What is Goodwill?
Goodwill is an intangible asset, which is recognised in the balance sheet after a business merger or acquisition/takeover. As an intangible asset, it does not have form and is expected to benefit business for more than one year.
Goodwill treatment and associated international accounting standards have been in debate. There are chances that the International Financial Reporting Standards (IFRS) related to goodwill could be altered over the near-term.
International Accounting Standards Board (IASB) is conducting discussions on IFRS 3 Business Combinations and suggestion are open until the end of 2020. Goodwill essentially reflects the non-monetary assets of the business.
An internally generated intangible asset is not recorded in the books of accounts until it satisfies certain conditions like measurement of costs, feasibility, ability to sale or use, and potential future benefits are viable.
Likewise, a firm cannot measure the value of its internally generated attributes like brand loyalty or brand reputation, therefore such potential benefits for firm are not recognised in the balance sheet because they are non-quantifiable. Thus, internally generated goodwill does not find a place in books of accounts.
Some intangible assets can be measured, recorded in the balance sheet such as cost of an export license, cost of the overseas trading license, cost incurred in developing proprietary technology. In addition to measurement, the asset should yield future benefits to the firm.
A firm that has not ever engaged in a business combination may not have goodwill on the balance sheet since internally generated goodwill is not recorded in the books.
Goodwill is the premium paid over the fair value of net assets at the time of acquisition and is recorded in the balance sheet after a business combination. Internally generated intangible assets are measurable, saleable and have the propensity to generate future benefits.
Intangible assets are amortised over the useful life of asset and expenses are incurred on the income statement, and value of the asset is lowered on the balance sheet. Whereas goodwill can last as long as the business is operating, therefore a downgrade in the value of goodwill is incurred as an impairment expense.
Impairment testing of goodwill
IFRS necessitates firms to test goodwill for impairments every year. Earlier standards required to amortise over a period of time, which was replaced with annual impairment testing. Firms pay a premium over the fair value of net assets, and the premium is carried on the balance sheet.
As combined entity embarks on trading in subsequent years after a business combination, there can be circumstances where the book value of goodwill may not reflect the adequate value. Impairment testing enables understanding whether the recorded goodwill is reflective of true potential benefits or otherwise.
Under impairment testing, the book value of goodwill is compared to future benefits or revenue-generating ability. Alternatively, the carrying value of goodwill is compared to the recoverable amount, which is fair value less cost of disposal.
In case when the recoverable amount is less than carrying value of goodwill, the firm will be required to incur impairment loss. But testing an individual asset is not viable, especially when it does not yield benefits individually and is used with other assets to generate future benefits.
Now cash-generating units (CGUs) come into play when a group of assets is yielding future benefits for the firm. A CGU is a small number of identifiable assets capable of generating cash inflows as a group.
Firms undertake impairment testing for the CGUs in the balance sheet. It is much more like a business valuation test. A potential impairment is charged to the assets constituting a cash-generating unit, should the carrying value be greater than the recoverable amount.
At the outset, firms are required to compare the carrying value of goodwill, which includes CGUs, against the recoverable amount. A cash-generating unit in a company could be one of many divisions of the firm, likewise, a firm can have multiple CGUs, depending on the acquired assets.
At the time of the acquisition, firms may assign goodwill to specific CGUs depending on the expected benefits. For impairment testing of CGUs, the carrying value of CGU along with assigned goodwill is compared to the recoverable amount.
Similarly, an impairment loss is recognised when the carrying value of an asset is greater than the recoverable amount. First, the impairment loss is charged to assigned goodwill on the CGU during acquisition, and the leftover is allocated proportionately to assets within the CGU.
Limitations of goodwill
Goodwill is a volatile intangible asset, and the carrying value of CGUs can incur write-downs or impairment losses as business environment of a firm worsens, and anticipated benefits appear overstated, therefore altering the expected benefits through impairment losses.
A firm executing inorganic growth strategy through business combinations can have a large amount of goodwill on the books, especially when acquisition target has low net assets but is commanding a high premium.
A higher premium over the fair value of net assets means a higher level of goodwill as well, and the firm needs to justify higher goodwill by generating expected benefits through synergies of combined business entity.
Should the expected benefits from a transaction turn otherwise, the impairment loss as a result can be labelled as writing-off the premium paid upon business combination over the fair value of net assets.
As asset-light businesses have grown increasingly, the premium paid over the fair value of net assets is sometimes quite huge. As a result, the combined entity may have a higher level of net assets to goodwill ratio.
Increasingly, the annual impairment testing undertaken by the firms is becoming a source of concern given that it takes considerable time, assumptions in an uncertain business environment, efforts and knowledge.
It is the reason why IASB is conducting a discussion on IFRS 3 Business Combinations, and the outcome would be available over the near term. Return to amortisation of goodwill could lower the fluctuations in corporate profits.
What is EBITDA? Earnings Before Interest, Taxes, Depreciation, and Amortisation (EBITDA) is a widely used financial metric in evaluating cash flows and profitability of a business. Market participants closely track EBITDA and apply it in decision making extensively. Although conventional investors like Charlie Munger had raised concerns over the use of EBITDA, it is very popular in markets, and M&A transactions are mostly priced on EBITDA-based valuation like EV/EBITDA (x). EBITDA is not recognised by IFRS and GAAP but is used extensively in the Corporate Finance world. It is now a mainstream financial metric that companies look to target. EBITDA depicts operational cash generation capacity of a firm in a given period. It acts as an alternative to financial metrics like revenue, profit or earnings per share. EBITDA allows to evaluate a business operationally and outcomes of operating decisions. Non-operating items are excluded to arrive at EBITDA. EBITDA excludes the impact of capital structure or debt/equity, and non-cash expenses like depreciation and amortisation. A particular criticism of EBITDA has been the inappropriate outlook of capital intensive businesses, which incur large depreciation expenses. Business with large assets incurs substantial costs related to repair and maintenance, which are not captured in EBITDA because depreciation expenses are accounted to calculate EBITDA. Meanwhile, EBITDA can paint an appropriate picture for asset-light business with lower capital intensity. While revenue, profit and earning per share remain sought-after headline generators for corporates, EBITDA has also found its growing application in the corporate finance world and is now a mainstream metric to evaluate a business financially. Perhaps the growth of asset-light business models has also added to the use of EBITDA. Its debt-agnostic approach to evaluate businesses has given reasons to investors, especially for high growth firms during capital expenditure cycles. But EBITDA has been present for close to four decades now. In the 1980s, the growth in corporate takeovers through leverage buyout transaction was on a boom. EBITDA grew popular to value heavy industries like broadcasting, telecommunication, utilities. John Malone is credited for coining this term. He was working at TCI- a cable TV provider. Since EBITDA has remained an important metric to determine purchase price multiples and is highly used in M&A transactions. EBITDA’s application in large businesses with capital intensive assets that are written down over a long period has been a source of concern for many investors. Although EBITDA is an effective metric to evaluate the profitability of a firm, it does not reflect actual cash flow picture of a firm during a period. Also, it does not account for capital expenditures of the firm, which are crucial in successfully running a business. EBITDA does not give a fair cash flow position because it leaves out crucial items like working capital, debt and interest repayments, fixed expenses, capital expenditure. At the outset, there can be times when EBITDA may overstate performance, value and ability to repay debt. How to calculate EBITDA? NPAT: Net Profit after tax is the amount reported by a firm in the given period. It is present on the income statement of the firm and is used in the calculation of earnings per share of an entity. To calculate EBITDA, interest expense, tax, depreciation and amortisation are added to NPAT. Interest Expense: Firms can employ debt in their capital structure, and interest expense is funds paid to lenders as interest costs on principal debt. Most companies have different financing structure, and excluding interest payments enable comparing firms on operating grounds through EBITDA. Tax: Firms also pay income tax on profits. Excluding taxes gives a fair picture of the operating performance of the business since tax vary across jurisdictions, and sometimes according to size of business as well. Depreciation: Depreciation is the non-cash expense to account for the steady reduction in value of tangible assets. Firms can incur depreciation expense on machinery, vehicles, office assets, equipment etc. Amortisation: Amortisation is the non-cash expense to account for the reduction in the value of intangible assets like patents, copyrights, export license, import license etc. Operating Profit: Operating profit is the core profit of a firm generated out of operations. It includes cash and non-cash expenses of a firm, excluding income tax and interest expenses. Operating Profit is also called Earnings Before Interest and Tax (EBIT). Read: EBIT vs EBITDA What is TTM EBITDA and NTM EBITDA? Trailing Twelve Months (TTM) or Last Twelve Months (LTM) EBITDA represents the EBITDA of the past twelve months of the firm. It allows to review the last operation performance of the business. Whereas NTM EBITDA represents 12-month forward forecast EBITDA of the firm. NTM EBITDA is also one-year forward EBITDA. Market participants are provided with consensus analysts’ estimates for a firm, which also include NTM EBITDA, NTM EPS, NTM Net Income or NPAT. What is EBITDA margin? EBITDA margin is the percentage proportion of a firm EBITDA against total revenue. It indicates the operational profitability of the firm and cash flows to some extent. If a firm has a higher margin, it means the level of EBITDA against revenue is higher. It is widely used in comparing similar companies and enable to evaluate businesses relatively. If a firm has a total revenue of $1 million and EBITDA is $800k, the EBITDA margin is 80%. What is adjusted EBITDA? Adjusted EBITDA is calculated to provide a fair view business after adding back non-cash items, one-time expenses, unrealised gains and losses, share-based payments, goodwill impairments, asset write-downs etc.
What is an impairment? Impairment is accounting write off of a company’s asset, which can be an intangible asset as well as a fixed asset. An impairment loss is incurred when the fair value of the asset is lower than the carrying value in the balance sheet. Alternatively, impairment charges can be incurred when the recoverable value of the asset is lower than the book value. Impairment charges are recorded in the income statement of the company as an expense. Image Source: © Kalkine Group 2020 A widespread economic crisis is followed by a recession, which usually impacts the value of assets held by a company. Such events force companies to test the value of assets in the balance sheet, and this often leads to an impairment charge. IFRS accounting standards ensure that a company’s carrying value of assets depicts a value which is not in excess of the recoverable amount. Why are impairments charged by companies? As per the accounting rules, a business is often measured by its book value of assets. Specifically, the assets of the company carry the capability to generate future cash flows for the firm. When the ability of an asset to deliver expected future returns is hampered, the value of assets is decreased. Therefore, it becomes an ethical responsibility of the companies to show a fair picture of the assets. Goodwill generated at the time of business combination is required to be tested for impairments annually. Companies are required to assess any indication that could cause a potential devaluation to the asset. When a company is holding intangible assets with an indefinite life, they are required to test the assets for impairments annually. Cash generating units are often valued on the discounted value of future cash flows. Consequently, when market interest rates are rising, it impacts the discount rate used in estimating the recoverable amount. Assets can be impaired because of other reasons as well. Suppose the plant and machinery of the company were damaged due to earthquake, it would result in a reduction in the value of an asset or even full write-off of the asset. Image Source: © Kalkine Group 2020 Companies often avail consulting services to improve the performance of the business. Consultants may advise companies to shut down operations at any plant, which could result in the sale of the asset at a consideration lower than carrying value. Oftentimes, internal reporting of the companies indicate that the performance of the asset may not yield expected benefit. This would force the management to undertake impairment testing for the asset. Impairment vs amortisation Amortisation is a systematic decrease in the value of an intangible asset. Amortisation of intangible assets is a process of capitalising the expense incurred on the acquisition of the asset, and then periodically recording the expense on the income statement. Impairment, on the other hand, is an irreversible decrease in the value of the asset, which is shown as an expense in the income statement. It is charged when the recoverable amount from the asset is lower than the carrying value of the asset. Impairment vs depreciation Depreciation is a periodic devaluation of fixed assets. It is undertaken by the companies to account for the wear and tear caused to the asset during its useful life. When a firm seeks to sell an existing asset, the buyer of the asset will deduct the depreciation from the cost of the asset before adding any premium or discount to the value for arriving at the purchase price. Impairment on fixed assets could be related to an unusual fall in the fair value of the asset. For instance, the fair value of the machinery could be impacted significantly when a new and more efficient machine is available in the market. Similarly, an earthquake or fire can also devalue the value of the fixed asset in the balance sheet. Reversal of impairment loss Under the reversal of impairment loss, the approach used to determine reversal is similar to the approach used in identifying the impairment loss. Reversal of impairment loss cannot be undertaken for goodwill, and it is prohibited. Companies assess whether any impairment loss recognised in the prior periods may no longer exist or have decreased. Impairment losses can only be reversed when the estimates used in determining recoverable amount are changed. Individual asset Previously incurred impaired individual asset can be reversed only when the estimates used in calculating the recoverable amount have changed. For instance, the changes in market interest rates could impact the discount rates used in calculating the recoverable amount. Unless the reversal relates to a revalued asset, the reversal of impairment loss is recognised in the income statement. The revalued asset should not be more than depreciated historical cost without impairment. Cash generating unit In a cash-generating unit, the reversal of impairment loss is allocated on a pro-rata basis with the carrying amounts of the assets. The carrying value of an asset must not be increased above the lower of: recoverable amount and carrying amount should have been determined without any prior impairment loss, net of amortisation and depreciation.
What is an asset? An asset is an item that is invested in with the intention of gaining future benefits from it. An asset can be any item that holds monetary value. Any individual or organisation can own an asset that promises them a future financial benefit or a stream of income. Assets can be tangible or intangible. For instance, land is an asset as it can be loaned out in exchange for rent. Similarly, a patent, which is intangible, can also be considered as an asset as it provides monetary value to the owner of the patent. How is an item categorised as an asset? All assets hold three fundamental properties that set them apart from any other type of holdings or investments by firms and individuals. These include: Ownership: Assets involve the concept of ownership. The owner of the asset must pay for it and should benefit from the future income stream. This ownership is what allows the owner to gain monetary benefits from the asset. Economic Value: Assets are items that hold some form of monetary value and are not entirely worthless. This is important because an item can only be sold, loaned, or exchanged in the market when it holds some value. Future Benefit: This quality is what sets an asset apart from any other item purchased by an individual or a company. For any resource or object to be categorised as an asset for the owner, there must be a stream of income that it promises in the future. For instance, an individual might consider a family heirloom as an asset. However, the economic value associated with it might not be much. So, if the heirloom were to be exchanged in the market, it would not be of any benefit to the owner. Hence, it is not an asset. What are the types of assets? Assets can be divided into various types based on different categorisations. Broadly, assets can be divided into the following types: Personal Assets: These are the assets owned by individuals or households, and they generate some value for the owner. These may include property, jewellery, physical cash and cash equivalents, savings accounts, and investments such as bonds, pensions, mutual funds, etc. Business Assets: These assets are held by companies and are held with the intention of generating profits. These assets are added in the balance sheet of a company while the liabilities are subtracted from them. Assets may serve different purposes in a business. Individual businesses may use physical assets like machinery and equipment to produce output. While other intangible assets can be used for profit generation in the future, simply by selling them, for instance, a company might sell the intellectual property rights of one of their products to gain profits from them. Based on how easily the assets can be converted into cash, they can be further categorised into different types: Current Assets: Assets that can be easily converted into liquid money are current assets. The time frame for this conversion is typically under a year. These may include cash and cash equivalents, account receivables, inventory, marketable securities, short-term deposits. These assets help finance the day to day operations of a business and thus, are easily convertible into liquid money. Fixed or Non-Current Assets: These assets can not be easily converted into cash. They are typically used in the production process and can last more than a year. They are recorded in the balance sheet under the headings “property, plant and equipment”. They are long term assets and are generally tangible assets. Some examples of fixed assets include building, vehicles, machinery, office furniture. Assets can be categorised based on their usage into Operating and Non-Operating Assets. Operating assets are the assets used daily, while Non-Operating Assets are not used as frequently but are still crucial for a business. Operating assets would include cash, machinery, equipment patents, etc. In comparison, non-operating assets would consist of short-term investments or land or real estate that might come in usage later and do not have an immediate requirement. Assets may also be categorised based on their physical existence into tangible and non-tangible assets. Tangible assets are physical assets like land, building machinery, inventory, while intangible assets may include various other aspects of a business that do not have a physical existence like goodwill, copyrights, trademarks, licenses and permits, intellectual property, etc. How are assets valued? The value of an asset held by an individual or an organisation at a time may not be equal to what it was at the time when it was bought. The value of an asset is affected by factors like depreciation and fair value. In case of a physical asset, depreciation is the wear and tear that an asset undergoes with the course of time. However, depreciation can be generalised as the process of spreading the cost of an asset over time. It decreases the value of an asset or an item over time. Fair value refers to the market value of an asset at a point of time. If an asset of a company was to be sold in the market five years after it was bought, then the fair value of the asset refers to the amount that it would sell for at that point. This value is derived through the process of fair market value analysis, where prices of other assets are compared to the asset in question. Some professionals are skilled at calculating fair value.
Business Ethics Business ethics or corporate ethics dictates the policies and best practices that address ethical morals and hardships faced while operating a business. The best practices or code of conduct are applicable to all stakeholders associated with the corporate including individuals and the entire organization and how the stakeholders should conduct themselves to maintain an ethical decorum and legality while running a business. A clearly defined business ethics basic guideline helps taking decisions when the company or an individual stakeholder faces an ethical predicament. Need for Business Ethics “Ethics is knowing the difference between what you have a right to do and what is right to do” said by Potter Steward (former American lawyer and judge) The concept developed in 1960s-70s as globalization started taking world business to the next level. With rising interaction and an increasing focus on customer satisfaction, respecting cultural norms, social causes started to become an integral part of the process to connect a chord with the customers. For adding maximum value, corporates started following practices that showcase honesty, transparency, equality, integrity, loyalty, respect, compassion, and fairness. It also assisted in building brand value or goodwill in the market, along with creating a trust level with customers or clients. As a company expands, its communication within existing stakeholders and new stakeholders increases. For the business to operate smoothly, rules and regulations set by the company help the stakeholders to follow ethical guidelines and conduct themselves virtuously with each other. Business ethics also supports fair practices being conducted in the business and adhering business commitments. The best practices assist in deciding the right path and not to take a wrong path for immediate business gains. It ensures that when two entities or individuals carry out a business deal, there is fairness maintained in the agreement. For example, suppose a TV manufacturing company expects quality spare parts from its suppliers in a given time, the suppliers are liable to remain committed to the business deal i.e. to provide spare parts that have all gone through quality checks, and not a single defective part should reach the manufacturer which may lead to production hassle or customer loss for the manufacturer. If a supplier fails to comply with quality issues or time commitment, the manufacturer can experience considerable criticism from its end-users. Another example would be that of insider trading. Insider trading is the purchasing or selling of a public company's stock or other securities because of access a piece of nonpublic information regarding the company. For example, a director or a stakeholder of a publicly traded company gets to know that the company is set to announce a development that may trigger the share price of the company comparatively higher. On the basis of the information, the said stakeholder buys a share of a certain amount at lower prices and once the price goes up, sells them making a huge profit. The practice is illegal as all stakeholders who possess shares of a publicly traded company, were not aware of this development and only a few sitting inside the company could access this data and earn profit whereas a fair practice calls for information to be used only when it’s available for all shareholders associated with the company. How to ethically frame a code of conduct? While framing a code of conduct, an organization must take into consideration that the guidelines should take into considerations societal responsibilities and causes and should be virtuous. Four schools of thoughts have been in use to frame business ethics, including deontological, utilitarian, virtuous, and communitarian approaches. Deontological: The theory focuses on framing code of conduct on the basis of “duty” or obligations irrespective of the consequences that will stem out from following the code of conduct. The theory had been promoted by Immanuel Kant, who believed that morality arising from respect for one another, and the proper behavior should be the underlying factor for ethical reasoning. Utilitarian: The Utilitarian approach calls for actions that will lead to the ideal outcome for a given business scenario or problem. The actions will be based on a greater good with less impact on any stakeholder involved. However, there has to be clarity in the ethical line of reasoning on what is considered best and why, as the term “best” can be relative for each stakeholder involved. Virtue Ethics: This point of view focuses on the virtue that will be obtained from the actions taken. The actions will focus on the fact that the result obtained is desirable without being connected with any certain behavior or decisions. Hence, the behavior has to be rational and virtuous to ensure it is valid, beneficial, and valuable. Communitarian: In this perspective, the individual decision-maker ask about the duties owed to the communities in which they participate. This is a relatively simple frame of reference, where the individual decision maker will recognize the expectations and consequences of a given decision relative to the needs, demands and impacts of a certain preferred community. Here are more examples Conflict between company stakeholders: In case of conflict between two stakeholders in an organization, it is always advisable to treat the matter with utmost impartiality. Giving preference or being partial to any one party is considered to be unfair to the other party. This demonstrates unethical conduct. Management team or supervisor should provide solutions to the problem, which is fair and ethical to both the parties. An unfair final decision will ultimately hold the organization, and the supervisor jointly responsible for the adverse effect. Transparency while dealing with shareholders or customers: The Company should always be transparent regarding its dealings. Whether with shareholders or customers, the information provided on any development or about the company and its products should always be accurate and real. The disclosures should not be wrong or partial for attaining capital gains. If a company engages in providing incorrect material or partially disclosed information, it is considered to be unethical as the customers or shareholders may experience loss based on the wrong information. For example, a food and beverage company are expected to declare the name of its ingredients while labeling the product. If any discrepancy is found in labeling, the entire lot of that product is recalled from the market, as intake of that product may lead to health hazards for the consumer. Such incidences lead to business loss and goodwill of the company. Equality in the wage system: An organization should follow an unbiased wage system where discrimination regarding gender, race, or LGBTQ should not take place.