GOODWILL
One of the more attractive benefits achieved by pooling treatment is the elimination of "goodwill." Simply calculated, goodwill is the difference between the eventual purchase price and the net value of assets acquired. The resulting goodwill value is set up as a "asset" on the balance sheet of an acquiror, but is rarely considered as such by bankers, investment analysts, and others reviewing the company's financial statements.
A very important aspect in the establishment of goodwill is that current accounting principles require it to be amortized over periods typically ranging from 10 to 40 years, as a charge against each year's current income. Aggressive acquirors in industries where goodwill arises regularly in business combinations may also be faced with the problem of building an unattractively high amount of goodwill. Of equal import, for many years, the IRS did not permit amortization of goodwill as a deduction for income tax purposes.
Purchasers faced with large amounts of goodwill in an impending transaction can customarily take one of two approaches to its treatment. Companies primarily interested in earnings per share will generally book the maximum amount of available goodwill, and amortize it over the longest possible period, thereby minimizing the negative impact on annual earnings. Accounting firms will rarely concern themselves with 40 year amortization, although problems can arise in this area. In certain rare cases, where the goodwill amount represents a benefit which can theoretically be exhausted in fewer than 40 years, accounting firms may insist on more rapid amortization. This can also occur if goodwill is accelerating to an unbalanced position on an acquiror's balance sheet.
Those acquiring companies more concerned with cash flow than reported periodic profits, will usually take a different approach to that portion of purchase price which could be established and amortized as goodwill. A business combination is one of very few instances in which companies may be permitted to revalue their assets, and book such increased values. In such cases, some or all of the excess of purchase price over net assets received may be attributed to specific assets and the value of such assets increased on the books of the newly combined entity. These revalued assets can then be amortized more rapidly for either or both book and tax purposes—reducing income to some degree—but also reducing taxes and increasing cash flow.
Unmistakable assets subject to revaluation may include such things as fully depreciated production and transportation equipment; undervalued land, buildings, and other real estate; and occasionally inventories. Such revaluations are generally accomplished more easily through use of an independent third party appraiser. If revalued assets represent material amounts, when related to total balance sheet assets, outside appraisals are an absolute necessity.
Intangible assets can also be revalued, and may represent considerable benefit to acquirors. In many cases, an acquisition will permit intangible assets to have values established and booked for the first time. Such items as internally developed computer software; widely diverse types of databases; and other intangibles, can all be valued, booked, and subsequently amortized to reduce future taxes on income. The tax benefits realized by such treatment of potential goodwill items can substantially shorten the payback period on completed transactions. This valuation of intangible assets often looked upon by bankers and analysts as "non-assets," is generally viewed in a more positive manner when used to offset goodwill.
Great care must be taken when deciding which intangibles to value for balance sheet purposes. Accounting primers traditionally define goodwill as a broad group of factors which combine to make one company more attractive than another. This rather amorphous definition is one of the reasons behind the lengthy period in which goodwill may be amortized—40 years apparently being considered somewhat "indefinite."
A good combination of advertising, research, management talent, and product timing can give one company a dominant market position, for which another company may be willing to pay a very high price. Many intangibles acquired with such a company may be valued and set up on the newly combined balance sheet but also may arguably be classified as precisely those items which fall within the classic definition of goodwill. Databases, customer lists, subscriber lists, and similar items are typical of intangibles which fall into this gray area. It is possible, however, to define a value for all of them and thus gain the benefits of faster amortization—and concomitant tax benefits.
To accomplish the goal of converting questionable intangibles from goodwill to more valuable assets, buyers must carefully establish a rationale which clearly demonstrates the "perishable" nature of items under discussion. Each item to be valued must be supported fully by cogent arguments which relate specifically to the asset under discussion.
Customer lists are a clear indication of market dominance. As such, they are clearly part of goodwill—or are they? It is certainly possible to establish value for customer lists. This can be based on a calculation of periodic revenue per customer, frequency of purchase per customer, length of customer tenure, and similar quantifiable measurements. Buyer must construct a logical argument which demonstrates that customer lists have measurable value at the time of their acquisition—the eventual asset value. This must be followed by substantiation of the fact that such value will be exhausted during a finite period of time—the period of amortization. Buyer must finally arrive at a measurement technique to quantify how the asset will be exhausted—the method of calculating periodic amortization. Through use of such methods with similar intangible assets, buyers should be able to convert large portions of goodwill into beneficial assets.
In our last issue we discussed customer lists and similar items, falling within the "gray area" of intangibles which will be difficult to categorize as amortizable assets, as opposed to goodwill. We have been informed that Cap Gemini Sogeti S.A. carries $430 million of intangible assets, described as "market share." This asset arose from Cap Gemini's purchase of the Hoskyns Consulting Group and consists of multi-year contracts, thus avoiding "goodwill" classification.(FORBES, June 24, 1991)
The problem of intangibles is particularly critical in transactions which involve service companies. As we have pointed out, revaluation of assets on seller's balance sheet is an excellent way to reduce or eliminate goodwill for buyer. This technique is beneficial to buyer, as goodwill must be amortized—but has only recently begun to represent a charge against income for federal income tax purposes. Revaluation is difficult to accomplish in service companies, since most of their "assets" are intangible.
On June 6, 1991 two members of the Senate Finance Committee introduced a bill (S 1245), which would allow taxpayers to amortize the cost of customer and subscriber lists, and other similar intangible assets. The intent is to make it easier for owners of small service companies to sell their businesses. The bill would permit taxpayers to write off intangibles such as client lists, so long as the asset has an ascertainable value and a limited useful life, which can be reasonably estimated. A similar bill was introduced in the House (HR 1456). Unfortunately, another member of the House Ways and Means Committee has introduced HR 563, which holds that a "customer base, market share, or any renewing or similar intangible item has an indeterminate useful life..." and therefore cannot be amortized.(The Bureau of National Affairs, Inc., June 10, 1991)
The Joint Committee on Taxation has referred the matter to the General Accounting Office, which is expected to release a report shortly. According to the GAO the report will discuss the options of maintaining status quo; expanding the definition of goodwill to clearly include intangibles, thus clearly precluding their amortization; or limiting the definition of goodwill to exclude certain defined intangibles.
In our last issue we reported on several bills currently pending in Congress which would permit amortization of the costs of customer and subscriber lists, and similar intangible assets. Another bill has been introduced (HR 3035) which will permit intangibles, including goodwill, to be amortized over a 14 year period. The bill excludes self-created intangibles, such as advertising. The amortization of goodwill for tax purposes would be a particular boon to both buyers and sellers of service businesses as it would eliminate the need to revalue assets in an attempt to shift values from goodwill to presently amortizable categories.
The GAO report, pending at the time of our previous issue, generally supported the amortization of purchased intangibles, but said that similar treatment should be afforded to self-created intangibles. The author of HR 3035 opposes this aspect of the report and GAO does not insist that they be included in discussion of the pending measure in order to receive its support.
GAO also differs from the author of HR 3035, in that they suggest various categories of recovery periods, as opposed to the single period proposed by the bill. The Treasury Department supports the bill, including a single period for all intangibles covered under it. The American Bar Association also supports single periods of amortization but hedges by requesting a Treasury Department study to determine if the useful lives of intangibles vary significantly across different industries or among different categories of assets.
In the software area, Treasury is trying to exclude purchases of non-exclusive licenses to use commercial software, although willing to go along with 14 year amortization if purchasers acquire all rights to software. Representatives from the software, electronics, and business equipment industries oppose this as extending currently accepted amortization periods by more than three times. Other industry groups favor varying (shorter) periods of amortization as being more reflective of actual asset lifetimes, and varying categories are possible in any completed bill. We believe that several categories of amortization time will be included in any eventual legislation.
There has been discussion about making the bill's provisions retroactive, in an attempt to benefit taxpayers and potentially settle a large number of pending taxpayer disputes. In our opinion the bill will not be passed with a retroactive provision, as this could have negative effects on overall federal revenue. (The Bureau of National Affairs, Inc., October 3, 1991)