The Negative Side of Goodwill

FASB's proposed business combination rule requires companies to recognize negative goodwill immediately.
Marie LeoneOctober 18, 2007

A proposed accounting rule expected to be finalized later this year may cause short-term problems for companies that have scooped up assets at bargain prices. The proposal on business combinations, a rewrite of FAS 141, changes the way companies book a gain known as negative goodwill.

That change could lead to an increase in a company’s reported assets, net income, and shareholders’ equity, thereby skewing performance ratios tied to those underlying items, according to a report released this month by the Financial Analysis Lab at the Georgia Institute of Technology.

For example, if the value of assets and equity are boosted by negative goodwill, then the return on assets and equity will appear to be lower, noted Charles Mulford, an accounting professor at Georgia Tech and the director of the lab. At the same time, an increase in equity might cause debt to look comparatively lower.

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Negative goodwill is the gain created when a company buys an asset — including another corporation — for below the asset’s fair value, or current market price. The proposal, issued jointly by the Financial Accounting Standards Board and the International Accounting Standards Board in June 2005, would force companies to carry negative goodwill as an immediate extraordinary gain on the day of the sale, rather than write down the gain to zero through a series of allocations, as they currently do.

Traditionally, accountants and even FASB, “were somewhat loathe to recognize negative goodwill because they questioned whether there was such a thing as a bargain price,” Mulford told CFO.com, noting that accountants typically believed that an efficient marketplace would rarely yield a bargain price. Essentially, accountants “do not believe in a free lunch,” he said.

And while inking a merger deal that includes negative goodwill is rare, the accounting change could end the current quest by acquirers for distressed assets, at least until the market sorts out the potential accounting change and factors its affects into deals.

But don’t expect financial statement controversies to rein in the standard setter’s efforts. “FASB has been on a fair value tear,” Mulford said. To be sure, the update of FAS 141 – and Wednesday’s approval of FAS 157 – are two examples of the FASB’s commitment to replacing historical pricing with fair-value accounting.

Mulford, who authored the study along with Georgia Tech colleague Eugene Comiskey, explained that the current accounting rule generally does not allow companies to recognize negative goodwill as an immediate gain. Rather, FAS 141 instructs financial statement preparers to first allocate the gain to assets that are considered hard to value, and thus most likely to be overvalued.

Those assets include intangibles, property, plant and equipment, and other non-monetary and non-current assets. Under FAS 141, if there’s any negative goodwill remaining after the allocations are made, the residual is booked as an immediate extraordinary gain.

The study looked at 11 companies that recorded negative goodwill in their financials during 2005 and 2006. The report cited eight corporations that would have had to adjust their accounting if the proposed rule had been in affect at the time of the acquisitions.

The two largest swings shown in the study occurred at Claymont Steel and AIDA Pharmaceuticals. Under the new proposal, the value of Claymont Steel’s assets after H.I.G. Capital, a private equity firm, bought the company, would have increased by 58 percent, to $280 million. Net income would have climbed by 252 percent to $144 million and shareholder’s equity would have gone from a negative $30 million to a positive $73 million.

Similarly, after AIDA bought a 78 percent stake in Shanghai Qiaer Bio-Technology and consolidated the target company’s financials into its own, the assets of AIDA would have risen by 23 percent, to $66 million. Net income would have increased by 850 percent to $14 million, and equity up by 1119 percent to $23 million.

Less dramatic adjustments were recorded in the cases of retailer The Children’s Place and holding company The Vector Group. After the Children’s Place bought several hundred Disney Store businesses, the company’s assets would have risen by 6 percent, to $806 million, net income would have climbed by 71 percent to $112 million, and equity would have jumped by 7 percent to $422 million.

After it purchased New Valley Corp., assets of the The Vector Group would have risen 2 percent, to $618 million, with net income up by 30 percent to $64 million, and equity up by 44 percent to $48 million.

Mulford thinks that what he considers the questionable valuations of the assets under a fair-value model will be a headache for CFOs. If a finance chief learns later, for instance, that the asset isn’t worth the value recorded, the company runs the risk of a writedown and recorded loss. “It’s easy to look more profitable if you don’t record full fair value,” Mulford contended.

Officials at FASB declined to comment on the rule at this time.

Despite the study’s findings about how the proposal may distort year-over-year comparisons of financials, Mulford points out that the first fair-value jolts felt by companies will fade fairly quickly as fair-value accounting replaces historical pricing models.

Mulford says he doesn’t disagree with the fair-value concept, although the study’s findings support current criticism of fair value accounting, specifically its short-term affects on financial statements. “I understand the attraction of fair-value accounting,” he said. “However, there may be pain [in applying it.]”