Amortization of Goodwill

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Posted by Bob on December 13, 1999 at 09:52:20:

For background on the two current methods of accounting for business combinations (purchase versus pooling), go to the Global Value Investing LinkList page and visit the links for FASB Exposure Drafts and for CPA Class. The CPA Class website currently includes two relevant links: a link to a 9Sep99 press release about the proposal to eliminate pooling of interest as a method of accounting for mergers and acquisitions (M&A), and another link to download the proposed statement of financial accounting standards about Business Combinations and Intangible Assets dated 8Sep99.

As you know, companies grow one of two ways: as a continuing going concern with same ordinary recurring operations, and through so-called "resource conversions" such as M&A with new extraordinary non-recurring operations. This is reported, respectively, as cash flow from continuing operations, and as cash flow from financing activites.

The purchase method of accounting for M&A requires that one company be the buyer and the other company be the seller. The excess of the purchase price over the seller's book value is called "goodwill." The goodwill has to be amortized or charged against earnings over a period of years instead of being all charged against earnings in the year of the M&A transaction that created the goodwill. This effectively converts the stock of goodwill into an annual flow of charges against earnings over a number of years.

What is the best theoretical measure of true economic earnings for a company that buys a controlling ownership interest in one or more other companies? It is misleading to generalize across all companies because each company can have a different frequency of significant M&A activity. For example, if an agressive company is expected to rely heavily on annual acquisitions to grow in the future, then it might be more accurate to write off the full amount of its goodwill in the year incurred. But if a company is expected to have recourse to acquisitions only rarely and probably defensively to prevent being taken over by another company, then it might be more accurate to write off the goodwill over the maximum number of years allowed. This might occur during an industry consolidation phase that is not likely to repeat. And last, there are many companies between these two extreme frequencies of M&A activity.

As a practical matter, the handling of M&A-related goodwill also will depend largely on the purpose of the financial analysis. For more on this, visit the MergerStat link that is included on the LinkList page.

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