Controversy has persisted in recent decades over the accounting treatment of the vast sums expended on purchased goodwill – variously described as a “present-value estimate of future rents” from an acquisition or “the difference between what you pay [for an acquiree] and the assets that you can identify.” Standard-setters have repeatedly tried to show whether shareholders’ funds expended on goodwill have been recouped after merger by requiring formulaic amortization in the income statement to represent the depletion of goodwill over time. This is the equivalent of depreciation for tangible assets such as machinery. But the prime movers in M&A – executives of acquirers and their advisers – have repeatedly, and almost always successfully, resisted any amortization.

Initially they favored hiding goodwill. In the U.S. they opted for pooling accounting, in which goodwill was not recognized and therefore not amortized; the book value of the assets and liabilities of the two businesses were just added together.  Acquirers devised methods to qualify for pooling and thereby avoid amortization by complying with the letter of the restrictions on pooling but not the spirit of the rules. For example, professors Thomas Lys and Linda Vincent reported that, in its purchase of NCR, AT&T was willing to expend at least $50 million of shareholder funds to qualify for pooling of interests rather than use purchase accounting.[1] It thereby escaped any amortization of purchased goodwill.

In the UK, acquirers also sometimes avoided amortization by pooling (“merger accounting” in the UK), but more often with a different device allowed by the UK standard-setters – and indeed treated as the “normal” method: writing off goodwill to reserves immediately on acquisition. With no goodwill left on the balance sheet there was no amortization to depress reported profit in subsequent years.

Along with other accounting manipulation, this contributed to the situation in the UK described by leading analyst Terry Smith: “…much of the apparent growth in profits which had occurred in the 1980s was the result of accounting sleight of hand rather than genuine economic growth…[2].”

In the UK, after very strong initial opposition, the national standard-setters, the Accounting Standards Board (ASB), imposed amortization. This was supplemented by impairment (discretionary writing down) where amortization had failed to keep pace with the depletion of goodwill. In exceptional cases, impairment-only was permitted, but rigorous qualifying, measurement and monitoring restrictions were placed on impairment[3].

The new rules drew admiration from experts abroad. For example, a former chairman of the U.S. Financial Accounting Standards Board (FASB), Dennis Beresford, wrote in 1997, “These are great improvements to the accounting for business combinations in the UK, and they represent a model that the U.S. board should emulate in its own project.”[4]

FASB did indeed propose new rules similar in important respects to those initiated by ASB. They proposed in 1999 that goodwill be routinely recognized in the balance sheet and amortized through the income statement. But the subsequent hostile lobbying by business, whose objections were taken up by Congress, was so intense that FASB abandoned the proposal and instead introduced compulsory recognition plus discretionary impairment.[5] For FASB, impairment was a complete substitute for amortization rather than (ASB’s) complement to amortization. And the board did not adopt the stringent monitoring and verification of impairment that ASB had introduced.

When the new International Accounting Standards Board (IASB) turned to M&A accounting early this century, it was faced with a choice of models for dealing with purchased goodwill: FASB’s impairment-only scheme or ASB’s hybrid model of amortization plus impairment, and ASB’s rigorous approach to verifying impairment or FASB’s more trusting arrangement. Fresh from their defeated effort to adopt amortization in the U.S., the American members of the IASB (the biggest national group) were reluctant to return to the conflict, and the IASB in general was seeking, with good reason, to converge with U.S. standards.[6] So, in broad terms, IASB followed FASB. And then, from 2005, UK-listed companies became governed by the IASB regime and were freed from amortization.

There is one line of thought on which the stance taken by the business lobbyists (acquirer executives and their advisers) might appear to be vindicated. This derives from value-relevance being the main accounting objective in the U.S., as the American Accounting Association noted[7]:“The primary use of information in financial reports is for investment decisions (equity and debt).”

The evidence is that amortization does not contribute directly to “value-relevance”[8] for it does not directly affect share prices. However, impairment is correlated with share price movements: It provides stock markets with fresh information potentially relevant to investment decisions – disclosure based on executives’ estimates of future cash flows. But this argument for favoring impairment is undermined by evidence from a range of sources that  shows that, except for under the ASB’s short-lived rigorous regime, impairment standards have permitted widespread self-serving manipulation.

Several opportunities for manipulating impairment numbers have been identified in the academic and practitioner literatures. Managers’ judgments are inevitably needed when selecting a valuation model for goodwill – estimating future cash flows and choosing discount rates[9]. As scholars have noted, “The subjectivity inherent in estimating goodwill’s current fair value is greater than in most other asset classes such as accounts receivables, inventories and plant, making the goodwill impairment test under SFAS 142 particularly unreliable.”[10] Also, it has proved problematic to disentangle the cash flows attributable to internally generated intangibles from those generated by the purchased goodwill. And allocation procedures open to managers have allowed them to delay or accelerate impairment depending on their own interests. “[I]mpairment is almost bound to be ‘too little, too late’,” commented former IASB Chairman Hans Hoogervorst.[11]

And if impairment figures are misleading, they are of course – literally – worse than useless for guiding investment:  false information is worse than no information. The contribution to value-relevance is negative.

Misleading impairment numbers also subvert the stewardship role of accounting – holding executive-agents to account for the funds of their shareholder-principals that they have expended on purchased goodwill.[12]Amortization helps serve this purpose by focusing attention on whether shareholders’ funds expended on goodwill are being recouped after merger.

Weaknesses over accountability are particularly significant in relation to M&A because of failures – evidenced by Meeks and Meeks (2022)[13] – in three interlinked markets:

(i) for acquisitions

Meeks and Meeks’ review of 55 studies for different periods and countries (chiefly U.S. and UK) found that “only a fifth of the studies report that in the mergers they investigated, the average deal, or a majority of deals, produced higher operating profits for the combined firms, or increased the wealth of the acquirers’ shareholders.” Drawing on different sources of evidence, consultants McKinsey (2010) have concluded that, “Anyone who has researched merger success rates knows that roughly 70% fail.”[14]

(ii) for top executives

While the outcome for shareholders has often been disappointing, this is not so for most of the managers who initiated the deals. An analysis by Harford and Li (2007) found that “even in mergers where bidding shareholders are worse off [as a result of an acquisition], bidding CEOs are better off three quarters of the time.”[15]

(iii) for financial service providers

Such potential misalignment of agent’s and principal’s interests may also intrude in the relationship between acquirer stockholders and the professional service firms that facilitate mergers. The fees earned by the banks, lawyers, accountants, and PR advisers acting for acquirer and target are striking. In a single case, AB InBev’s merger with SABMiller, they totalled $1.5 billion; the deal was followed by unimpressive financial performance.[16][17]

If executive pay is linked to accounting measures of performance, the permissive impairment regime offers the executives opportunities to inflate their firm’s reported profit and their own income.  But accounting measures incorporating amortization limit executives’ ability to manage their pay (and their reputation). Financial service providers, for whom M&A is a lucrative source of income, share the executives’ interest in masking failure – in retaining an impairment-only regime where reported earnings can be readily managed.

These divergent interests may help explain some puzzling recent decisions by U.S. and international accounting standard-setters. At first it seemed that there might be a change of heart on amortization. In 2020 it was reported that “FASB tentatively said it would require public companies to amortize goodwill over a 10-year period on a straight-line basis only, without exception[18].” It was noted in a subsequent IASB Discussion (November 2022) that, in consultations with IASB, six out of seven FASB members favored including amortization in the rules.

Similarly, IASB addressed the issue and invited views on the possibility of restoring amortization, noting that board members were divided concerning its merits, the chairman being inclined to favor its inclusion in the standard.

But then a development occurred that recalls the standard-setters’ retreat in the face of lobbying around the millennium. Lugo reported (in 2022) that:

the board [FASB] had leaned toward requiring that entities apply an impairment with amortization model, where an entity would amortize goodwill over a 10-year default period that would be limited to a 25-year cap. [But]…on June 15, 2022, [FASB] unanimously voted to drop its project on identifiable intangible assets and the subsequent accounting of goodwill…The decision came as a huge surprise to market watchers[19]. (emphasis added)

In November 2022, IASB again followed FASB, rejecting any move towards the ASB’s hybrid model incorporating amortization alongside impairment.

Those who benefit richly from mergers that yield no operating gains will be relieved that acquirers can continue delaying or avoiding accounting for the depletion of that most nebulous of assets, purchased goodwill.

ENDNOTES

[1] Lys, T. and Vincent, L. (1995) An analysis of value destruction in AT&T’s acquisition of NCR, Journal of Financial Economics, 39, 353-78.

[2] Smith, T. (1992). Accounting for Growth. London: Century, Random House.

[3] Tweedie, D., Cook, A. and Whittington, G. (2023) The UK Accounting Standards Board, 1990-2000: Restoring Honesty and Trust in Accounting, Routledge

[4] Beresford, D. (1997) US should import UK improvements, Accountancy, 4 December 1997.

[5] Beresford, D. (2001) Congress looks at accounting for business combinations, Accounting Horizons, 15(1), 73-86, https://doi.org/10.2308/acch.2001.15.1.73.

Zeff, S.A. (2002). “Political” Lobbying on Proposed Standards: A Challenge to the IASB. Accounting Horizons, 16(1), pp. 43–54.

[6] Tweedie, D., Cook, A. and Whittington, G. (2023) The UK Accounting Standards Board, 1990-2000: Restoring Honesty and Trust in Accounting, Routledge, p.152.

[7] AAA (2007). The FASB’s conceptual framework for financial reporting: a critical analysis. Financial Accounting Standards Committee, AAA. Accounting Horizons, 21(2), pp. 229-238.

[8] Amel-Zadeh, A., Faasse, J., Li, K., and Meeks, G. (2020) Stewardship and value-relevance in accounting for the depletion of purchased goodwill, in Amel-Zadeh and Meeks, eds. (2020), Accounting for M&A: Uses and Abuses of Accounting in Monitoring and Promoting Merger, Routledge

[9] Comiskey, E. and Mulford, C. (2010). Goodwill, triggering events, and impairment accounting. Managerial Finance, 36(9), pp. 746-767.

[10] Ramanna, K., and Watts, R. L. (2012). Evidence on the use of unverifiable estimates in required goodwill impairment. Review of Accounting Studies, 17(4), pp. 749–780.

[11] Hoogervorst, H. (2018) ‘Are we ready for the next crisis’, Speech, Washington, DC, 11 December 2018; available at: https://www.ifrs.org/news-and-events/2018/12/speech-are-we-ready-for-the-next-crisis/

[12] This stewardship role for accounting has played a major role in the UK – for example the UK Law Lords opined (1990):

‘There is nothing in Part VII [of the 1985 Companies Act] which suggests that accounts are prepared and sent to members for any purpose other than to enable them to exercise class rights in general meeting…Advice to individual shareholders in relation to present or future investment in the company is no part of the statutory purpose of the preparation and distribution of the accounts. ’(Zeff (2013), op cit)

[13] Meeks, G. and Meeks, J.G. (2022), The Merger Mystery: Why Spend Ever More on Mergers When so Many Fail, https://www.openbookpublishers.com/books/10.11647/obp.0309

[14] McKInsey & Company (2010) Perspectives on Merger Integration, June 2010, https://www.mckinsey.com/client_service/organization/latest_thinking/~/media/1002A11EEA4045899124B917EAC7404C.ashx

[15] Harford, J. and Li, K. (2007) Decoupling CEO wealth and firm performance: The case of acquiring CEOs, Journal of Finance, 62(2), 917-49, https://doi.org/10.1111/j.1540-6261.2007.01227.x.

[16] Massoudi, A. (2016) ABInBev-SABMiller deal to yield $2billion in fees and taxes, Financial Times, 27 August 2016

Massoudi, A. and Abboud, L. (2019) How deal for SABMiller left AB InBev with lasting hangover, Financial Times, 24 July 2016, https://www.ft.com/content/bb048b10-ad66-11e9-8030-530adfa879c2.

[17] Another example, reported by Crooks, is GE, which, between 2000 and 2018 paid more than $6bn in fees to banks advising on mergers, a period in which 700 deals were completed (and GE’s market valuation declined very significantly (Dissanaike, Jayasekera and Meeks)). GE was also notable for its expertise in accounting manipulation (Gryta and Mann).

Crooks, E. (2018) GE bases strategy on ‘robust industrial logic’, Financial Times, 27 June 2018

Dissanaike, G., Jayasekera, R. and Meeks, G. (2022), Why do unsuccessful companies survive? A case study of US airlines and aircraft leasing, 2000-2008 Business History Review 96(3), 615-642, doi:10.1017/S0007680521000465

Gryta, T. and Mann, T. (2020) Lights Out: Pride, Delusion and the Fall of General Electric, Boston: Houghton Mifflin Harcourt.

[18] Lugo, D. (2020) FASB to reintroduce amortization of goodwill for public companies, 18 December 2020, https://tax.thomsonreuters.com/news/fasb-to-reintroduce-amortization-of-goodwill-for-public-companies/.

[19] Lugo, D. (2022) In a surprising move, FASB drops project on subsequent accounting of goodwill, https://tax.thomsonreuters.com/news/in-a-surprising-move-fasb-drops-project-on-subsequent-accounting-of-goodwill/

This post comes to us from Professor Geoff Meeks at the University of Cambridge’s Judge Business School. It is based on his recent article, “Why Are Acquiring Companies So Reluctant to Amortise Purchased Goodwill?” available here, and on the further analysis in his book, available here.