Goodwill—positive thoughts and acts of generosity—may be the genesis of the accounting term for paying too much. But comes year-end and the debate about ‘writing off’ goodwill.
The validity of some accounting rules is sometimes called into question. This highlights the benefit of having a working knowledge of accounting rules and what changes in accounting rules mean, particularly for publicly-traded companies. The accounting rules, for example, changed the treatment of goodwill and other intangible assets.
Goodwill comes from acquisitions. It’s the price one company pays another less the book values of the target company’s assets. Let’s say, for example, that ABC company buys XYZ company for $7. If the book values of XYZ’s assets total $5, then ABC adds $2 of goodwill to its assets ($7 less $5). Whether this goodwill has any real value or not depends upon a number of factors (see below).
At one time, companies making acquisitions had to ‘amortize’, or write off, goodwill over no more than 40 years. These write-offs reduced the parent company’s reported profits. This could make upper management look bad. As a result, the old accounting rules tended to discourage the top brass from paying outrageous amounts (or giving away the money of their shareholders). Companies like Nortel Networks, for example, looked foolish after overpaying and writing off huge amounts of goodwill.
Acquisitions may become less disciplined
Accounting rules no longer require such write downs or write offs of goodwill—or other intangible assets with indefinite lives. Instead, they “will be subject to annual impairment tests based on fair values”. That is, if goodwill is carried on the books for more than it’s really worth, then the company is supposed to write it down to its fair market value. If the book value of goodwill is worth less than its fair market value, then the company faces no write downs or write offs. If the goodwill is equal to the assets’ fair market values, no write downs or write offs are required.
One concern we have is about the calculation of the ‘fair value’ of goodwill and other intangible assets. What does fair value mean? It appears too flexible. The danger is that upper management might massage the numbers to make itself look good. If the company is doing better than expected, upper management might write-off some goodwill to show steady growth. If the company is doing worse than expected, they might take an overly-optimistic view of the fair value of the goodwill.
Remember, the prevalence of stock options and ‘performance-based’ pay gives upper management an incentive to present the numbers in the best possible light. Doing so can make top management seriously rich—as opposed to simply well off.
A second concern is that the rules have removed the natural restraint that automatic write-offs formerly imposed. That is, they can let upper management of the parent company off the hook if there’s no need to write off goodwill. This makes it easier for the company to overpay when it makes acquisitions.
Many studies have concluded that most mergers and acquisitions fail. The elimination of automatic write-offs, however, may make it harder to tell a sound acquisition from a poor one.
Goodwill is reported as an ‘asset’ on the balance sheet, of course. In calculating a company’s quality ratings, we subtract goodwill from the company’s total assets. We usually accept the company’s numbers for other intangible assets since such assets are more important these days.
Does goodwill have any real value?
As we said above, goodwill is the price one company pays another less the book value of the target company’s assets. The value of this goodwill depends on a number of factors. Here are two worth keeping in mind.
One factor is the fair market values—as opposed to the book values—of the target’s assets. Say the target owns a building and land in downtown Toronto. The true value of this real estate may be worth far more than its book value (its original price). In this case, paying some goodwill is justified. By contrast, if the target is liable for contamination of the land, then goodwill may be worth no more than air.
A second factor to remember is whether the parent company can create enough value from the acquisition to exceed the goodwill. If so, the goodwill is justified. If not, then the goodwill is just a transfer of wealth from the shareholders of the parent to the shareholders of the target. In fact, that’s why firms that make costly acquisitions often see their share prices plummet.
This is an edited version of an article that was originally published for subscribers in the November 8, 2019, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.
The Investment Reporter, MPL Communications Inc.
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