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The Winner’s Dilemma in ‘Liar’s Poker’Could a Change to the Goodwill Rule Boost Private Equity?
Writing off the value of customer loyalty and human capital might shrink and change the M&A market.
- By
- June 07, 2024
- CBR - Accounting
Accountants have been wringing their hands for decades over how to treat a business’s goodwill—the value of customer loyalty, human capital, and synergies—when a company changes hands. Should it be allowed to sit on the books perhaps indefinitely, or should an acquirer write it off over a defined period of time?
The issue has been a hot potato for years, and research explains why the stakes are high: Currently the carrying value of goodwill is tested each year for impairment to determine whether its fair value has decreased. Changing the rules to require that buyers amortize, or gradually expense, goodwill over 10 years would slash buyout prices, dramatically shrink the $1.6 trillion-a-year US mergers and acquisitions market, and push more businesses into the arms of private-equity buyers, according to Rice University’s Stefan J. Huber and Chicago Booth’s Charles McClure.
Goodwill, formally defined as the difference between the purchase price of a business and the fair value of the net identifiable assets acquired, typically accounts for almost half of US corporate deal values, according to the researchers. As the largest share of the purchase price paid in corporate mergers, it can significantly impact the amount an acquirer is willing to pay, they write.
The Financial Accounting Standards Board, the 51-year-old private standard-setting organization for US companies, had not long ago been considering a change for the accounting of goodwill. For almost 20 years, it has held that goodwill isn’t subject to amortization but should be tested annually for impairment that could force a write-down. Research in 2012 by Oxford’s Karthik Ramanna and MIT’s Ross L. Watts suggested that the FASB's 2001 ruling “was the result of political pressure” from businesses that preferred the impairment approach, Huber and McClure write.
In 2018, the FASB revisited the issue and considered whether to revert back to requiring companies to amortize goodwill over 10–25 years. It dropped the idea in 2022, with FASB chairman Richard Jones citing the magnitude of the change and uncertainty about the impact.
To better understand that impact, Huber and McClure built a model based on 861 all-cash deals involving takeover auctions of publicly traded companies from July 2001 through September 2022. They make a distinction between strategic bidders—such as competitors, customers, or suppliers seeking to increase earnings—and financial bidders, such as private-equity funds, which prioritize maximum cash flow.
The effect of goodwill accounting on acquisitions
In each case, the bidders’ valuations of the target depend on the resulting mix of earnings and cash flow from the merger. Strategic bidders are willing to pay more for companies that produce earnings under the current approach, which involves reducing the value of goodwill assets only when conditions change rather than consistently over a fixed period.
The researchers find that strategic bidders paid more than financial bidders under the current goodwill accounting rules. They calculate that if the rules were changed to require buyers to expense goodwill over time, all bidders’ premiums over the market price would fall by 6 percentage points, and M&A volume would decline by 4.29 percent, or $68.6 billion a year. Premiums offered by strategic buyers would fall by 13 percentage points, and the proportion of private-equity acquirers would rise by 7.74 percentage points.
“Such changes in the makeup of winners can influence the ownership of a substantial portion of the economy,” the researchers write. “Adopting an accounting standard that amortizes goodwill reduces the relative strength of strategic bidders” but “does not affect financial bidders’ values.” They estimate that such a shift would increase the likelihood of a financial bidder winning the takeover from nearly 30 percent to about 37 percent.
The findings could be of interest to the US Securities and Exchange Commission, which has expressed concern about the growth of private-equity ownership at the expense of public investment. Accounting standards, note the researchers, “can contribute to the balance between public and private markets.” Also, intangible assets such as goodwill have become a significant source of economic value. Goodwill assets alone on the balance sheets of S&P 500 companies increased 37 percent from 2017 to 2022, when M&A activity was booming, according to data provider Calcbench.
McClure and Huber say that their paper, by quantifying the economic consequences of different accounting treatments, can serve as a guidepost for standard setters, who “continue to debate how to account for intangible assets.”
- Stefan J. Huber and Charles McClure, “Accounting for Goodwill,” Working paper, December 2023.
- Karthik Ramanna and Ross L. Watts, “Evidence on the Use of Unverifiable Estimates in Required Goodwill Impairment,” Review of Accounting Studies, May 2012.
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