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In chapter 15 we briefly mention how figuring out the best way to account for goodwill can turn into a philosophical discussion during HBS classes. We didn’t really explain why beyond a vague reference to organic versus inorganic growth. If you read that snippet and were desperate to know more this explanation is for you. It has nothing to do with getting you admission to the 2+2 program. It’s here in case you can’t wait two years to find out the answer.
When one firm acquires another firm it typically pays a premium on that firm’s book value. So if the company was worth $1 billion, then they may have to pay $1.2 billion to acquire the firm. That additional $0.2 billion is known as “Goodwill” and is an intangible asset that sits on the acquiring firm’s balance sheet. They need to put it somewhere. Otherwise, from an accounting perspective, it looks like the firm just set $0.2 billion on fire, which has significant tax implications.
But if instead of acquiring another company, which is known as inorganic growth, a company were to “organically” grow to include the exact same assets, without any acquisitions, then it would not show the Goodwill on its balance sheet. So if a company was acquired it is worth $1.2 billion. If that exact same company is grown in-house it is worth $1 billion. We do not consider the intangible value of assets that are grown instead of acquired.
This creates measurement issues. The firm that grew inorganically through acquisitions looks like it has more assets than one that grew organically. The debt to asset ratio will look better for the company that grew inorganically, and it’s price to book ratio will make its shares look artificially cheap.
You could try to address this by forcing companies to report the intangible value of all their assets on their balance sheet – not just the ones they acquired. But measuring the value of intangible assets is difficult. In the case of an acquisition you simply subtract the book value from the price paid. Without such a clear calculation the calculation of goodwill would necessarily be guesstimates and could make it easier to manipulate numbers in ways that flatter a company’s balance sheet.
There are multiple proposals for how this incongruity could be addressed. Each has it’s own set of advantages and disadvantages. The debate has ranged on for decades. It’s a debate that has become even more important in recent times as the global economy has shifted towards intangible assets such as brands.