December 12, 2002
Grotesque Goodwill Games
Goodwill/intangible assets are a hideous wart bulging from Corporate America’s neck.
By Brady Willett
Investors Don’t Need Intangibles
The argument that the ‘intangible’ qualities of a company have some ‘value’ is legitimate. However, the Financial Accounting Standards Board (FASB) should have never attempted to flush out this value using imprecise accounting standards. Rather, investors can value assets without the FASB’s meddling.
Take SM&A, a company that provides consulting and strategy services to the defense industry (they help defense companies acquire government contracts and are extremely good at what they do). SM&A has zero dollars in intangibles, yet it is clear to every shareholder that the company’s reputation and experience have some unbooked value: the company currently trades at 10 times book.
What the SM&A example shows is that investors can determine on their own – using a crazy little thing called a free market – how much a company is worth above its book.
Intangible assets and goodwill games: they have created more problems for investors than they have solved.
Brief Background
Company ABC buys company XYZ for $100 million, but XYZ’s is only valued at $80 million. Presto! $20 million in goodwill is born (using the purchase method of accounting).
Before ‘pooling of interests’ was abolished (FASB 141) companies would buy out competitors to pad earnings. The logic of pro-pooling companies was that instead of taking over a company by booking and then amortizing goodwill, which would be a drag on earnings, just use stock as a currency to ‘merge’ with the company, and avoid creating and having to write down goodwill altogether.
In an attempt to get rid of the scheme that was pooling the FASB initially proposed (1999) that all takeovers be done using the purchase method of accounting, and that the subsequent creation of goodwill be amortized over 20 years instead of 40 years. Following this proposal goodwill loving CEO’s replied: “I can’t use pooling anymore, and you want me to write down the underlying ‘asset’ over 20 years instead of 40? Are you crazy?”
Nevertheless, and after the Cisco’s delayed the process by making timely donations to Congressmen and by lobbying against the FASB, a final ruling on the pooling/goodwill conundrum eventually arrived (FASB 142). Now companies can no longer use the pooling method of accounting for takeovers and goodwill is no longer amortized but impaired when, and if, applicable.
Incidentally, Warren Buffett forecasted the above chain of events with remarkable accuracy:
“Now, the FASB has proposed an end to pooling, and many CEOs are girding for battle. It will be an important fight… We would first have the acquiring company record its purchase price -- whether paid in stock or cash -- at fair value. In most cases, this procedure would create a large asset representing economic goodwill. We would then leave this asset on the books, not requiring its amortization. Later, if the economic goodwill became impaired, as it sometimes would, it would be written down just as would any other asset judged to be impaired.
If our proposed rule were to be adopted, it should be applied retroactively so that acquisition accounting would be consistent throughout America -- a far cry from what exists today. One prediction: If this plan were to take effect, managements would structure acquisitions more sensibly, deciding whether to use cash or stock based on the real consequences for their shareholders rather than on the unreal consequences for their reported earnings.”
http://www.berkshirehathaway.com/letters/1999htm.html
In the Beginning: The ‘Gap’ Theory
“The accounting profession is failing to recognize the importance of intellectual capital.”
David Skyrme, Measuring the Value of Knowledge.
“The [existing] accounting system is failing us. The value is in the people, and that asset is not easily counted. It's created a gap.”
Amy Hutton, an accounting professor at Harvard Business School.
What the Skyrme’s and Hutton’s argue is that since companies trade with market caps well above their book values, or the ‘gap’, that the accounting industry has failed to properly value ‘intangible’ assets. Quite frankly, this theory, which is backed by many academics, companies, and all accountants, is absurd.
To begin with, the gap theory assumes investors actually use price/book as a criteria when investing. However, if the last 20 years have proven anything it is that price/book, like price/earnings ratios, can be completely ignored by investors: during the last two decades people who knew nothing about investing gave a fund manager their money and began dreaming about sailboats -- the manager threw this money at stocks because he had to -- no one ever cared that P/B ratios were escalating...
Consider also that during the last 20 years intangible assets have increasingly gained acceptance, yet the average price/book value on the Dow is more than double what is was in the early 1980s. If prehistoric accounting practices were previously to blame for escalating price/book levels why then are companies with oodles of intangibles on their books today still being valued at near record P/B levels? Should we forget about hard assets completely and continually tweak already meaningless GAAP until book values near market caps?
Suffice it to say, the gap theory is riddled with flaws, and ignoring rising goodwill levels can prove dangerous. For example, when FASB 142 was adopted AOL wrote off $54 billion, JDSU dumped $44 billion, and cumulatively American companies wrote off upwards of $1 Trillion: the wanton need to include intangibles on the balance sheet backfired in a big way. After this destruction no one was left whining about the book value/market cap ‘gap’. Rather, everyone was left to ask, ‘Where did all the goodness go? Did it every really exist?’ Ironically, the funny money erased from corporate America’s balance sheets because of FASB 142 would have never existed if it were not for the Hutton’s and the Skyrme’s.
Incidentally, many companies have long backed accounting standards that inflate intangibles, even though no one can answer how intangibles should be valued:
‘There is no clear way to account for intangible assets. However, this should not mean we do not account for them at all’ Corporate America.
Notice how the bias quickly changes when it comes to expensing stock options:
‘There is no clear way to account for the expensing of stock options. This means we should not expense them at all’. Corporate (tech) America.
The Asset That Cannot Be Sold
TEAM America, Inc. has $9.4 million in total equity and $37 million in intangibles (59% of assets).* It doesn’t matter whether or not TEAM America accumulated goodwill through official accounting channels. Rather, all that matters it the companies book value is complete garbage because the company continually loses money. What good is all the goodwill in the world if it cannot help a company generate cash?
*TEAM America amassed its goodwill fortune via a series of takeovers. The company may suffer impairment in the quarters to come.
In fact, a company like TEAM America highlights everything that is wrong with intangibles being on the balance sheet at all. The company had $1.1 in total debt in 1999 versus $290,000 in total assets, and today the company has $61 million in assets versus $43 in total debt. Sounds like a good growth story, doesn’t it? Only problem being is that the company has never made a profit. Therefore, the question becomes: Is TEAM America more valuable today than it was in 1999, or is it closer to bankruptcy than it was in 1999? That depends on whether or not intangibles tickle your fancy (TMOSE has $37 million in current liabilities versus $17 million in current assets).
Which brings us to the final point: Goodwill is only an asset when, and more importantly if, a company can sell it.
Banks will not accept intangibles as collateral, as they would say a pipeline asset or piece of machinery or land. Moreover, when, and if, it comes to the point when a company’s intangibles are one of the only assets left on the balance sheet, as Enron with intangibles of 30% assets found out, the value of this ‘asset’ is rendered worthless. Put simply, and the FASB has agreed with this point but neglected to carry it any further, goodwill is not an asset because, in most cases, it can not be sold separately from the business.
Conclusion
The FASB would be well served to eliminate intangibles altogether or, at minimum, maintain the standards that are in place but relegate goodwill/intangibles to the footnotes. Perhaps it is wishful thinking to believe that the FASB will ever suggest that intangibles and goodwill should be eliminated? Nevertheless, the next time a company makes a point of stating that earnings were impacted by a ‘non-cash’ goodwill/intangibles charge ask yourself question: what does this non-cash charge impact? Well, it is impacting the balance sheet of course: supposedly, according to gap theorists, the very instrument investors use to buy and sell stocks.
In sum, Corporate America admits that goodwill is ‘non-cash’, the FASB knows that goodwill is not an ‘asset’ because you cannot separate it from the business, and to date no company has ever been in the business, save the bankruptcy business, of ‘selling goodwill and/or intangibles’. Why then has so much time and energy been wasted by the FASB trying to quantify intangible assets when nothing would change if these assets didn’t exist? After all, if TEAM America can turn a buck it wouldn’t matter that they have zero dollars in goodwill/intangibles (if the assets they did have could consistently generate cash their price/book value would rise from 0.45 today to 10 just like the SG&As).
Company ABC buys company XYZ for $100 million, but XYZ’s is only valued at $80 million. End of story.
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