# Goodwill on the Balance Sheet Investing Lesson 3 - Analyzing a Balance Sheet http://beginnersinvest.about.

com/od/analyzingabalancesheet/a/goodwill-on-thebalance-sheet.htm 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'sbook 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, thebalance 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: 1.29 Billion (You don't need McDonald's other information for this example) Wendy's Book Value: \$1,082,424,000 Book Value per Share: \$10.3482 Shares Outstanding: 104.6 Million 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

648. If you find this to be the case. there is no goodwill left on the balance sheet. over-eager managers are able to pay outrageous prices for acquisitions with little or no accountability on the balance sheet. meaning 1/40 the amount must be deducted from next year's earnings. Goodwill reduced earnings by 4¢ per share.) Take the premium \$2.62 per share (compared to the \$1. McDonald's can only report earnings of \$2. you will probably want to avoid the stock (why would you want to invest in a company that was throwing your money around?). 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). you would simply divide it by the number of shares outstanding (1.000. Now.264. but for simplicity sake. or \$1.146. their earnings will be combined. Now that McDonald's and Wendy's are one company. 2. the exact same transaction could have two vastly different impacts on earnings per share.948. the company would earn \$2. 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. We're assuming McDonald's bought Wendy's for cash. you will want to look at recent acquisitions to determine if they were too expensive. If the pooling of interest method had been used. and McDonald's would have reported EPS (earnings per share) of \$1.000 + \$169. Assuming next year's results were identical.66. no goodwill would have been created.) Companies .) Since McDonald's purchased Wendy's. Since no goodwill is created.328.090. Once you are able to value a business.be subtracted from McDonald's earnings so that by the 40th year.66 they would have been able to report before the goodwill charge).000. Meaning that depending on how the accounting was handled.66 per share1. McDonald's must deduct \$56. If stock had been used. we are going to assume this not to be the case. Remember that goodwill must be amortized. Goodwill on the Balance Sheet Receives New Accounting Rules It is no wonder that managements.29 billion).000 and divide it by 40 years = this is the charge against earnings each year 3.400 from earnings next year as a charge against goodwill2. Since it makes no sense to have two different ways for accounting for a merger.619. As a concession. in order to avoid this reduction in reportable earnings. Notes: 1. the two companies' profits will be combined. To get the earnings per share. Pay careful attention to the mergers a company has made in the past few years.000 = \$2.300.146.977.776.600.948. frequently opted to use the pooling of interest method when they complete a merger. \$1. 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. or \$1. the number of shares would change.

S. if your firm is in the acquisition mode. statement: ³The new rules have no real economic consequences since corporate cash flows are not impacted. Yet.´ In a report titled entitled The Furor Over Purchase/Pooling.edu/2010/08/the-battle-over-merger-accounting/ Maybe you¶ve never taken an accounting class.pepperdine. it would surely seem that you should be.purchased before 1970 are not required to be amortized off the balance sheet. the wave of consolidations that has enhanced productivity. encouraged innovation.´ Yet listen to the very next. They can stay there forever. in a report entitled Valuing the New Economy: How New Accounting Standards will Inhibit Economically Sound Mergers and Hinder the Efficiency and Innovation of U. Bancorp Piper Jaffray make the following alarming statement right after summarizing the proposed new rules: ³These changes could potentially have a chilling impact on the mergers and acquisitions market.S. This issue is whether or not pooling of interests accounting should be allowed. . has preliminarily decided to eliminate this method by the end of the year. when two firms combine. Business. and it is creating a firestorm in the merger and acquisition arena arena. Should you be concerned? More importantly. if you are thinking of acquiring another company or are in the market to be acquired. and stimulated dynamism in the U. or maybe you took one years ago and don¶t remember much. virtually contradictory. there are two methods that can be used to account for the combined value of the firm. they yield radically different outcomes ± with pooling resulting in a much better looking income statement for years to come.´ In other words. In essence. the primary accounting rulemaking body in the U. economy may notably decline. the proposed new rules don¶t change cash flows one iota.. As a result. In most cases. one issue in accounting should be of interest to you.S. However. The Battle Over Merger Accounting ± Graziadio Business Review Proposed pooling ban unlikely to halt activity.S. For example. the Financial Accounting Standards Board (FASB). http://gbr. Daniel Donoghue and others with the investment banking firm U. They are the purchase method and the pooling of interests method. Merrill Lynch states that ³the (purchase) accounting method itself would prove an obstacle to a merger that both parties want to consummate. should you be trying to wrap it up by the end of this year? If you take literally some of the comments reported recently in the business press.

the combined balance sheet and income statement look as follows: Balance Sheet A Current Assets PP&E Intangibles Total Current Liabilities Long Term Liabilities Stockholder¶s Equity Total Income Statement A Revenues Expenses 1000 -400 B 600 -200 A+B Pooling 1600 -600 700 100 200 400 700 150 50 50 50 150 850 150 250 450 850 200 500 B 100 50 A+B ³Pooling´ 300 550 Net Income 600 400 1000 If.intellectual property. however. If the combination is treated as a pooling. the combination is treated as a purchase. the combined financial statements will look as follows (pooling totals shaded for comparison): Balance Sheet A Current Assets PP&E Intangibles Total Current Liabilities Long term Liabilities Stockholder¶s Equity Total 700 150 85 1450 400 50 45 +600 1050 700 150 85 100 200 50 50 15 25 200 500 B A+B Purchase A+B Purchase 300 +100 +500 650 500 1450 150 250 Pooling Adjustments 100 30 50 55 .

Income Statement A Revenues Expenses Net Income Extra Depreciation (10 year life) Amortization of goodwill (20 year life) Net Income after extra depreciation and amortization of B A+B Purchase A+B ³Purchase´ 1600 -600 1000 -10 -25 965 Pooling Adjustments 1000 600 1600 -400 -200 -600 600 400 1000 goodwill Note that the balance sheet looks stronger under the purchase method due to a higher asset base. there is no other instance in which it is proper and legal to avoid recognizing a payment for something ± especially something that can run into the billions of dollars. this is an amazing statement that actually highlights the fatal flaw of the pooling method ± The premium paid is never recorded. One company buying another for cash is decidedly different than an exchange of stock. and .´ The problem with this argument is two-fold. due to the extra depreciation and amortization of goodwill. Although financial accounting may be deficient in myriad ways. In a very real sense. the acquiring firm estimates what the target firm is worth in total. Research Findings A question that has been directed to the FASB is whether an acquisition paid for with stock is fundamentally different from an acquisition paid for with cash. the current market value of both companies¶ stock. chairman and CEO of American Express. is the primary determinant of the ratio. In many of today¶s mega mergers. which consolidates the ownership of the two entities. divides that by the acquiring firm¶s current share price to determine the number of shares to be offered. Different business combinations require different accounting treatment.´ Yet. and not book value. First. The FASB has been asked to consider this. in negotiating the exchange ratio of the stocks. if you think about it. Harvey Golub. The income statement looks worse. To put the difference between the two methods into the simplest terms. the previously cited Merrill Lynch report states it this way: ³The premium paid for the intangible goods ± the goodwill ± is never recorded (in a pooling). put it this way in a recent article in theWall Street Journal: ³«a merger with stock isn¶t the same as a purchase for cash. the income statement differences are far greater because goodwill can comprise 8090% of the purchase price resulting in huge amortization charges that can even cause the combined entity to report operating losses for years to come. however.