We’re old fashioned?
I have been called many things in the past, all of which I have accepted in good humour. But to be called “old fashioned” is a slur on my character that I need to vigorously defend (see the letter to the editor in the March 2002 Accountancy SA). My previous tussles with Hilton Shuttleworth have usually resulted in a win/win situation (he would win the argument and I would learn something new). Here is hoping that I can turn the tables this time.
I made a statement in the January 2002 Accountancy SA that an analyst should treat negative goodwill as equity when analysing financial statements. The example I gave was a balance sheet where the assets were 500 (fairly valued), the negative goodwill was 300, equity was 100 and debt was 100. I stated that the debt to equity ratio was 25% (100 to 400). Mr. Hilton Shuttleworth and Mr Gavin Leake stated that this was “old fashioned” thinking and that the assets were in fact only 200 because we paid less for them.
Before analysing the problem in some detail, let’s see what the standards in the statement on business combinations tell us:
1. The excess of the fair value of the assets acquired over the cost of acquisition should be recognised as negative goodwill and should be presented as a negative asset.
2. To the extent that negative goodwill relates to future losses or expenses that are identified in the acquirer’s plan, the negative goodwill should be amortised to income as the losses or expenses are recognised.
3. If the negative goodwill exceeds the non-monetary assets, the excess should be recognised in income immediately.
4. Whatever is left should be recognised over the useful lives of the depreciable/amortisable assets.
Now, let’s consider some situations, all of which I have seen in practice:
Situation 1
The balance sheet at acquisition was:
Plant 1
Inventory 159
Receivables 40
Total assets acquired 200
Paid for entity 120
Negative goodwill 80
The assets in the company acquired were fairly valued (the inventory was in fact sold at a profit and all the debtors had been collected by the year-end). No losses or expenses were expected as a result of this acquisition. The company was obliged to leave the negative goodwill as a negative asset and amortise it over the life of plant with a carrying value of 1! This is GAAP. From an analyst’s point of view is this 80 not equity?
Situation 2
The balance sheet at acquisition was:
Tangible assets 10
Deferred tax asset 30
Total assets acquired 40
Paid 20
Negative goodwill 20
In this situation the negative goodwill arose because the assessed loss totalling 100 was only valued at 10 on acquisition. The statement on deferred tax does not permit us to discount deferred tax on the balance sheet. Where should the negative goodwill go in this case? If we deduct it from the deferred tax asset we are not being consistent with GAAP and comparative analyses cannot be performed with other companies. One day, hopefully, we will be able to value an assessed loss by discounting it (see the letter and answer below). In the meantime, is this 20 not equity?
Situation 3
The balance sheet at acquisition was:
Plant 500
Inventory 300
Net monetary assets 100
Total assets acquired 900
Paid 100
Negative goodwill 800
The seller of the company could not make a go of this operation and was a desperate seller. The company had been making losses and the buyer bought it on the basis that the company was going to incur future losses. The buyer was entirely happy that the carrying values of the assets represented fair values on acquisition. Within a few months, the buyer was able to turn the company around and it is now profitable. What do we do with the negative goodwill? Leave it as a negative asset or realise it? Hilton and Gavin argue that the assets cost 800 less than book value and historical values are relevant to the analyst. Who is calling whom old-fashioned?? I thought that the world was moving towards fair values? Analysts are definitely interested in fair values as the replacement cost of an asset is far more relevant to them than the historical cost. Replacement cost is an indicator of future cash flows; historical costs are irrelevant.
Situation 4
Keep the facts as in situation 3 but assume that the payment for the company is 1 000 and the company is profitable. Hilton and Gavin try to make a case for treating negative goodwill as a deduction from the assets as “this is what the assets actually cost”. If that is the case should we not allocate the positive goodwill to the assets as this is what the assets actually cost? Why limit the argument to the negative side only? Just by the way, most analysts I know (me included) write positive goodwill off when calculating the debt to equity ratio – really old fashioned!
In Conclusion
Hilton and Gavin make an interesting statement: “Most analysts ignore goodwill when they calculate their ratios. If they wish to ignore negative goodwill, the number to be ignored is readily available under International and South African GAAP.” If you “ignore” goodwill, you are really eliminating it from the asset side of the balance sheet. The entry is to credit goodwill and to debit reserves. If you “ignore” negative goodwill, you are really eliminating a credit asset. The entry is to debit negative goodwill and to credit reserves. This is what analysts do. If analysts do this and GAAP is designed to communicate with users, should GAAP not do the job for the analysts?
We in RSA do know that there is a proposal to change the accounting standards for negative goodwill. Clearly the existing rules for its treatment are wrong. But to just deduct negative goodwill from the assets acquired without further thought would, in my opinion, be more of a disaster than the present situation.
Dear Uncle Charlie
I read in SAICA’s “Communiqué” that the insurance industry is lobbying standard setters to permit the discounting of deferred tax. Do you believe that GAAP should permit discounting? The statements on employee benefits and provisions allow one to discount provisions.
Let’s be consistent
Dear Let’s be Consistent,
I fully agree that discounting should be required in the case of an assessed loss but I have reservations about discounting in the case of deferred tax assets or liabilities resulting from temporary differences. Here are two examples to illustrate:
Example 1
A company incurs a tax loss of 100 in the current year. Future taxable profits are expected to be 20 p.a. How should the deferred tax asset be measured?
Opinion
At present GAAP does not permit discounting. However, the economic benefits from this assessed loss are only going to be received over the next five years so, assuming a discount rate of 12% p.a. (should this be a before tax or an after tax rate?) the deferred tax asset should not be 30 but 22. The balance sheet would be more meaningful but the tax reconciliation in the income statement would be a fun calculation to do.
Example 2
A company bought shares in listed companies for 100 after 1 October 2001. The market price and carrying value is 300 at the balance sheet date. GAAP requires a deferred tax liability of 30 to be raised (15% of 200). However, if we use discounting the calculation would be as follows:
Carrying value of asset (already discounted as it is the present market value) 300
Tax base of asset, which will only be allowed sometime in the future, say, 20
Temporary difference 280
Deferred tax liability at 15% 42
I wonder if the insurance industry would be keen to discount if they understood the implication of discounting, i.e. having to recognise a much higher “liability” on their balance sheets.
The existing concept of deferred tax is that if we show the current value of the asset on the balance sheet we need to show the shareholders’ share of this current value. If the economic benefits were realised at the balance sheet date, SAR’s share of the economic benefits realised would be 30. This makes sense. To discount would not make sense because one of the two determinants of the temporary difference is already discounted.
Uncle Charlie