Local buyers to take a huge goodwill hit

MUMBAI: Shareholders, analysts and Dalal Street watchers should make a mental note of the sudden and dramatic shocks that await many Indian companies that have gone in for overseas acquisitions in the past few years. These might surface when the local company has to absorb the ���goodwill��� loss suffered by the foreign firm that was bought when the going was good.

No Indian corporate has so far encountered such an accounting hit. But this year, many will, when they consolidate the books of their foreign acquisitions. Goodwill of several overseas companies has taken a knock due to the economic meltdown and a trade downturn. But the erosion in goodwill, though an intangible, will not be confined to the balance-sheets of the foreign firms. It will also find its way into the profit and loss accounts of the listed Indian company.

Local shareholders could suddenly discover that the net profits of the company have been wiped out ��� such losses, which accountants call ���goodwill impairment���, could run into billions of dollars. But this may not be a reason to panic: such hits don���t mean a cash drain or reversal of fortune for the acquirers. Rather, it���s a fallout of stringent accounting rules which force a firm to bluntly admit that the company it bought is less valuable than what it had paid when times were different.



While acquiring a company, the buyer works out the enterprise value (EV) of the target firm ��� the minimum someone would have pay to buy it. EV is calculated by estimating the fair value of the net assets of the target firm and adding its loans to the number.

The extra money that is forked out over and above the EV is captured in the books as goodwill. Goodwill reflects the extra the acquirer is paying due to synergy benefits, innovation and excellence which have not been factored in the fair value.

A few companies will have to announce the goodwill loss sooner than others if the foreign company has publicly traded securities. According to corporate circles, the market will get a taste of it this month, when a few local companies disclose the goodwill decline suffered by their foreign subsidiaries.

How would Indian investors take it? Sanjay Aggarwal, executive director at KPMG, says: ���Investors typically focus on EPS. Additionally, it is essential to focus on sustainable earnings, particularly in relation to the extent and quality of investments in assets, including intangibles, goodwill and the like. Therefore, changes in carrying values of such assets although impact current earnings, these are not generally expected to be recurring items that would impact sustainable earnings of an enterprise.���

Even though it���s an accounting impact, an acquirer will see its reserves shrink due to the goodwill loss of the foreign subsidiary. So, the company will start the next financial year with a lower opening reserves which has to be gradually replenished with new profits.

While there are many differences between Indian and other accounting standards (US GAAP and IFRS), accounting for goodwill, the amortisation and/or impairment thereof is a significant area of difference. The important issue is impairment is a provision made on the basis of estimate of cash flows in the manner prescribed by the various generally accepted accounting standards.

A provision could be temporary and is qualitatively very different from a write-off of assets or permanent diminution in assets. However, some accounting standards are extremely stringent on writeback of such impairment provisions even if cash flows improve significantly. Under US GAAP, this upside can be recognised only when the company is once again sold off and the new buyer pays the extra as goodwill.