I’ve always had an issue with
goodwill. Not goodwill in the charitable sense,
but rather goodwill in the accounting sense.
For those that toil away in the accounting profession, be it public
accounting or industry, goodwill has likely been a recurring pain in your
ass. If you work in the accounting
department of a company that has goodwill, every year you probably hear about
the need to test for whether your goodwill has been impaired. If you are the auditor of a company that has
goodwill, it is your unfortunate job to make sure your client didn’t screw the
pooch with its latest analysis.
For the most part goodwill
remains a headache only for those who have chosen accounting as their means to
make a living. However, as we have seen this week with Microsoft, goodwill can occasionally rear its
ugly head and splash down on the front page of the business section. Almost always accompanied in press releases
with the words, “accounting charge,” massive write-downs of goodwill can
obliterate a company’s bottom line. The
question I have is: does anyone really care?
The most boring history
lesson ever
Maybe it’s worth looking at the
history of goodwill. Up until SFAS 142
(now codified in ASC 350) came out in June 2001, the authoritative guidance for
accounting for goodwill fell to APB Opinion No. 17, which stated that:
[A] company
should record as assets... goodwill acquired in a business combination. ... The
Board also concludes that the cost of each type of intangible asset should be
amortized by systematic charges to income over the period estimated to be
benefited. The period of amortization should not, however, exceed forty years.[i]
Basically if a company acquired
goodwill (remembering that goodwill is calculated as the difference between
consideration paid and the net amount of assets and liabilities acquired) there
were two things you had to worry about: (1) recognize goodwill; and (2)
amortize goodwill.
Was this system perfect? No.
APB 17 even had a paragraph labeled, “criticism of present practice,”
which explained the main arguments being made regarding the amortization of goodwill.
Present
accounting for goodwill and other unidentifiable intangible assets is often
criticized because alternative methods of accounting for costs are acceptable.
Some companies amortize the cost of acquired intangible assets over a short
arbitrary period to reduce the amount of the asset as rapidly as practicable,
while others retain the cost as an asset until evidence shows a loss of value
and then record a material reduction in a single period. Selecting an arbitrary
period of amortization is criticized because it may understate net income during
the amortization period and overstate later net income. Retaining the cost as
an asset is criticized because it may overstate net income before the loss of
value is recognized and understate net income in the period of write-off.[ii]
It took them a while (nothing out
of the ordinary there), but the FASB finally addressed the above concerns in
SFAS 142. But not really. Leading up to the final standard the FASB had
considered a number of methods for accounting for goodwill, including: “(a)
write off all or a portion of goodwill immediately, (b) report goodwill as an
asset that is amortized over its useful life, (c) report goodwill as an asset
that is not amortized but is reviewed for impairment, or (d) report goodwill as
an asset, a portion of which is amortized and a portion of which is not
amortized (a mixed approach).”[iii]
It was eventually concluded that
goodwill would be accounted for as a nonamortized asset (option c), “combined
with an adequate impairment test,” and that this model, “[would] provide financial
information that more faithfully reflects the economic impact of acquired
goodwill on the value of an entity than does amortization of goodwill.”[iv] This has basically been how the accounting
profession has had to account for goodwill since.
Beginning in 2012, the FASB is
allowing a more, “qualitative,” approach to evaluating whether or not goodwill
was impaired before heading down the familiar two-step impairment test
road. Except for small, private
companies, whose auditors can be a little more lenient when it comes to the
extent of documentation (and who probably don’t have significant amounts of
goodwill in the first place), I can’t really see this new approach changing
much. Auditors, especially with the PCAOB
breathing down their necks, are going to have to push back on clients’
qualitative assessments, probably to the point where the clients will just
throw their hands up and perform the same tests they have been doing since
2001.
If goodwill impairment
appears on an income statement but no one cares about it, does it still make a
noise?
Microsoft announced that it was
writing down goodwill related to its Online Services Division by $6.2 billion
on July 2, 2012. On July 3, Microsoft’s
stock closed up $0.20. So has Wall
Street given up on goodwill? Did it ever
really care? A 2011 Duff & Phelps
report, 2011 Goodwill Impairment Study[v],
provides quite a bit of insight to this question. The study includes a rather interesting set
of statistics that created a portfolio of public companies that HAD
recorded a goodwill impairment any time during fiscal years 2006 through 2010
and another portfolio of public companies that HAD NOT recorded a
goodwill impairment during that same period.
The value of $1 invested into each of those portfolios at year-end 2005
was tracked through year-end 2010, with the following results:
|
Portfolio
|
Value
of $1 at 12/31/2010
|
|
Had
recorded impairment
|
$0.96
|
|
Had
not recorded impairment
|
$1.39
|
But the above data do not
necessarily tell us if the goodwill impairments are the cause of a decline in
market value or if poor operating results resulted in both the goodwill
impairment and the decline in stock price (causation versus correlation, or
something like that). Which is exactly
why the same Duff & Phelps study measured performance relative to the
S&P 500 before and after goodwill impairments are disclosed. The study found that while companies which
report goodwill impairments underperform the market as a whole, most of that
underperformance occurs BEFORE the disclosure, concluding that, “in
general, investors are aware of the issues that may lead to a subsequent
impairment long before the actual impairment is taken.”
So if Wall Street doesn’t really
give a shit about goodwill, who does?
I’ll give you my goodwill
when you take it from my cold, dead hands
Controller: “Excuse me, CFO, but
we need to take a multi-million dollar hit to our earnings because this
ridiculously complex spreadsheet says this number is bigger than this number.”
CFO: “Get the fuck out of my
office.”
There you have an over-simplified
reaction between the two main parties that typically end up dealing with the
mess that is goodwill impairment testing.
Chances are that if the accounting department has determined the need
for an impairment to be recorded against goodwill, the company’s bottom line
hasn’t been looking too robust lately.
So would you expect a different reaction from the person in charge of
reporting numbers to the CEO and Board of Directors when you tell him or her
that you want to kick EBT down a few flights of stairs?
Management is never going to be
happy about having to reduce earnings, especially when the reduction is coming
from an impairment number that is, in the minds of most managers without an
accounting background (and quite a few with), completely made up. With the pressure on management to make sure
this quarter’s results beat last quarter’s, ensuring financial statements are
prepared in accordance with accounting principles generally accepted in the
United States of America will require more tact and negotiation from the head
accountant than 150 credit hours from a business school’s accounting program
probably provided. So how can we
preserve the fragile psyches of the controllers and accounting managers that
work in corporate America?
Sometimes you have to break
a few regs to make a reasonable accounting standard
It is this humble accountant’s
opinion that we should go back to amortizing goodwill. The original APB 17 method was criticized
because the useful lives assigned to goodwill were deemed to be completely
arbitrary, which is a perfectly valid criticism. But how is assigning an indefinite useful
life to goodwill any less arbitrary? The
average life of a multinational corporation is between 40 and 50 years.[vi]
The fact of the matter is that
goodwill represents a premium a company is willing to pay for another
company. Company A has $100 in net
assets. Company B is willing to pay $110
for Company A. Company B gets to book
$10 in goodwill (assuming all of Company A’s assets and liabilities were at
fair value).
The official definition for
Company B’s $10 is, “an asset representing the future economic benefits arising
from other assets acquired in a business combination that are not individually
identified and separately recognized.”
In reality, Company B gets to capitalize for the fact that they had to
overpay to get the assets they wanted, which is actually completely fine with
me.
If there was no asset recognition
allowed for goodwill (i.e., the acquirer would have to expense any difference
between consideration paid and the fair value of net assets) then no one would
want to acquire anyone else. And despite
how many douchebag M&A guys you may have run into at bars, acquisitions of
companies by other companies is a pretty integral part of keeping our economy
moving forward.
The problem, as I have alluded
to, is our assumption that a goodwill asset is indefinitely lived. If we know that companies are not really
infinitely lived, that investors don’t really care about goodwill, and that
putting a subjective measurement of impairment in management’s hands may not
always result in the, “most correct,” answer, why wouldn’t we just come up with
a solution that addresses all three of these considerations? Well, we used to have one.
Amortize goodwill over 40 or 50
years (or shorter, if individual entity circumstances dictate) to match the
typical life of a company, present it as its own expense line item so investors
can easily ignore it, and since it is a required accounting treatment
management can’t try to ignore its diminishing effect. The lengthy amortization period also softens
the blow for acquiring entities so M&A activity isn’t suppressed. If the goal of financial accounting is to
present comparable financial statements between any number of entities (I’m not
saying that is the ONLY goal, but it has to be one of them), amortizing
goodwill presents a much more level playing field on which the entities must
report.
[i] Accounting Principles Board Opinions
No. 17: Intangible Assets, par. 9
[ii] Accounting Principles Board Opinions
No. 17: Intangible Assets, par. 14
[iii] Financial Accounting Standards Board Statements
of Financial Accounting Standards No. 142: Goodwill
and Other Intangible Assets, par. B68
[iv] Financial Accounting Standards Board Statements
of Financial Accounting Standards No. 142: Goodwill
and Other Intangible Assets, par. B99
[v] http://www.duffandphelps.com/SiteCollectionDocuments/Reports/vFIN_DP111225_Goodwill_Impairments_Report.pdf
[vi] http://www.businessweek.com/chapter/degeus.htm
