Unveiling Goodwill: Navigating the Complexities after an M&A Transaction

There has been a significant increase in intangible assets on the balance sheets of major companies or conglomerates. In addition, goodwill has become an increasingly significant part of balance sheet assets over the years, especially since 2010. The key reasons behind this are increasing growth in competition stimulated by the globalization of trade, and advances in technology. As a result, the increase in cultural and economic intangibles is inevitable.

Determining goodwill, accounting for it, and defining its link with performance measurements remain difficult tasks. The issue of how to treat goodwill for accounting purposes has become an increasingly important one in the last few years, especially after the adoption of SFAS 142 and IFRS 3 concerning the accounting treatment of goodwill. Determining its nature and specifying its accounting treatment clearly have quantitative effects on financial statements, as well as on stakeholders and capital markets.

IFRS 3 defines goodwill as an asset representing the future economic benefits arising from other acquired assets in a business combination that are not identified individually and recognized separately. In other words, the accounting perspective defines goodwill as "the price paid for the acquisition over the fair value of identifiable net assets". Starting from 2005, companies had to switch to a goodwill impairment test. This helps determine any decline in the value of goodwill more effectively compared to the previous accounting treatment.

Goodwill represents the premium that the acquirer is willing to pay for the acquiree. This premium is often paid for intangible assets that are not reflected on the acquiree’s balance sheet, but which are nevertheless valuable to the acquirer, such as a brand name, customer relationships, and intellectual property. Goodwill can be analysed in two ways:

1. As future excess profit, where goodwill is the present value of the excess of expected future profits over that considered to be a normal return on total intangible assets. Goodwill is thus the net present value of those assets which are difficult to list and value separately.
2. As a residual, where intangibles indicate the balance of the legitimate values adhering to a company as a whole over the sum of the legitimate values of the various tangible assets taken individually.

Determining the fair value of goodwill is a process that is complicated by several factors. We list below some of these key factors:

1. Intangible Nature of Goodwill: Unlike tangible assets, such as buildings or machinery, goodwill lacks physical substance, making it challenging to assess accurately.
2. Complex Valuation Process: The valuation of goodwill involves significant subjectiveness and judgment. Unlike tangible assets with observable market prices, the value of goodwill depends on assumptions about future cash flow projections, growth prospects, and risk factors. These assumptions can vary among experts, leading to different valuation outcomes.
3. Risk of Impairment: Goodwill is subject to impairment testing. If its value declines, companies must recognize an impairment loss. Under IFRS, impairment testing of goodwill is governed by IAS 36, which mandates at least annual assessments to prevent the overstatement of asset values and to ensure that the financial statements offer dependable and pertinent information to users.
4. Disclosure Requirements: Transparency is key in financial reporting. Auditors ensure that companies disclose relevant information about goodwill, especially if it holds material significance, elevating it to a ‘key audit matter’ in their audit reports.
5. Economic Impact: Goodwill often forms a substantial portion of a company's asset base. Any misstatement or impairment significantly impacts financial statements and users' decisions. IFRS 3 has implemented a goodwill impairment test by eliminating the amortization of goodwill. To do this, a comparison between the recoverable amount and the book value of the cash generating unit’s (CGU) goodwill is crucial.

Case study

In November 2015, General Electric Co. (“GE”) took control of the power and grid division of the French company Alstom SA (“Alstom”) for a total consideration of USD 11.89 billion. The deal represented a strategic investment for GE, which was expecting the transaction to strengthen its power business both financially and strategically. Indeed, GE reported some bold expectations for the acquisition, forecasting an impact on the company’s earnings per share (“EPS”) of about USD 0.15 – USD 0.20, expecting the creation of cost synergies of up to USD 3 billion and growth synergies of up to USD 0.6 billion for the period from 2015 to 2020.

As required by US GAAP, the company assessed and measured all the identifiable assets acquired and liabilities assumed in the transaction as part of the purchase price allocation process. From this assessment, which lasted almost one year, the value of net assets arising from the acquisition was below zero, leading GE to add goodwill of USD 17.3 billion to its books in 2016. Goodwill attributed to Alstom was allocated to the power business units, which did not report any impairment loss in 2016.

With a total amount of USD 26.4 billion, GE’s power division was the reporting unit with the larger amount of goodwill. However, due to the decline in the power market, GE reported its first write-off of about USD 1 billion of the power division’s goodwill at the end of 2017. In 2018, the whole power business was sinking fast, forcing the newly appointed CEO, Larry Culp, to write down additional goodwill of about USD 2 billion in June of that year. Because of the weak performance of its business supplying equipment to the power industry, in October 2018, GE disclosed, in its third-quarter report, that would write off around USD 22 billion to USD 23 billion of goodwill in 2018, which was, substantially, all of the goodwill in the power division.

Moreover, GE said that both free cash flow and earnings per share were expected to fall, resulting in a significant negative market reaction, with the stock price decreasing from USD 12.09 per share at the first of October 2018 to USD 7.57 per share at the end of December 2018.

This case is an interesting example of the risks associated with business combinations and accounting for goodwill. While the substantial impairment loss cannot be attributable to the acquisition of Alstom, because the whole power business was performing badly, it is difficult not to wonder how such a large amount of goodwill could be recognized and then written down two years later.

The initial overpayment for the target, the misevaluation of the earning power initially envisioned for it, and the failure to realize the expected synergies are probably some of the reasons that led GE to make such a significant write-off. While the huge impairment could be compared to an admission of a bad investment decision, it also represented a substantial opportunity, since it would benefit both future earnings and the new CEO by removing the need to make small changes for years to come. Last year, during an interview, the ousted CEO, John Flannery, admitted that GE had overpaid for the target company, stating that, “if we can go back in a time machine today, we would pay a substantially lower price than we paid”.

The IFRS have not included any special provisions to account for a business combination in which a buyer overpays for its interest in the acquiree, because this is unlikely to be detectable or known at the acquisition date. The International Accounting Standards Board acknowledged that overpayments are possible, and, in concept, an overpayment should lead to the acquirer’s recognition of an expense. However, in practice, it is not possible to identify and measure reliably an overpayment at the acquisition date. To address the issue related to accounting for an overpayment, subsequent impairment testing is called for when evidence of potential overpayment arises, such as the weak performance of GE’s power division.

Conclusion

In essence, during financial audits, auditors meticulously evaluate the appropriateness of goodwill valuations, ensuring compliance with accounting standards and assessing the reasonableness of assumptions made by management. This attention to goodwill reflects its nuanced role in accounting after an M&A transaction, highlighting the need for a thorough evaluation of its intangible nature, valuation intricacies, and overarching impact on financial integrity.