Gu and Lev (2011) argue that the root cause of many goodwill write-offs is that the shares of the buyer are overpriced at the acquisition date.

Figure 8.11 presents eBay's cumulative stock return against the S\&P 500 index from 2003. In mid-September 2005, eBay acquired the internet phone company Skype for \(\mathbf{\$ 2 . 6}\) billion. On 1 October 2007, it announced a massive goodwill write-off of \(\$ 1.43\) billion ( \(55 \%\) of the acquisition price) related to the Skype acquisition.

Gu and Lev argue that the root cause of this behaviour is the incentives of managers of overvalued firms to acquire businesses, whether to exploit the overpricing for shareholders' benefit or to justify and prolong the overpricing to maintain a facade of growth. Goodwill write-offs are accordingly an important business event signalling a flawed investment strategy.

Required 

1. Explain the circumstances under which goodwill is recognised and how any subsequent write-off occurs.

2. Explain why a significant goodwill write-off may signal a 'flawed investment strategy'.

Transcribed Image Text:

FIGURE 8.11 eBay vs S&P 500: The Skype acquisition - cumulative stock returns 145% 95% 45% -5% -55% Acquired Skype eBay S&P500 Wrote off goodwill ($1.43b) 2003 2004 2005 2006 2007 2008