Gaining a better understanding of goodwill

A finance controller walked into his house, waving a document. “You remind me of your school days, when you would walk into the house, head held high, flashing your report card. It’s been a while, but it’s good to see you like this,” said his 70-year-old father.

“It’s true dad. In the last 15 years, this is the first time that I feel so happy. This is the first annual report in which we have presented results of our global operation and it is a matter of pride that after much planning and execution we find ourselves in this position.” He handed the copy to his dad and touched his feet.

Sum of different parts

After dinner, he asked his father for his opinion on the report. “Sorry son, I have not progressed much — I was stuck at the first paragraph of the Chairman’s report. He says he was questioned by sceptics when he paid $1 billion as goodwill to acquire a loss-making foreign company, and how proud he is now after putting all doubts to rest with the results after the acquisition. I don’t understand… Why would someone pay a huge amount as goodwill? That too for a loss-making unit so far away?”

The financial controller thought for a moment, wondering how he could better explain the company’s move. “Dad, businesses today have become very global. We all need each other. The foreign company had the technology, a strong brand, and a world-class facility. If we tried to build such a facility now, it would cost us far more than what they incurred. They also had trained staff, dedicated customers and, above all, a willing set of shareholders who wanted to see the company grow. That said, some of the overhead costs were high, they did not anticipate competition and the overall market was bad for a couple of years — which put them into loss. The promoters didn’t want to invest more, so we bought them. It was a great fit for us,” he replied.

Simplifying complexities

“But why is the Chairman calling it goodwill?” the father countered.

“Dad, this statement is a part of the annual report, which also gives the financial statements. The financial results should be prepared in line with the accounting and regulatory framework.

Currently, if you buy a company, the difference between what you pay and the assets you acquire should be shown as ‘goodwill’. Simple.”

“Well, after your explanation, the extra amount you paid makes sense. But I still don’t understand why you don’t say so in your financial statements.”

Sensing that his father was atleast comfortable with the overall business decision, the son he tried to explain the complexities. “The challenge lies in putting a value to each of the separate bits we paid for. You would have then questioned the amounts attributed to each item without looking at the overall business. Also, once you recognise the assets separately, you will have to consider amortising them, which will impact the overall profits. So, while the overall business value may still be the same, the mere splitting of different assets and amortising them over a period brings in subjectivity, which is not useful. Wouldn’t that be more confusing too? Isn’t it better for investors to know the amount we paid under one head, and be assured that the value is still recoverable.”

“Well, I understand the idea is to make it easy for all. I’m glad you are by my side to explain it to me,” the father said, before setting aside the report.

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