Difficulties with valuing and accounting for goodwill

IEA Chairman Prof. D.R. Myddelton writes to the FT letters page

Sir, Lex’s discussion of goodwill, “Goodwill games”, September 28, and how accountants are now required to treat it, reminds us of two serious problems.

First, there is a need to estimate the current value of continuing goodwill in order to determine whether, and to what extent, there may be a need to write any “impairment” off against profit.

There is almost never an active market for such an intangible yet specific asset, so valuation requires some kind of “marking to model”, often based on discounted cash flows. These are notorious both for the difficulty of forecasting future cash flows and for extreme sensitivity to small changes in the discount rate. In other words, as we saw in the recent financial crisis, the attempt to “mark to market” in the absence of an active market is subject to huge margins of error.

The second problem concerns the nature of goodwill itself. It seems clear that most “goodwill” depreciates over time, probably quite rapidly, unless it is constantly “topped up”, usually by further investment. (For this reason I much prefer the former system of accounting which required the systematic amortisation of the cost of purchased goodwill against profit.)

Lex reports that, apart from RBS’s write-off of €32bn, only about 4 per cent of European companies’ goodwill has been written down since the recession began – a surprisingly small amount. More or less “maintaining” the existing value of goodwill on the balance sheet in effect “capitalises” much of the internal expenditure on goodwill – which seems imprudent.

I don’t blame auditors for all this, as Lex seems inclined to do. I blame the accounting standard-setters who have landed us with a very unsatisfactory system of accounting.

D.R. Myddelton,

Emeritus Professor of Finance and Accounting,

Cranfield School of Management,

Bedford, UK

Read the letter on the FT website (subscription required)