ALEXANDRIA, VA (April 2, 1998) -- Today's glossary only has one item in it -- amortization of goodwill. Well, I'll also explain what goodwill is, but we're still in the income statement glossary here, so I just want to play by the rules! This is a very confusing item to some people, so I want to deal with it in a somewhat comprehensive manner. If you have any questions, please email me at DWettlaufer@fool.com and we'll go over them tomorrow on Touchstone Friday.
Amortization of Goodwill
This is an expense associated with acquisitions a company has made. Goodwill is an asset that needs to be expensed off (or written off or charged off) the balance sheet just as other assets do. Goodwill arises from the difference in market value paid for an acquired company and the appraised net asset value of that company (which falls in the neighborhood of the company's book value, or shareholders' equity).
Goodwill arises from purchase method accounting, in which a company acquires another company in a transaction other than a pooling of interests. In a pooling of interests, which is usually the accounting method chosen when two companies enter into a stock swap merger, the balance sheets of the two companies are combined with no adjustments for the value by which the merger price exceeded the appraised net asset value of the subsumed company.
In texts, a pooling of interests is sometimes described as the method used in a merger of equals, but outright acquisitions often use this accounting methodology because acquirors want to avoid goodwill amortization expenses in the future, which makes the income statement look better but makes no difference to actual cash flows.
Warren Buffett has said that the securities analyst and investor can live a long and fruitful life without paying attention to, or understanding, goodwill or the amortization thereof. This is especially true in the banking industry when talking about amortization expense. Most purchases of companies in the banking industry are financed with debt. The debt that is issued to cover the purchase price of acquisitions turns up on the income statement of the acquiring company in the form of interest expense. When the income statement shows the interest expense from that debt as well as amortization of goodwill, the acquirer's net income is understated and the expense of past acquisitions is overstated.
The asset of goodwill and the amortization thereon was supposed to account for the expenditure of capital to buy a set of customer relationships and assets. We want to identify how well a company has expended its resources, but we also want the financial statements to portray economic reality. As we point out above, though, the expense of buying versus building can be double-counted, which is surprisingly misunderstood by even professional investors. In addition, the level of expenses depends completely on the amortization schedule chosen by the acquiring company.
If a company has $1 billion in goodwill on the balance sheet, 100 million shares outstanding, and chooses to amortize the goodwill over 10 years, then the annual charge to earnings will be $1.00 per share. Done over 40 years, though (the maximum allowable goodwill amortization schedule according to Generally Accepted Accounting Principles (GAAP) and the Securities and Exchange Commission, the annual charge to earnings will be $0.25 per share. At 20 times earnings, that's a $15 per share difference in share prices if the market does not price the companies properly, which does happen. It doesn't make a whit of a difference on the cash flow statement of either company, though. In both cases, the net cash inflow (or outflow) of the companies in any given accounting cycle is no different, all other things being equal.
Since goodwill is not an asset against which banks can make loans or use as collateral in taking on debt themselves, it is also not a useful balance sheet account when assessing the capital strength of a company. International banking convention dictates that goodwill be entirely deducted from elements of capital for regulatory purposes. Investors would be well advised to follow the same dictum when assessing the capital strength of a company they're looking at. Market value and multiples to invested capital, earnings, tangible shareholders' equity, and other financial statement items will indicate to what degree investors believe the goodwill on the balance sheet is a worthwhile asset.