5 Reasons why CFOs Like (and Dislike) Goodwill

Tax savings – A buyer could be entitled to certain tax benefits under Section 338(h)(10) election or a straight asset deal as any goodwill (and select acquired intangibles that fall under IRC Section 197) may be amortized over 15 years. This would yield a lower taxable income as reported to the IRS, and in select instances, the “tax-deductible” goodwill is very attractive to the Buyer CFOs.

Personal goodwill – A shareholder’s sale of personal goodwill results in substantial income and tax benefits for the target company owner. If approved by the IRS, the sale of goodwill attached to a key person or owner would create long-term capital gains for the shareholder (taxed at around 23%). Under corporate income tax, the transaction proceeds would be classified as ordinary income (taxed at around 30%) followed by an additional tax of 23% on the residual amount of the sale distributed by the target to its shareholders. Target shareholders obviously prefer the first option, wherein the total tax may be less than half of the second option.

Favorable Write Offs – New management employees (CEOs and CFOs) usually have the tendency to recognize hefty impairments on its predecessors’ acquisitions to tighten the balance sheet and not be held accountable to generate returns for these acquisitions. Given the nature of the intangibles, it would be difficult for the analysts to quantify whether the written-off goodwill mandated any adjustments to the earnings. A cleaner, smaller balance sheet supplemented with the same level of operating profit allows the management to predict a steady flow of earnings in future and meet or beat analyst estimates with regards to Return on Assets.

Genuine asset – While it may not seem true as most M&A transactions destroy value, there are certain transactions that do have an “unexplained” and “unaccounted” value proposition explaining the significant difference between the purchase price and net value of identifiable (tangible & intangible) assets. In these select scenarios, the value of acquired ‘individual’ assets as reported at fair value may truly be lower than when used and valued together. A part of the uncertain incremental value in such situations may be classified as goodwill and should be appropriately reflected in the acquirer’s balance sheet.

Validation – Goodwill is usually recorded as part of the purchase price allocation (PPA) process under the ASC 805 and FAS 141 standards. The exercise is performed by accredited professional valuation firms in an independent capacity. A comparatively modest amount of goodwill concluded by an independent appraiser in its valuation opinion fundamentally supports the management’s transaction thesis and valuation analysis, establishing credibility for future acquisitions.

Asset speculation – Goodwill adds a fair bit of speculation to the acquirer’s balance sheet, potentially hampering its authenticity. It represents an untold portion of the transaction that the market/shareholders now have to accept and live with. It is an intangible asset that may not necessarily be tied to future cash flows. Incorrect goodwill reporting inflates the balance sheet and could consequently overstate the true value of the Company, a big concern for CFOs as this could result in shareholder lawsuits.

Potential impairment – Business plans presented at the time of acquisition are always optimistic and are seldom realized once the target is incorporated by the acquirer. The goodwill value recorded at the time of acquisition is often exaggerated. Following the implementation of the GAAP and IFRS guidelines, companies are required to test for goodwill impairments every year, and such overstatements generally indicate the need for massive impairments, reflecting overpayment by the management team for the past transaction, a huge red flag for investors.

Wasteful expense – Goodwill is recorded and tested by independent appraisers appointed by the board. In order to process these goodwill valuations, most valuation firms request certain inputs and data points from the company. The management and CFO’s team have to dedicate resources to honor these requests. Therefore, sometimes valuing goodwill is viewed as a wasteful expense that requires time, effort, and investment. If the acquiring company’s CFO believes that the goodwill associated with a transaction is truly overvalued, the entire exercise becomes futile. The company’s share price in an efficient market would reflect the impairment much sooner than the company’s fiscal closing. In other words, the impairment test is too late, and the damage is already done.

Bias – Goodwill is essentially the output of a complex PPA and business valuation exercise based on certain assumptions and hypothetical situations. Certain valuation firms rely on the management’s inputs for most, if not all, of the key drivers. It is difficult, at times almost impossible, for the company’s management team to have an unbiased opinion of forecasts and other key assumptions, essentially defeating the purpose of having an “independent” appraisal, adding to the skepticism of CFOs in recording goodwill.

Control – Fair value measurements have become an intrinsic part of financial reporting, especially in M&A deals. Goodwill calculation is simple in theory, but complex in practice, even for the most experienced valuation professionals. Given the intricacy and analytics involved, certain CFOs are not involved with the details and hence cannot control the outcome, which could result in disappointments, particularly if this implies a goodwill impairment.