: academic research
GAAP Goodwill and Debt Contracting Efficiency
Executive Summary: The primary purpose of this academic paper is to study the role of goodwill in lending agreements that utilize net-worth covenants and how those agreements have been affected by the changes in accounting for goodwill in SFAS 141 – “Goodwill and Other Intangible Assets” and SFAS 142 – “Business Combinations”. Overall, the authors say that lenders do find restricting goodwill worthwhile, but that the recent accounting changes have reduced some of that benefit.
Key Findings: The authors’ analysis suggests that lenders to a firm with substantial goodwill should use a net-worth covenant that allows for goodwill impairments and additions to the book value of goodwill to effect the lending agreement’s covenants. This finding is consistent with lenders’ belief that goodwill is informative and is an efficient means of limiting firms’ agency costs. Agency costs exist when a firm has debt, because management’s interests are not aligned with those of the lenders but rather with shareholders. With interests not aligned, management may overpay, take on risky acquisitions, or under-invest, thereby lowering the value of the firm, which may adversely impact the lender’s loan repayment.
The second finding is that the adoption of SFAS 141 and 142 is associated with a reduction in the contracting efficiency (i.e., the ability of the lender to restrict the borrower’s actions and reduce the firm’s agency costs) of goodwill, because the adoption of these pronouncements was found to increase the number of tangible net-worth covenants, which do not capture goodwill impairments or additions to goodwill.
The third finding is that net-worth and tangible net-worth covenants had no significant advantages over one another, because the type of net-worth covenant used did not significantly change the amount of control the lender retained.
Research Impacts: Bank lending officers, chief financial officers, treasurers, rating-agency analysts, and accounting policy setters.
Authors and Link to Article
Richard Frankel – Olin School of Business, Washington University frankel@wustl.edu
Chandra Seethamraju – Mellon Capital Management chandras@mcm.com
Tzachi Zach – Olin School of Business, Washington University zach@wustl.edu
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=930530
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