What is goodwill?
We will discuss the definition of the finance and accounting term goodwill, and make sense
of how goodwill works by discussing one of the largest technology acquisitions in recent
history: the acquisition of social network Linked In by Microsoft.
We will review the calculation of goodwill for that headline-grabbing deal, which is
a great example of how to record goodwill on the balance sheet.
For some companies, goodwill is in the top 3
of largest categories of assets on their
balance sheet.
If you want to make sense of a company's financial statements,
then a basic understanding of
the concept of goodwill is invaluable.
Let's start with the definition of goodwill, please don't panic if this sounds somewhat
cryptic to you, it will all become clear very soon.
Goodwill is the excess of the purchase price paid for an acquired firm, over the fair value
of its separately identifiable net assets.
Let's illustrate that definition of goodwill with an example.
The business man in the blue suit and the business man in the red suit come to an agreement.
Blue pays a large sum of money to red, and in return red transfers the ownership of a
factory to blue.
How does goodwill come into this picture?
If the purchase price is $3B, and the net assets are $2B, then the difference of $1B
is goodwill.
You could disrespectfully call goodwill an "accounting plug" in order to make the journal
entry balance: if $3B of cash leaves the door, and on paper I only get net assets of $2B
in return, then I need to "plug" $1B somewhere in order for the debits to equal the credits.
So here is the definition of goodwill in simpler terms: goodwill is the difference between
what a company pays to buy an acquisition target, and what that acquired company is
worth "on paper".
Goodwill is recognized only in a business combination, and goodwill is not amortized.
Why would any acquiring company pay a premium for an acquisition target above what that
company's net assets are worth?
Goodwill reflects the perceived superior earnings capacity of the business combination.
Let's make the concept of goodwill come alive by reviewing one of the most exciting technology
deals of 2016: the acquisition of social network Linked In by Microsoft.
On June 13, 2016, Microsoft and Linked In announced that Microsoft will acquire Linked
In for $196 per share, which adds up to a purchase price of $26.2B. The transaction
had been unanimously approved by the Boards of Directors of both LinkedIn and Microsoft,
and the CEO's of both companies held a joint conference call to explain the rationale of
the deal and their optimism for the opportunities created when combining the companies.
Nearly six months later, on December 8, 2016, the deal closed, once regulatory approvals
had been obtained.
$26B was a very large purchase price, including a significant premium.
Microsoft believes the benefits of the business combination between the world's leading professional
cloud and the world's leading professional network justify the deal.
So how does the accounting for goodwill work in the Microsoft - Linked In acquisition?
Microsoft's filing with the SEC of its FY17 Q2 quarterly report on January 26th 2017,
which is called a 10-Q filing, gives us the answers we are looking for.
Goodwill is recorded as an asset on the balance sheet, so let's look up Microsoft's balance
sheet per the end of the quarter: December 31st 2016.
If we look at the left-hand side of the balance sheet, we get a listing of the assets on the
balance sheet date.
Goodwill is a non-current or long-term asset, so we need to look towards the bottom of the
list, as the balance sheet for American companies starts with the most liquid assets (cash and
items that are ready to convert to cash) and ends with the least liquid assets.
There we have it: goodwill per December 31st 2016 at $34.5B, the second largest line item
out of the balance sheet with a total of $224.6B in assets.
Goodwill has increased by $16.7B since June 30, 2016.
More detail on how the deal was accounted for can be found in the notes to the financial
statements, more specifically in note 8 business combinations.
Microsoft states:
On December 8 we completed the acquisition
of LinkedIn for $27B.
Most of the purchase price was cash.
The acquisition is expected to accelerate the growth of
LinkedIn, Office 365, and Dynamics 365.
The purchase price allocation
as of the date of the acquisition
was based on a preliminary
valuation and is subject to revision.
In other words, this is the accounting for the time being, it might change, so check
the annual report once the full fiscal year is complete.
It is good to remember that a quarterly report publishes unaudited financial statements,
while an annual report has audited financial statements.
Here is the overview of the purchase price allocation.
$27B paid in total, what does Microsoft get in return?
First of all, Linked In's tangible assets such as cash and cash equivalents, short term
investments, other current assets, and property and equipment.
This adds up to $5.7B.
If you acquire a company, you don't just take on the assets (what the company owns), you
also take up the liabilities (what a company owes).
Linked In's liabilities that Microsoft took on were primarily short term debt, other current
liabilities, and deferred income taxes.
This added up to $3.4B. Microsoft paid $27B in total, got tangible
net assets in return of $5.7B minus $3.4B is $2.3B. So is the rest of the amount to
be booked as goodwill?
Not quite.
In an acquisition, you first have to figure out what the value is of the intangible assets;
nonmonetary assets without physical substance.
Microsoft's valuation of the intangible assets that were acquired by purchasing Linked In
is $7.9B. Valuation of intangible assets is a separate topic, which is out of scope for
this video.
The important things for us in this discussion of the purchase price allocation, based on
fixed amount of purchase price and tangible net assets,
is that if the value of intangible
assets is high, then goodwill will be low, and if the value of intangible assets is low,
then goodwill will be high.
Microsoft assessed the fair value of the intangible assets acquired at $7.9B.
The intangible assets
are thought to have a useful life of 9 years on average, and will be amortized over this
period.
On average, this will lead to an incremental amortization charge for Microsoft due to the
Linked In deal of $875MM per year.
Now that we have looked at all the items except goodwill, we have a fair value of the net
assets of $5.7B plus $7.9B minus $3.4B is $10.2B.
The purchase price is $27B, the fair
value of the net assets $10.2B, therefore goodwill is $16.8B.
So is that it?
Amortize the intangible assets over their useful lives, keep goodwill on the balance
sheet forever as goodwill is never amortized?
Not necessarily!
Check the "Risk Factors" section of Microsoft's 10-Q. Companies have to perform an annual
impairment test to both goodwill and intangible assets.
What that impairment test does is basically to assess whether the carrying value of goodwill
and intangible assets is recoverable.
In simple terms: if the financial results and future prospects of the business you acquired
are dramatically dropping, you need to write off all or part of the goodwill and intangible
assets.
Microsoft acquired Nokia's Devices and Services business for a total purchase price of $9.4
billion on April 25, 2014.
During the fourth quarter of fiscal year 2015, just over one year later, almost all of the
goodwill and half of the intangible assets of that deal were written off due to impairment.
Time will tell whether the acquisition of Linked In by Microsoft will live up to the
optimistic strategic and financial expectations.
Thank you for watching!
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