GROUPS. THE APPRAISER NEEDS TO DETERMINE HOW MUCH A NON-COMPETE AGREEMENT IS WORTH, HOW MUCH AN ASSEMBLED WORKFORCE IS WORTH, THE VALUE MARKET PARTICIPANT WILL PLACE ON A PATENT AND MORE.

2)

ONCE AN ACQUISITION IS MADE, AND PROVIDED IT WAS A SOUND PURCHASE, GOODWILL REMAINS ON THE ACQUIRING FIRM'S BALANCE SHEET INDEFINITELY. PRIOR TO 2002, GOODWILL WAS AMORTIZED OVER 40 YEARS, MUCH THE WAY A PIECE OF EQUIPMENT MIGHT BE DEPRECIATED OVER A PERIOD, DEPENDING ON ESTIMATES OF ITS USEFUL LIFE. BUT SINCE THEN, RULES HAVE GOTTEN MORE STRINGENT: GOODWILL CAN BE AMORTIZED ON A STRAIGHT-LINE BASIS OVER A PERIOD NOT TO EXCEED 10 YEARS. IF AT ANY TIME, THE VALUE DECLINES, AS HAPPENED IN RAPID FASHION WITH GOODWILL RELATED TO AUTONOMY, THEN AN IMPAIRMENT CHARGE IS REQUIRED.

HP, AND OTHER FIRMS THAT END UP WRITING DOWN SIGNIFICANT AMOUNTS OF GOODWILL, ARE QUICK TO POINT OUT THAT A GOODWILL IMPAIRMENT CHARGE IS NON-CASH, AND SO DOES NOT AFFECT CASH FLOWS. IT REPRESENTS, HOWEVER, A HUGE PAST MISTAKE THAT DRAINED THE CORPORATE COFFERS. IN REGARD TO HP, WHICH FUNDED THE AUTONOMY PURCHASE THROUGH CASH RESERVES, IT ENDED UP DESTROYING BILLIONS IN SHAREHOLDER VALUE, SINCE THE COMPANY IS WORTH ONLY A FRACTION OF ITS EARLIER ESTIMATED VALUE.

OODWILL IMPAIRMENT CHARGES DON'T HURT CURRENT YEAR CASH FLOWS, BUT THEY DEMONSTRATE MISTAKES MADE IN THE PAST BY MANAGEMENT TEAMS. IN HP'S CASE, THE DECISION TO PURCHASE AUTONOMY WITHOUT SUFFICIENT DUE DILIGENCE AND TIRE-KICKING REPRESENTED ONE OF MANY INSTANCES WHERE A SERIOUS LAPSE IN JUDGMENT WAS MADE.

FOR OTHER COMPANIES, GOODWILL IMPAIRMENT CHARGES ARE GENERALLY LESS SIGNIFICANT, BUT THEY STILL REQUIRE ANALYSTS TO INVESTIGATE JUST WHAT WENT WRONG AND IF THE MISTAKE IS LIKELY TO BE REPEATED IN THE FUTURE, TO THE DETRIMENT OF EXISTING SHAREHOLDERS.