My daughter, who’s in an MBA program, called up the other night to register her thoughts (read: complaints) on how bogus the concept of goodwill is.
She’s right…the concept of goodwill is a patchwork fix of a problem that arises with an accounting system like GAAP (Generally Accepted Accounting Principles, used for financial accounting) whose ground-level assumption is that value resides in the net worth (after depreciation) of tangible assets.
On the other hand, past attempts to alter GAAP to account for intangibles have ended in disaster. So, GAAP may be the least of the possible evils.
where GAAP goes wrong
1. For tangible assets like buildings or equipment, GAAP assumes that they decline in value through use. Depreciation/depletion reduces their balance sheet carrying value according to a regular schedule to account for this.
But the parking lot that was on the outskirts of town fifty years ago may be in the center of downtown today–and worth a fortune, even though its current balance sheet value is close to zero. This kind of thing has been the idea behind the recent wave of takeovers of retail companies like JCP–that their properties are worth way more (sometimes in alternate use) than the balance sheet shows.
2. For intangible assets, like patents, software, brand names, the ability to make extra-good, extra-dependable products that consumers love, distribution networks…, they usually don’t appear on the balance sheet anywhere. In fact, the money spent creating these company attributes–like advertising, R&D, and training–appear only as expenses on the income statement. These expenditures reduce income, and, therefore, shareholders’ equity. GAAP treats them as a net minus!
how goodwill arises
Suppose Company A buys Company B. Company B has book value of $1,000,000, but Company A pays $2,000,000 to obtain it.
Overbidding? …maybe not. Maybe Company B has a lot of undervalued property. In that case, Company A is allowed to revalue Company B’s tangible assets upward to reflect current market values. Say that adds $200,000 to asset value.
What about the other $800,000?
Maybe Company A has indeed overpaid. If so, it has to immediately write the $800,000 off as a loss. But maybe Company A wants Company B because it has valuable patents or a great brand name or a powerful sales force–all intangibles. In Company A’s view, these factors alone justify the entire purchase price. If it can make its case convincingly to its auditors, Company A can add the value of the patents, etc. to the balance sheet at a value of $800,000 as goodwill. That way it avoids a gigantic writedown on the acquisition–something that wouldn’t thrill Wall Street, and might ding its credit rating.
What’s bogus about the concept is that Company B can’t do this for intangibles it developed itself while independent.
a history of abuse
1. At one time, GAAP allowed tech companies to put their R&D expenditures on the balance sheet as an asset. But after widespread abuse–companies claimed tons of loss-making activity was “R&D”–led to the bankruptcy of a bunch of companies with apparently pristine income statements, the practice was prohibited.
2. In the early 1980s, the SEC required companies to calculate and disclose their own shareholders equity using “current cost” accounting, a method of dealing with the effects of then-rampant inflation. The idea was that companies would know the true value of their assets better than anyone else. They could, in effect, write up their assets for increases in value of their tangibles, as well as give a value to intangibles.
Firms did know their true value, all right. But the way I read the resulting numbers, company managements fell in to two categories. Those afraid that disclosing their true value would make them takeover targets lied by making their book value figure extraordinarily low. Those that wanted to be taken over made their book values laughably high. Despite the fact that the SEC was asking, few companies told the truth, in my view. The project was abandoned.
But I think the lesson was learned. Management political agendas are too powerful to allow companies to do their own asset valuations. GAAP is as good as we’re going to get.