Goodwill Accounting: Time for an Overhaul

Abstract

The U.S. treatment of goodwill is at odds with the practices of many major industrialized nations. On August 8, 1989, Marvin Davis offered $240 per share ($5.4 billion) for United Airlines (UAL) when the stock was trading for $164.50. On September 1, the pilots' union and UAL management offered $300 per share ($6.75 billion). Following the mini market crash on October 13, 1989, UAL stock dropped from $285 to $223; the union-management offer was reduced to $225 to $240 per share ($5.1 billion to $5.4 billion) on October 23, 1989. This offer subsequently fell to an estimated $185 per share ($4.1 billion) on March 20, 1990, and negotiations were terminated soon after. Was this normal give-and-take in merger deliberations? Consider the following: Although UAL's share price varied significantly, the market value of its net tangible assets changed very little during the eight-month negotiation period. What supposedly did change, according to Accounting Principles Board Opinion no. 16, Business Combinations, was the value assignable to the intangible asset The goodwill amount at March 20, 1990, would have been $2.72 billion (the difference between the high and low offer prices) lower than the amount recordable on September 1, 1989. Could UAL's goodwill really have changed that much in eight months? Does valuation of a company's goodwill depend solely on the vagaries of the stock market? According to Opinion no. 16, the answer to both questions automatically is yes. Compounding this capricious valuation procedure, Opinion no. 17, Intangible Assets, provides negligible guidance on how to allocate goodwill to the periods benefiting from it. It simply specifies it be amortized over a period not exceeding 40 years. These two opinions, now over 20 years old, are among the most controversial accounting pronouncements ever issued. Both were implemented amid a storm of dissension at the end of a wave of mergers in the 1960s. Opinion no. 16 sought to curb flagrant abuses commonplace when the pooling-of-interests method was used to account for mergers. (See APB 16: Time to Reconsider, by Michael Davis, JofA, Oct. 91, page 99.) The goodwill capitalization and amortization guidelines of Opinions nos. 16 and 17 provide the impetus for this article's look at the current state of business combination rules in the United States. CURRENT DISSATISFACTION WITH GOODWILL ACCOUNTING There are two reasons why goodwill is due for an overhaul. 1. It is now a far larger component of companies' acquisition price than it was when the rules were implemented in 1970. As a result, goodwill has a more negative impact on net income. For example, 90% of the $12.9 billion Philip Morris paid for Kraft Inc. in 1988 was attributable to goodwill. In the 1989 Time Warner merger, 80% of the $14 billion paid was for goodwill. The annual goodwill writeoff, even over the maximum 40-year period, totaled $275 billion, resulting in a reported net loss for Time Warner of $217 million in 1990; losses are expected to continue for several years. 2. Lack of tax deductibility under U.S. income tax rules puts domestic bidders at a potential disadvantage in the international merger marketplace; other countries permit goodwill to be carried as a permanent asset or allow tax deductibility of goodwill ri teoffs. Is the Financial Accounting Standards Board concerned? Apparently not, even though it was aware of the problems as far back as 1973. When the FASB replaced the in that year, responses to its request for views on previous opinions indicated nos. 16 and 17 were of greatest concern. In 1974, the FASB began the process of reevaluating the pooling rules. In 1975, it expanded the scope of its efforts to encompass all business combination issues, including goodwill. In 1976, it issued a Discussion Memorandum, Accounting for Business Combinations and Purchased Intangibles. …