And the amortization of goodwill Rules and Reality
BERKSHIREHATHAWAY
INC.
Berkshire Hathaway Co., Ltd.
Goodwill and its Amortization:
The Rules and The Realities
Goodwill and amortization: Rules and Reality
This appendix deals only with
economic and accounting Goodwill - not the goodwill of everyday
usage. For example, a business may be well liked, even loved, by
most of its customers but possess no economic goodwill. (AT & T,
before the breakup, was generally well thought of, but possessed
not a dime of economic Goodwill.) And, regrettably, a business may
be disliked by its customers but possess substantial, and growing,
economic Goodwill. So, just for the moment, forget emotions and
focus only on economics and accounting.
This appendix is just economic and accounting of goodwill, rather than the reputation of the daily said. For example, a company may be most of the customers like, even love, but do not have any economic goodwill. (AT & T in the spin-off before the general reputation of good, but not a penny of economic goodwill.) Unfortunately, a company may be their customers do not like, but with a large and growing economic goodwill. So, for now, let us forget the feelings, just focus on the economy and accounting.
When a business is purchased,
accounting principles require that the purchase price first be
assigned to the fair value of the identifiable assets that are
acquired. Frequently the sum of the fair values put on the assets
(After the deduction of liabilities) is less than the total
purchase price of the business. In that case, the difference is
assigned to an asset account entitled in net assets acquired mouthful, we will substitute
When a company being acquired, the accounting standards require the acquisition price is allocated first to the acquisition the fair value of identifiable assets. The sum of the fair value of assets (after deduction of liabilities) is often less than the total price of the company's mergers and acquisitions. In this case, the difference between the two is assigned to an asset account, called In order to avoid repeating this long argument, we will use the
Accounting Goodwill arising
from businesses purchased before November 1970 has a special
standing. Except under rare circumstances, it can remain an asset
on the balance sheet as long as the business bought is retained.
That means no amortization charges to gradually extinguish that
asset need be made against earnings.
In November 1970 the purchase of the goodwill arising on a different treatment. Except in rare circumstances, as long as the company continues to hold the purchased goodwill can exist in the balance sheet. This means that accounting earnings without amortization costs for the gradual reduction of the assets.
The case is different, however,
with purchases made from November 1970 on. When these create
Goodwill, it must be amortized over not more than 40 years through
charges - of equal amount in every year-to the earnings account.
Since 40 years is the maximum period allowed, 40 years is what
managements (including us) usually elect. This annual charge to
earnings is not allowed as a tax deduction and, thus, has an effect
on after-tax income that is roughly double that of most other
expenses.
But after the merger in 1970 is different. When the acquisition generated goodwill, the goodwill must be no more than 40 years amortization period. Equal annual amortization expenses reduce profits account. Since 40 years is the maximum time allowed, which is the management (including our own) is usually optional. The annual cost reduction of profits is not allowed to be used to offset tax, so has the general cost is about twice the impact of after-tax income.
That'show accounting Goodwill
works. To see how it differs from economic reality, let's look at
an example close at hand. We'll round some figures, and greatly
oversimplify, to make the example easier to follow. We'll also
mention some implications for investors and managers.
This is the practice of accounting for goodwill. In order to reveal the actual situation in which the different economic goodwill, let's look at an example at hand. We will approximate some figures, and greatly simplified to make the example easy to understand. We will also mention some of the impact of investors and managers.
Blue Chip Stamps bought See's
early in 1972 for $ 25 million, at which time See's had about $ 8
million of net tangible assets. (Throughout this discussion,
accounts receivable will be classified as tangible assets, a
definition proper for business analysis.) This level of tangible
assets was adequate to conduct the business without use of debt,
except for short periods seasonally. See's was earning about $ 2
million after tax at the time, and such earnings seemed
conservatively representative of future earning power in constant
1972 dollars.
Blue Chip
Stamps in early 1972 to $ 25,000,000 purchase of s Candy. At that time, joy poems about 8 million of the net tangible assets. (Throughout the discussion, the receivables will be attributed to tangible assets, the definition of the business analysis is appropriate.) This level of tangible assets, in addition to seasonal short period of time, debt was not enough operations. Hi poem after-tax profit at the time is 2 million, which seems to represent a conservative in 1972 dollars to future profitability.
Thus our first lesson:
businesses logically are worth far more than net tangible assets
when they can be expected to produce earnings on such assets
considerably in excess of market rates of return. The capitalized
value of this excess return is economic Goodwill.
So the first lesson we learned: When the net tangible assets to produce far more than the market rate of return levels, the value of the company, logically, far more than the net tangible assets. The value of the excess market returns are capitalized to become an economic goodwill.
In 1972 (and now) relatively
few businesses could be expected to consistently earn the 25% after
tax on net tangible assets that was earned by See's - doing it,
furthermore, with conservative accounting and no financial
leverage. It was not the fair market value of the inventories,
receivables or fixed assets that produced the premium rates of
return. Rather it was a combination of intangible assets,
particularly a pervasive favorable reputation with consumers based
upon countless pleasant experiences they have had with both product
and personnel.
In 1972 (and still are) relatively few companies, as stable as the hi Poetry 25% of the after-tax net tangible assets. And this rate of return is based on conservative accounting methods and financial leverage is not the case. Is not the fair market value of inventory, receivables, fixed assets, or to produce such a remarkable rate of return. On the contrary, is a combination of intangible assets, particularly good reputation among consumers had it all. This reputation is built on consumer products and its employees over many enjoyable experience.
Such a reputation creates a
consumer franchise that allows the value of the product to the
purchaser, rather than its production cost, to be the major
determinant of selling price. Consumer franchises are a prime
source of economic Goodwill. Other sources include governmental
franchises not subject to profit regulation, such as television
stations, and an enduring position as the low cost producer in
anindustry.
The reputation of creating a consumer franchise. This allows buyers the value of products, rather than production costs, the decision to become the main determinants of sales prices. Consumer franchise is a major source of economic goodwill. Other sources include non-profit franchise of government control, such as television and low-cost producers in an industry's persistent position.
Let's return to the accounting
in the See's example. Blue Chip's purchase of See's at $ 17 million
over net tangible assets required that a Goodwill account of this
amount be established as an asset on Blue Chip's books and that
$ 425,000 be charged to income annually for 40 years to amortize
that asset. By 1983, after 11 years of such charges, the $ 17
million had been reduced to about $ 12.5 million. Berkshire,
meanwhile, owned 60% of Blue Chip and, therefore, also 60% of
See's. This ownership meant that Berkshire's balance sheet
reflected 60% of See's Goodwill, or about $ 7.5 million.
Let us return to hi this case the accounting treatment of poetry. BlueChip acquisition of hi poetry beyond the net tangible assets of $ 17,000,000. This requires BlueChip established on the balance sheet of the same amount of the goodwill account, and in 40 years, the annual amortization of this asset to the cost of $ 425,000, be reduced profits. By 1983, after 11 years of such amortization, which 17 million has been reduced to 1,250 million. Berkshire, meanwhile, has 60% of the BlueChip, so that is 60% of the hi poetry. The ownership of the means Berkshire's balance sheet reflects 60% of the hi poetry goodwill, $ 7,500,000.
In 1983 Berkshire acquired the
rest of Blue Chip in a merger that required purchase accounting as
contrasted to the Under purchase accounting, the (Or acquired from Blue Chip. This almost always is when public companies use their shares to make
acquisitions, by the market value of the shares given up.
1983, Berkshire acquired BlueChip the remaining shares. The merger requires the use of acquisition accounting, rather than some combination allowed by the M & A accounting treatment, we give (or Chip of the shares of the The
The assets consisted of 40% of everything owned by Blue Chip (as noted,
Berkshire already owned the other 60%). What Berkshire more than the net identifiable assets we received by $ 51.7 million,
and was assigned to two pieces of Goodwill: $ 28.4 million to See's
and $ 23.3 million to Buffalo Evening News.
When Berkshire Evening News.
After the merger, therefore,
Berkshire was left with a Goodwill asset for See's that had two
components: the $ 7.5 million remaining from the 1971 purchase, and
$ 28.4 million newly created by the 40% amortization charge now will be about $ 1.0 million for the next 28
years, and $ .7 million for the following 12 years, 2002 through
2013.
So after the merger, Berkshire has hi poetry goodwill, has two parts: from the 1971 acquisition of the remaining 750 million, and in 1983 40% of the In the next 28 years, amortization expense will be 1 million per year, that is, 12 years after the 2002-2013 year is $ 700,000 per year.
In other words, different
purchase dates and prices have given us vastly different asset
values and amortization charges for two pieces of the same asset.
(We repeat our usual disclaimer: we have no better accounting
system to suggest. The problems to be dealt with are mind boggling
and require arbitrary rules.)
In other words, different acquisition dates and prices, the same one we had two very different asset value and amortization charges. (We repeat our Disclaimer: We do not recommend a better accounting system. A number of issues must be resolved is hard to imagine, so there must be hard and fast rules.)
But what are the economic
realities? One reality is that the amortization charges that have
been deducted as costs in the earnings statement each year since
acquisition of See's were not true economic costs. We know that
because See's last year earned $ 13 million after taxes on about $ 20
million of net tangible assets - a performance indicating the
existence of economic Goodwill far larger than the total original
cost of our accounting Goodwill. In other words, whilea ccounting
Goodwill regularly decreased from the moment of purchase, economic
Goodwill increased in irregular but very substantial fashion.
However, the economic reality is what? One reality is that ex post poems from the hi annually from the income statement as cost less amortization costs are not real economic costs. Last year, we know Xi Poetry million in 2000 on top of the net tangible assets, earned $ 13,000,000 after-tax profit. The results show that the existing economic goodwill is far higher than the initial total cost of goodwill accounting. In other words, although the accounting of goodwill from the acquisition of the periodic law of the moment have decreased, but not the law of economy but of goodwill but very significant way to increase.
Another reality is that annual
amortization charges in the future will not correspond to economic
costs. It is possible, of course, that See's economic Goodwill will
disappear. But it won't shrink in even decrements or anything
remotely resembling them. What is more likely is that the Goodwill
will increase-in current, if not in constant, dollars -
because of inflation.
Another reality is that the future annual amortization expense will be unable to meet the economic costs. Of course, hi poetry economic goodwill may disappear. But the goodwill will not be stable consumption, or a similar stable way consumption. Most likely, the goodwill will be increased. As the role of inflation, goodwill will be the current value of the dollar, rather than constant dollar increase in value.
That probability exists because
true economic Goodwill tends to rise in nominal value
proportionally with inflation. To illustrate how this works, let's
contrast a See's kind of business with a more mundane business.
When we purchased See's in 1972, it will be recalled, it was
earning about $ 2 million on $ 8 million of net tangible assets. Let
us assume that our hypothetical mundane business then had $ 2
million of earnings also, but needed $ 18 million in net tangible
assets for normal operations. Earning only 11% on required tangible
assets, that mundane business would possess little or no economic
Goodwill.
This possibility exists because true economic Goodwill Qing Xiangyu with inflation in the nominal value proportional to the increase. To illustrate how this works, let us hi this poem a more general business and business to make a comparison. In 1972, we acquired the original poem hi, it is 8 million dollars in net tangible assets above the profit of 2 million. Let us assume that we assume that there are 2 general business of millions of dollars in profits, but it requires $ 18,000,000 of the net tangible assets to maintain normal operations. In tangible assets required to obtain only 11% above the return on the ordinary business with little or no economic goodwill.
A business like that,
therefore, might well have sold for the value of its net tangible
assets, or for $ 18 million. In contrast, we paid $ 25 million for
See's, even though it had no more in earnings and less than half as
much in as our purchase price implied? The answer is businesses were expected to have flat unit volume - as long as
you anticipated, as we did in 1972, a world of continuous
inflation.
Such a business is entirely possible to its net tangible assets of $ 18,000,000 and sold. In contrast,nike air max 90, we paid $ 25,000,000 to purchase a hi poetry, even if it is no more profitable, and only in front of general business assets of less than half the real deal. Is less both more like our acquisition price implies? The answer is Even if the two businesses are expected to have stalled traffic, as long as you expect inflation to a sustainable world, as we expected, as in 1972, the answer is
To understand why, imagine the
effect that a doubling of the price level would subsequently have
on the two businesses. Both would need to double their nominal
earnings to $ 4 million to keep themselves even with inflation. This
would seem to be no great trick: just sell the same number of units
at double earlier prices and, assuming profit margins remain
unchanged, profits also must double.
To understand why, imagine doubling the price level after the impact of these two operations. Both the name of profits need to double to 4 million dollars to keep up with inflation. This seems not too much means: as long as the number of selling the same amount, the price doubled on the line, assuming the same profit margin, profit will double.
But, crucially, to bring that
about, both businesses probably would have to double their nominal
investment in net tangible assets, since that is the kind of
economic requirement that inflation usually imposes on businesses,
both good and bad. A doubling of dollar sales meansc orrespondingly
more dollars must be employed immediately in receivables and
inventories. Dollars employed in fixed assets will respond more
slowly to inflation, but probably just as surely. And all of this
inflation-required investment will produce no improvement in rate
of return. The motivation for this investment is the survival of
the business, not the prosperity of the owner.
But the key is that, in order to achieve this, both probably have to be the normal double the net tangible assets. This is often because of inflation and economic requirements imposed on businesses, have advantages and disadvantages. Double sales in dollars means more money must be used immediately in receivables and inventory. The money used for fixed assets will have slower reaction on inflation, but certainly there will be reactions. Moreover, the requirements of all these inflation rate of return on investment will not improve. The reason for this investment is to maintain business survival rather than growth in the interests of owners.
Remember, however, that See's
had net tangible assets of only $ 8 million. So it would only have
had to commit an additional $ 8 million to finance the capital needs
imposed by inflation. The mundane business, meanwhile, had a burden
over twice as large - a need for $ 18 million of additional capital.
Remember, only 8 million dollar hi Poetry net tangible assets. Therefore, it only need to invest an additional 8 million dollars to support the capital requirements imposed by inflation. Ordinary business, then have a double burden, requires $ 18,000,000 of additional capital.
After the dust had settled, the
mundane business, now earning $ 4 million annually, might still be
worth the value of its tangible assets, or $ 36 million. That means
its owners would have gained only a dollar of nominal value for
every new dollar invested. (This is the same dollar-for-dollar
result they would have achieved if they had added money to a
savings account.)
After the dust settles, the general business, now an annual profit of 4 million, may still be a value equal to the value of its tangible assets, namely $ 36,000,000. This means that the owner of every dollar invested, produced only a nominal value of the dollar increases. (This is added to their money as deposit accounts, are a dollar for dollar.)
See's, however, also earning $ 4
million, might be worth $ 50 million if valued (as it logically
would be) on the same basis as it was at the time of our purchase.
So it would have gained $ 25 million in nominal value while the
owners were putting up only $ 8 million in additional capital - over
$ 3 of nominal value gained for each $ 1 invested.
Hi poem also profit 4 million, the same with our purchase method of valuation assessment (logically should be the case) could be worth $ 50,000,000. So hi poem received the nominal value of $ 25,000,000 increased, while the owner is only 8 million dollar investment in additional capital, which invested $ 1 each received the equivalent of more than three U.S. dollars in nominal value.
Remember, even so, that the
owners of the See's kind of business were forced by inflation to
ante up $ 8 million in additional capital just to stay even in real
profits. Any unleveraged business that requires some net tangible
assets to operate (and almost all do) is hurt by inflation.
Businesses needing little in the way of tangible assets simply are
hurt the least.
Remember, even so, hi poetry is also the owner of 8 due to inflation forced to pay millions of dollars in additional capital, which was only to maintain the real profit. Do not leverage any number of net tangible assets and the need to operate (almost all business is so) the business will be hurt by inflation. Only very few tangible assets by the business but at least the damage.
And that fact, of course, has
been hard for many people to grasp. For years the traditional
wisdom - long on tradition, short on wisdom-held that inflation
protection was best provided by businesses laden with natural
resources, plants and machinery, or other tangible assets (Goods We Trust generally earn low rates of return - rates that often barely
provide enough capital to fund the inflationary needs of the
existing business, with nothing left over for real growth, for
distribution to owners, or for acquisition of new businesses.
However, the fact that, of course, has been difficult by many people realize. For years, conventional wisdom, (longer than traditional, shorter than intelligence) that is full of natural resources, plant, machinery and other tangible assets (In fact not the case. Important business assets, access to low rate of return is usually low to provide only enough capital to meet the needs of existing business, inflation, and could not really left anything to support the growth of dividends to the owner, or the acquisition of new business.
In contrast, a disproportionate
number of the great business fortunes built up during the
inflationary years arose from ownership of operations that combined
intangibles of lasting value with relatively minor requirements for
tangible assets. In such cases earnings have bounded upward in
nominal dollars, and these dollars have been largely available for
the acquisition of additional businesses. This phenomenon has been
particularly evident in the communications business. That business
has required little in the way of tangible investment - yet its
franchises have endured. During inflation, Goodwill is the gift
that keeps giving.
In contrast, the disproportionately large number of business accumulating wealth in the inflation period. The wealth is by having achieved a number of business operations, these operations lasting value combined with the relatively few tangible intangible asset demand. In these examples, a substantial increase in nominal earnings, these funds can be used to acquire other businesses. This phenomenon is particularly evident in the telecommunications industry. The industry only needs a small investment in tangible assets, but was able to maintain the franchise. Inflation period, the goodwill and dedication is constantly present.
But that statement applies,
naturally, only to true economic Goodwill. Spurious accounting
Goodwill - and there is plenty of it around-is another matter.
When an overexcited management purchases a business at a silly
price, the same accounting niceties described earlier are observed.
Because it can't go anywhere else, the silliness ends up in the
Goodwill account. Considering the lack of managerial discipline
that created the account, under such circumstances it might better
be labeled typically is observed and the adrenalin so capitalized remains on
the books as an sensible one.
But this argument only applies to the real nature of economic goodwill. Deceptive accounting goodwill (there are many such examples) is another matter. When an over-excited with the management of high prices to buy a silly business, accounting previously described the details of the same can also be observed. Because it is nowhere to go, the final purchase price of stupid to stay in the goodwill account. Taking into account the lack of management discipline to create such an account, in this case, it should be called Regardless of period, usually observed 40-year ritual of amortization. Management adrenaline excitement was reserved on the books of the capital as a
If you cling to any belief that
accounting treatment of Goodwill is the best measure of economic
reality, I suggest one final item to ponder.
If you insist that the accounting treatment of goodwill is the best way to measure the economic reality, I suggest you think about the last example.
Assume a company with $ 20 per
share of net worth, all tangible assets. Further assume the company
has internally developed some magnificent consumer franchise, or
that it was fortunate enough to obtain some important television
stations by original FCC grant. Therefore, it earns a great deal on
tangible assets, say $ 5 per share, or 25%.
Suppose a company has 20 per share dollars in net assets, all tangible assets. Suppose further that the internal development of an excellent consumer franchise, or the company lucky enough to obtain some important FCC granted the first television station licenses. Therefore, the company profitable in tangible assets, such as 5 dollars per share, or 25% return.
With such economics, it might
sell for $ 100 per share or more, and it might well also bring that
price in a negotiated sale of the entire business.
Such economic conditions, this stock may be selling price per share $ 100 or more. But also may sell the entire business in a negotiation to get this price.
Assume an investor buys the
stock at $ 100 per share, paying in effect $ 80 per share for
Goodwill (just as would a corporate purchaser buying the whole
company). Should the investor impute a $ 2 per share amortization
charge annually ($ 80 divided by 40 years) to calculate earnings per share? And, if so, should the new $ 3 per share cause him to rethink his purchase price?
Suppose an investor paid $ 100 per share to buy shares, in fact, is a goodwill payment of $ 80 per share (as a mergers and acquisitions as the company). Should the investors $ 2 a year from the amortization of costs for the calculation of If so, the new $ 3
We believe managers and
investors alike should view intangible assets from two
perspectives:
We believe that managers and investors should look at intangible assets from two perspectives:
1. In
analysis of operating results - that is, in evaluating the
underlying economics of a business unit - amortization charges
should be ignored. What a business can be expected to earn on
unleveraged net tangible assets, excluding any charges against
earnings for amortization of Goodwill, is the best guide to the
economic attractiveness of the operation. It is also the best guide
to the current value of the operation's economic Goodwill.
In the analysis of operating results, that is, a business unit of the internal assessment of the economic situation, the amortization expense should be ignored. A business is expected to net tangible assets available to the profit, excluding any goodwill amortization expense, is the measure of whether the business operations economically attractive in the best guidance. This is also the business operations of the economic goodwill measure the current value of the best guidance.
2. In
evaluating the wisdom of business acquisitions, amortization
charges should be ignored also. They should be deducted neither
from earnings nor from the cost of the business. This means forever
viewing purchased Goodwill at its full cost, before any
amortization. Furthermore, cost should be defined as including the
full intrinsic business value - not just the recorded accounting
value - of all consideration given, irrespective of market prices
of the securities involved at the time of merger and irrespective
of whether pooling treatment was allowed. For example, what we
truly paid in the Blue Chip merger for 40% of the Goodwill of See's
and the News was considerably more than the $ 51.7 million entered
on our books. This disparity exists because the market value of the
Berkshire shares given up in the merger was less than their
intrinsic business value, which is the value that defines the true
cost to us. In assessing the wisdom of business mergers and acquisitions, the amortization expense should be ignored. Amortization should not be subtracted from the profitability of business, the cost should not be deducted from the business. This means that, as always purchased before goodwill amortization in any of the full cost. More importantly, the acquisition cost should be defined as the price paid includes all the intrinsic business value, not just the accounting value of its records, regardless of the securities involved in mergers when the market price, and regardless of whether it permits the use of merger accounting . For example, we merge Blue
Chip 40% of the hi poetry and Buffalo
Goodwill Evening News, the real price to pay far more than we recorded in the book's $ 51,700,000. The existence of this inconsistency is due to the merger, the market value of Berkshire stock below their intrinsic business value, the decision for us, this is the real cost value.
Operations that appear to be
winners based upon perspective (1) may pale when viewed from
perspective (2). A good business is not always a good purchase -
although it's a good place to look for one.
From the perspective of (1), appeared to be the winner of the business operations, it is possible from the perspective of (2) However it is eclipsed. A good business is not necessarily a good acquisition target, although a good business is the place to find good acquisitions.
We will try to acquire
businesses that have excellent operating economics measured by (1)
and that provide reasonable returns measured by (2). Accounting
consequences will be totally ignored.
We will seek acquisitions that use (1) measure is an excellent operating condition, but also with (2) measure to produce a reasonable return business. Accounting consequences will be completely ignored.
At yearend 1983, net Goodwill
on our accounting books totaled $ 62 million, consisting of the $ 79
million you see stated on the asset side of our balance sheet, and
$ 17 million of negative Goodwill that is offset against the
carrying value of our interest in Mutual Savings and Loan.
At the end of 1983, the accounting books in our net goodwill was $ 62,000,000, including $ 79,000,000 marked on the side of the balance sheet of assets and negative goodwill of $ 17,000,000 to write off our holdings of Mutual Savings and Loan interest value.
We believe net economic
Goodwill far exceeds the $ 62 million accounting number.
We believe that the net economic goodwill far exceed this $ 62,000,000 of the accounting figures. (1983 letter to Berkshire Hathaway shareholders in Appendix)
INC.
Berkshire Hathaway Co., Ltd.
Goodwill and its Amortization:
The Rules and The Realities
Goodwill and amortization: Rules and Reality
This appendix deals only with
economic and accounting Goodwill - not the goodwill of everyday
usage. For example, a business may be well liked, even loved, by
most of its customers but possess no economic goodwill. (AT & T,
before the breakup, was generally well thought of, but possessed
not a dime of economic Goodwill.) And, regrettably, a business may
be disliked by its customers but possess substantial, and growing,
economic Goodwill. So, just for the moment, forget emotions and
focus only on economics and accounting.
This appendix is just economic and accounting of goodwill, rather than the reputation of the daily said. For example, a company may be most of the customers like, even love, but do not have any economic goodwill. (AT & T in the spin-off before the general reputation of good, but not a penny of economic goodwill.) Unfortunately, a company may be their customers do not like, but with a large and growing economic goodwill. So, for now, let us forget the feelings, just focus on the economy and accounting.
When a business is purchased,
accounting principles require that the purchase price first be
assigned to the fair value of the identifiable assets that are
acquired. Frequently the sum of the fair values put on the assets
(After the deduction of liabilities) is less than the total
purchase price of the business. In that case, the difference is
assigned to an asset account entitled in net assets acquired mouthful, we will substitute
When a company being acquired, the accounting standards require the acquisition price is allocated first to the acquisition the fair value of identifiable assets. The sum of the fair value of assets (after deduction of liabilities) is often less than the total price of the company's mergers and acquisitions. In this case, the difference between the two is assigned to an asset account, called In order to avoid repeating this long argument, we will use the
Accounting Goodwill arising
from businesses purchased before November 1970 has a special
standing. Except under rare circumstances, it can remain an asset
on the balance sheet as long as the business bought is retained.
That means no amortization charges to gradually extinguish that
asset need be made against earnings.
In November 1970 the purchase of the goodwill arising on a different treatment. Except in rare circumstances, as long as the company continues to hold the purchased goodwill can exist in the balance sheet. This means that accounting earnings without amortization costs for the gradual reduction of the assets.
The case is different, however,
with purchases made from November 1970 on. When these create
Goodwill, it must be amortized over not more than 40 years through
charges - of equal amount in every year-to the earnings account.
Since 40 years is the maximum period allowed, 40 years is what
managements (including us) usually elect. This annual charge to
earnings is not allowed as a tax deduction and, thus, has an effect
on after-tax income that is roughly double that of most other
expenses.
But after the merger in 1970 is different. When the acquisition generated goodwill, the goodwill must be no more than 40 years amortization period. Equal annual amortization expenses reduce profits account. Since 40 years is the maximum time allowed, which is the management (including our own) is usually optional. The annual cost reduction of profits is not allowed to be used to offset tax, so has the general cost is about twice the impact of after-tax income.
That'show accounting Goodwill
works. To see how it differs from economic reality, let's look at
an example close at hand. We'll round some figures, and greatly
oversimplify, to make the example easier to follow. We'll also
mention some implications for investors and managers.
This is the practice of accounting for goodwill. In order to reveal the actual situation in which the different economic goodwill, let's look at an example at hand. We will approximate some figures, and greatly simplified to make the example easy to understand. We will also mention some of the impact of investors and managers.
Blue Chip Stamps bought See's
early in 1972 for $ 25 million, at which time See's had about $ 8
million of net tangible assets. (Throughout this discussion,
accounts receivable will be classified as tangible assets, a
definition proper for business analysis.) This level of tangible
assets was adequate to conduct the business without use of debt,
except for short periods seasonally. See's was earning about $ 2
million after tax at the time, and such earnings seemed
conservatively representative of future earning power in constant
1972 dollars.
Blue Chip
Stamps in early 1972 to $ 25,000,000 purchase of s Candy. At that time, joy poems about 8 million of the net tangible assets. (Throughout the discussion, the receivables will be attributed to tangible assets, the definition of the business analysis is appropriate.) This level of tangible assets, in addition to seasonal short period of time, debt was not enough operations. Hi poem after-tax profit at the time is 2 million, which seems to represent a conservative in 1972 dollars to future profitability.
Thus our first lesson:
businesses logically are worth far more than net tangible assets
when they can be expected to produce earnings on such assets
considerably in excess of market rates of return. The capitalized
value of this excess return is economic Goodwill.
So the first lesson we learned: When the net tangible assets to produce far more than the market rate of return levels, the value of the company, logically, far more than the net tangible assets. The value of the excess market returns are capitalized to become an economic goodwill.
In 1972 (and now) relatively
few businesses could be expected to consistently earn the 25% after
tax on net tangible assets that was earned by See's - doing it,
furthermore, with conservative accounting and no financial
leverage. It was not the fair market value of the inventories,
receivables or fixed assets that produced the premium rates of
return. Rather it was a combination of intangible assets,
particularly a pervasive favorable reputation with consumers based
upon countless pleasant experiences they have had with both product
and personnel.
In 1972 (and still are) relatively few companies, as stable as the hi Poetry 25% of the after-tax net tangible assets. And this rate of return is based on conservative accounting methods and financial leverage is not the case. Is not the fair market value of inventory, receivables, fixed assets, or to produce such a remarkable rate of return. On the contrary, is a combination of intangible assets, particularly good reputation among consumers had it all. This reputation is built on consumer products and its employees over many enjoyable experience.
Such a reputation creates a
consumer franchise that allows the value of the product to the
purchaser, rather than its production cost, to be the major
determinant of selling price. Consumer franchises are a prime
source of economic Goodwill. Other sources include governmental
franchises not subject to profit regulation, such as television
stations, and an enduring position as the low cost producer in
anindustry.
The reputation of creating a consumer franchise. This allows buyers the value of products, rather than production costs, the decision to become the main determinants of sales prices. Consumer franchise is a major source of economic goodwill. Other sources include non-profit franchise of government control, such as television and low-cost producers in an industry's persistent position.
Let's return to the accounting
in the See's example. Blue Chip's purchase of See's at $ 17 million
over net tangible assets required that a Goodwill account of this
amount be established as an asset on Blue Chip's books and that
$ 425,000 be charged to income annually for 40 years to amortize
that asset. By 1983, after 11 years of such charges, the $ 17
million had been reduced to about $ 12.5 million. Berkshire,
meanwhile, owned 60% of Blue Chip and, therefore, also 60% of
See's. This ownership meant that Berkshire's balance sheet
reflected 60% of See's Goodwill, or about $ 7.5 million.
Let us return to hi this case the accounting treatment of poetry. BlueChip acquisition of hi poetry beyond the net tangible assets of $ 17,000,000. This requires BlueChip established on the balance sheet of the same amount of the goodwill account, and in 40 years, the annual amortization of this asset to the cost of $ 425,000, be reduced profits. By 1983, after 11 years of such amortization, which 17 million has been reduced to 1,250 million. Berkshire, meanwhile, has 60% of the BlueChip, so that is 60% of the hi poetry. The ownership of the means Berkshire's balance sheet reflects 60% of the hi poetry goodwill, $ 7,500,000.
In 1983 Berkshire acquired the
rest of Blue Chip in a merger that required purchase accounting as
contrasted to the Under purchase accounting, the (Or acquired from Blue Chip. This almost always is when public companies use their shares to make
acquisitions, by the market value of the shares given up.
1983, Berkshire acquired BlueChip the remaining shares. The merger requires the use of acquisition accounting, rather than some combination allowed by the M & A accounting treatment, we give (or Chip of the shares of the The
The assets consisted of 40% of everything owned by Blue Chip (as noted,
Berkshire already owned the other 60%). What Berkshire more than the net identifiable assets we received by $ 51.7 million,
and was assigned to two pieces of Goodwill: $ 28.4 million to See's
and $ 23.3 million to Buffalo Evening News.
When Berkshire Evening News.
After the merger, therefore,
Berkshire was left with a Goodwill asset for See's that had two
components: the $ 7.5 million remaining from the 1971 purchase, and
$ 28.4 million newly created by the 40% amortization charge now will be about $ 1.0 million for the next 28
years, and $ .7 million for the following 12 years, 2002 through
2013.
So after the merger, Berkshire has hi poetry goodwill, has two parts: from the 1971 acquisition of the remaining 750 million, and in 1983 40% of the In the next 28 years, amortization expense will be 1 million per year, that is, 12 years after the 2002-2013 year is $ 700,000 per year.
In other words, different
purchase dates and prices have given us vastly different asset
values and amortization charges for two pieces of the same asset.
(We repeat our usual disclaimer: we have no better accounting
system to suggest. The problems to be dealt with are mind boggling
and require arbitrary rules.)
In other words, different acquisition dates and prices, the same one we had two very different asset value and amortization charges. (We repeat our Disclaimer: We do not recommend a better accounting system. A number of issues must be resolved is hard to imagine, so there must be hard and fast rules.)
But what are the economic
realities? One reality is that the amortization charges that have
been deducted as costs in the earnings statement each year since
acquisition of See's were not true economic costs. We know that
because See's last year earned $ 13 million after taxes on about $ 20
million of net tangible assets - a performance indicating the
existence of economic Goodwill far larger than the total original
cost of our accounting Goodwill. In other words, whilea ccounting
Goodwill regularly decreased from the moment of purchase, economic
Goodwill increased in irregular but very substantial fashion.
However, the economic reality is what? One reality is that ex post poems from the hi annually from the income statement as cost less amortization costs are not real economic costs. Last year, we know Xi Poetry million in 2000 on top of the net tangible assets, earned $ 13,000,000 after-tax profit. The results show that the existing economic goodwill is far higher than the initial total cost of goodwill accounting. In other words, although the accounting of goodwill from the acquisition of the periodic law of the moment have decreased, but not the law of economy but of goodwill but very significant way to increase.
Another reality is that annual
amortization charges in the future will not correspond to economic
costs. It is possible, of course, that See's economic Goodwill will
disappear. But it won't shrink in even decrements or anything
remotely resembling them. What is more likely is that the Goodwill
will increase-in current, if not in constant, dollars -
because of inflation.
Another reality is that the future annual amortization expense will be unable to meet the economic costs. Of course, hi poetry economic goodwill may disappear. But the goodwill will not be stable consumption, or a similar stable way consumption. Most likely, the goodwill will be increased. As the role of inflation, goodwill will be the current value of the dollar, rather than constant dollar increase in value.
That probability exists because
true economic Goodwill tends to rise in nominal value
proportionally with inflation. To illustrate how this works, let's
contrast a See's kind of business with a more mundane business.
When we purchased See's in 1972, it will be recalled, it was
earning about $ 2 million on $ 8 million of net tangible assets. Let
us assume that our hypothetical mundane business then had $ 2
million of earnings also, but needed $ 18 million in net tangible
assets for normal operations. Earning only 11% on required tangible
assets, that mundane business would possess little or no economic
Goodwill.
This possibility exists because true economic Goodwill Qing Xiangyu with inflation in the nominal value proportional to the increase. To illustrate how this works, let us hi this poem a more general business and business to make a comparison. In 1972, we acquired the original poem hi, it is 8 million dollars in net tangible assets above the profit of 2 million. Let us assume that we assume that there are 2 general business of millions of dollars in profits, but it requires $ 18,000,000 of the net tangible assets to maintain normal operations. In tangible assets required to obtain only 11% above the return on the ordinary business with little or no economic goodwill.
A business like that,
therefore, might well have sold for the value of its net tangible
assets, or for $ 18 million. In contrast, we paid $ 25 million for
See's, even though it had no more in earnings and less than half as
much in as our purchase price implied? The answer is businesses were expected to have flat unit volume - as long as
you anticipated, as we did in 1972, a world of continuous
inflation.
Such a business is entirely possible to its net tangible assets of $ 18,000,000 and sold. In contrast,nike air max 90, we paid $ 25,000,000 to purchase a hi poetry, even if it is no more profitable, and only in front of general business assets of less than half the real deal. Is less both more like our acquisition price implies? The answer is Even if the two businesses are expected to have stalled traffic, as long as you expect inflation to a sustainable world, as we expected, as in 1972, the answer is
To understand why, imagine the
effect that a doubling of the price level would subsequently have
on the two businesses. Both would need to double their nominal
earnings to $ 4 million to keep themselves even with inflation. This
would seem to be no great trick: just sell the same number of units
at double earlier prices and, assuming profit margins remain
unchanged, profits also must double.
To understand why, imagine doubling the price level after the impact of these two operations. Both the name of profits need to double to 4 million dollars to keep up with inflation. This seems not too much means: as long as the number of selling the same amount, the price doubled on the line, assuming the same profit margin, profit will double.
But, crucially, to bring that
about, both businesses probably would have to double their nominal
investment in net tangible assets, since that is the kind of
economic requirement that inflation usually imposes on businesses,
both good and bad. A doubling of dollar sales meansc orrespondingly
more dollars must be employed immediately in receivables and
inventories. Dollars employed in fixed assets will respond more
slowly to inflation, but probably just as surely. And all of this
inflation-required investment will produce no improvement in rate
of return. The motivation for this investment is the survival of
the business, not the prosperity of the owner.
But the key is that, in order to achieve this, both probably have to be the normal double the net tangible assets. This is often because of inflation and economic requirements imposed on businesses, have advantages and disadvantages. Double sales in dollars means more money must be used immediately in receivables and inventory. The money used for fixed assets will have slower reaction on inflation, but certainly there will be reactions. Moreover, the requirements of all these inflation rate of return on investment will not improve. The reason for this investment is to maintain business survival rather than growth in the interests of owners.
Remember, however, that See's
had net tangible assets of only $ 8 million. So it would only have
had to commit an additional $ 8 million to finance the capital needs
imposed by inflation. The mundane business, meanwhile, had a burden
over twice as large - a need for $ 18 million of additional capital.
Remember, only 8 million dollar hi Poetry net tangible assets. Therefore, it only need to invest an additional 8 million dollars to support the capital requirements imposed by inflation. Ordinary business, then have a double burden, requires $ 18,000,000 of additional capital.
After the dust had settled, the
mundane business, now earning $ 4 million annually, might still be
worth the value of its tangible assets, or $ 36 million. That means
its owners would have gained only a dollar of nominal value for
every new dollar invested. (This is the same dollar-for-dollar
result they would have achieved if they had added money to a
savings account.)
After the dust settles, the general business, now an annual profit of 4 million, may still be a value equal to the value of its tangible assets, namely $ 36,000,000. This means that the owner of every dollar invested, produced only a nominal value of the dollar increases. (This is added to their money as deposit accounts, are a dollar for dollar.)
See's, however, also earning $ 4
million, might be worth $ 50 million if valued (as it logically
would be) on the same basis as it was at the time of our purchase.
So it would have gained $ 25 million in nominal value while the
owners were putting up only $ 8 million in additional capital - over
$ 3 of nominal value gained for each $ 1 invested.
Hi poem also profit 4 million, the same with our purchase method of valuation assessment (logically should be the case) could be worth $ 50,000,000. So hi poem received the nominal value of $ 25,000,000 increased, while the owner is only 8 million dollar investment in additional capital, which invested $ 1 each received the equivalent of more than three U.S. dollars in nominal value.
Remember, even so, that the
owners of the See's kind of business were forced by inflation to
ante up $ 8 million in additional capital just to stay even in real
profits. Any unleveraged business that requires some net tangible
assets to operate (and almost all do) is hurt by inflation.
Businesses needing little in the way of tangible assets simply are
hurt the least.
Remember, even so, hi poetry is also the owner of 8 due to inflation forced to pay millions of dollars in additional capital, which was only to maintain the real profit. Do not leverage any number of net tangible assets and the need to operate (almost all business is so) the business will be hurt by inflation. Only very few tangible assets by the business but at least the damage.
And that fact, of course, has
been hard for many people to grasp. For years the traditional
wisdom - long on tradition, short on wisdom-held that inflation
protection was best provided by businesses laden with natural
resources, plants and machinery, or other tangible assets (Goods We Trust generally earn low rates of return - rates that often barely
provide enough capital to fund the inflationary needs of the
existing business, with nothing left over for real growth, for
distribution to owners, or for acquisition of new businesses.
However, the fact that, of course, has been difficult by many people realize. For years, conventional wisdom, (longer than traditional, shorter than intelligence) that is full of natural resources, plant, machinery and other tangible assets (In fact not the case. Important business assets, access to low rate of return is usually low to provide only enough capital to meet the needs of existing business, inflation, and could not really left anything to support the growth of dividends to the owner, or the acquisition of new business.
In contrast, a disproportionate
number of the great business fortunes built up during the
inflationary years arose from ownership of operations that combined
intangibles of lasting value with relatively minor requirements for
tangible assets. In such cases earnings have bounded upward in
nominal dollars, and these dollars have been largely available for
the acquisition of additional businesses. This phenomenon has been
particularly evident in the communications business. That business
has required little in the way of tangible investment - yet its
franchises have endured. During inflation, Goodwill is the gift
that keeps giving.
In contrast, the disproportionately large number of business accumulating wealth in the inflation period. The wealth is by having achieved a number of business operations, these operations lasting value combined with the relatively few tangible intangible asset demand. In these examples, a substantial increase in nominal earnings, these funds can be used to acquire other businesses. This phenomenon is particularly evident in the telecommunications industry. The industry only needs a small investment in tangible assets, but was able to maintain the franchise. Inflation period, the goodwill and dedication is constantly present.
But that statement applies,
naturally, only to true economic Goodwill. Spurious accounting
Goodwill - and there is plenty of it around-is another matter.
When an overexcited management purchases a business at a silly
price, the same accounting niceties described earlier are observed.
Because it can't go anywhere else, the silliness ends up in the
Goodwill account. Considering the lack of managerial discipline
that created the account, under such circumstances it might better
be labeled typically is observed and the adrenalin so capitalized remains on
the books as an sensible one.
But this argument only applies to the real nature of economic goodwill. Deceptive accounting goodwill (there are many such examples) is another matter. When an over-excited with the management of high prices to buy a silly business, accounting previously described the details of the same can also be observed. Because it is nowhere to go, the final purchase price of stupid to stay in the goodwill account. Taking into account the lack of management discipline to create such an account, in this case, it should be called Regardless of period, usually observed 40-year ritual of amortization. Management adrenaline excitement was reserved on the books of the capital as a
If you cling to any belief that
accounting treatment of Goodwill is the best measure of economic
reality, I suggest one final item to ponder.
If you insist that the accounting treatment of goodwill is the best way to measure the economic reality, I suggest you think about the last example.
Assume a company with $ 20 per
share of net worth, all tangible assets. Further assume the company
has internally developed some magnificent consumer franchise, or
that it was fortunate enough to obtain some important television
stations by original FCC grant. Therefore, it earns a great deal on
tangible assets, say $ 5 per share, or 25%.
Suppose a company has 20 per share dollars in net assets, all tangible assets. Suppose further that the internal development of an excellent consumer franchise, or the company lucky enough to obtain some important FCC granted the first television station licenses. Therefore, the company profitable in tangible assets, such as 5 dollars per share, or 25% return.
With such economics, it might
sell for $ 100 per share or more, and it might well also bring that
price in a negotiated sale of the entire business.
Such economic conditions, this stock may be selling price per share $ 100 or more. But also may sell the entire business in a negotiation to get this price.
Assume an investor buys the
stock at $ 100 per share, paying in effect $ 80 per share for
Goodwill (just as would a corporate purchaser buying the whole
company). Should the investor impute a $ 2 per share amortization
charge annually ($ 80 divided by 40 years) to calculate earnings per share? And, if so, should the new $ 3 per share cause him to rethink his purchase price?
Suppose an investor paid $ 100 per share to buy shares, in fact, is a goodwill payment of $ 80 per share (as a mergers and acquisitions as the company). Should the investors $ 2 a year from the amortization of costs for the calculation of If so, the new $ 3
We believe managers and
investors alike should view intangible assets from two
perspectives:
We believe that managers and investors should look at intangible assets from two perspectives:
1. In
analysis of operating results - that is, in evaluating the
underlying economics of a business unit - amortization charges
should be ignored. What a business can be expected to earn on
unleveraged net tangible assets, excluding any charges against
earnings for amortization of Goodwill, is the best guide to the
economic attractiveness of the operation. It is also the best guide
to the current value of the operation's economic Goodwill.
In the analysis of operating results, that is, a business unit of the internal assessment of the economic situation, the amortization expense should be ignored. A business is expected to net tangible assets available to the profit, excluding any goodwill amortization expense, is the measure of whether the business operations economically attractive in the best guidance. This is also the business operations of the economic goodwill measure the current value of the best guidance.
2. In
evaluating the wisdom of business acquisitions, amortization
charges should be ignored also. They should be deducted neither
from earnings nor from the cost of the business. This means forever
viewing purchased Goodwill at its full cost, before any
amortization. Furthermore, cost should be defined as including the
full intrinsic business value - not just the recorded accounting
value - of all consideration given, irrespective of market prices
of the securities involved at the time of merger and irrespective
of whether pooling treatment was allowed. For example, what we
truly paid in the Blue Chip merger for 40% of the Goodwill of See's
and the News was considerably more than the $ 51.7 million entered
on our books. This disparity exists because the market value of the
Berkshire shares given up in the merger was less than their
intrinsic business value, which is the value that defines the true
cost to us. In assessing the wisdom of business mergers and acquisitions, the amortization expense should be ignored. Amortization should not be subtracted from the profitability of business, the cost should not be deducted from the business. This means that, as always purchased before goodwill amortization in any of the full cost. More importantly, the acquisition cost should be defined as the price paid includes all the intrinsic business value, not just the accounting value of its records, regardless of the securities involved in mergers when the market price, and regardless of whether it permits the use of merger accounting . For example, we merge Blue
Chip 40% of the hi poetry and Buffalo
Goodwill Evening News, the real price to pay far more than we recorded in the book's $ 51,700,000. The existence of this inconsistency is due to the merger, the market value of Berkshire stock below their intrinsic business value, the decision for us, this is the real cost value.
Operations that appear to be
winners based upon perspective (1) may pale when viewed from
perspective (2). A good business is not always a good purchase -
although it's a good place to look for one.
From the perspective of (1), appeared to be the winner of the business operations, it is possible from the perspective of (2) However it is eclipsed. A good business is not necessarily a good acquisition target, although a good business is the place to find good acquisitions.
We will try to acquire
businesses that have excellent operating economics measured by (1)
and that provide reasonable returns measured by (2). Accounting
consequences will be totally ignored.
We will seek acquisitions that use (1) measure is an excellent operating condition, but also with (2) measure to produce a reasonable return business. Accounting consequences will be completely ignored.
At yearend 1983, net Goodwill
on our accounting books totaled $ 62 million, consisting of the $ 79
million you see stated on the asset side of our balance sheet, and
$ 17 million of negative Goodwill that is offset against the
carrying value of our interest in Mutual Savings and Loan.
At the end of 1983, the accounting books in our net goodwill was $ 62,000,000, including $ 79,000,000 marked on the side of the balance sheet of assets and negative goodwill of $ 17,000,000 to write off our holdings of Mutual Savings and Loan interest value.
We believe net economic
Goodwill far exceeds the $ 62 million accounting number.
We believe that the net economic goodwill far exceed this $ 62,000,000 of the accounting figures. (1983 letter to Berkshire Hathaway shareholders in Appendix)