First, Do No Harm

Another Elective Procedure on Goodwill Accounting is Too Risky for Investor Health

By: PJ Patel

(Estimated reading time: 4 minutes 6 seconds)

As the Financial Accounting Standards Board considers additional interventions in the way public companies account for goodwill, they would do well to remember one of Hippocrates’ maxims for physicians: First, do no harm.

The FASB is soliciting feedback on whether and how to further simplify the accounting for goodwill and intangible assets for public companies. From my perspective, the chances are growing that, in trying to improve something that already works well, further changes could wind up making it worse. I would point to at least two areas where this may be setting off down a harmful course of accounting treatment, the first conceptual, the second practical.

Up-Front Disclaimer

As a valuation professional who has worked on over a thousand deals over the last two decades, I have a unique perspective on the topic. I’ll also be the first to acknowledge that as a valuation specialist and co-head of a valuation firm that is regularly engaged to value intangible assets and goodwill, I have some professional skin in the game too.

Still, I like to think I can be objective.

VRC works with companies on the purchase price allocation and opening balance sheet work, and we remain engaged post-deal to test for impairment but we also work with companies pre-deal as they are thinking about the structure of the deal – what the implications will be for financial reporting and tax. Our work in all deal stages protects investors as it gives companies the tools to think critically and strategically about what they are buying, the price they are paying, and the implications, risks, and communication requirements if the deal goes bad. In the end, investors get to judge management’s performance. Under the current accounting rules, management can run, but they can’t hide. When the current rules were implemented in 2001, many companies took significant goodwill impairments.

Conceptual Problems with the Current Trajectory on Goodwill

Some market participants have pointed to recent headline-grabbing impairment announcements from Kraft Heinz as evidence of problems in the current approach. After all, when Kraft surprised the market early this year with a nearly $15 billion writedown of goodwill, its shares plunged some 14% in a single trading day. The drop serves to illustrate what happens when companies seemingly don’t think a goodwill impairment is meaningful and may serve as a warning to other companies to do a better job communicating to the market, thereby heading off unpleasant surprises.

In the case of Kraft Heinz’s impairment, and other shocking noteworthy losses as of late, I think we must look beyond the headlines to see the facts and the truth. I liken these situations to the chicken or the egg scenario—does testing for impairment cause companies to communicate more openly and more frequently with the market? Alternatively, does communication to the market occur regardless, rendering the impact of impairment testing meaningless? Kraft’s impairment headlines and our pre-2001 experience seem to suggest the former.

Now the FASB is explicitly considering allowing companies to amortize goodwill. Amortization, so the thinking goes, could provide somewhat of a smoothing effect by gradually reducing the amount of goodwill subject to impairment.

Impairments tell us a lot about the one variable many financial analysts care most about, yet find hard to assess - the quality of management.

However, I would suggest that the only effect of amortizing will be adding another non-GAAP reconciling item with minimal benefit. Investors certainly aren’t going to be fooled; they operate within the framework where all available information is immediately reflected in the share price.

Even further out on the conceptual spectrum, some observers are questioning whether goodwill, a non-cash “nuisance” they call it, belongs in financial statements at all.

Again, I would defer to the invisible hand of the market and point to the significant share price drop in Kraft Heinz when it announced its impairment writedown: it would seem investors believe there is a great deal of information to be gleaned from this non-cash nuisance data point. Among other things, I suspect investors share my view that goodwill impairments tell us a lot about the one variable many financial analysts care most about, yet find hardest to assess—the quality of management. Are they good at doing deals that create value?

Practical Problems with More Major Accounting Changes

In addition to the conceptual challenges to overhauling the treatment of goodwill yet again, there is an essential practical consideration: Companies are telling us they simply don’t have the bandwidth to implement another major accounting change anytime soon.

The evidence isn’t just anecdotal. We’re in the middle of conducting a survey of financial reporting professionals (specifically, CFOs, CAOs, controllers, SEC reporting directors) at public companies to gauge their views on goodwill and, while the survey is currently in progress, one thing that is loud and clear from the nearly 150 responses received to date is that the finance departments of many public companies are simply maxed out. On top of dealing with new lease accounting and revenue recognition rules, there have been so many tweaks to the accounting for goodwill that companies can’t keep up. The big changes are with the addition of step 0 and the elimination of step 2. However, there have been other tweaks too – like what to do with negative carry value reporting units and new PCC rules for private companies.

FASB has taken a confusing area, made it more confusing, and is now talking about additional changes.

Additionally interesting to note is that when the FASB announced their ITC on intangibles and accounting for goodwill one key point of feedback they’re seeking is whether or not the cost outweighs the benefit. This topic is another focus of our survey and an area that has been a point of discussion I’ve had with many survey respondents as well. Considering the “maxed out” commentary related to revenue recognition and lease accounting I would suggest the cost outweighs the benefit in all rule changes as the soft and hard expense incurred in professional hours to implement them have skyrocketed.

First, Do No Harm

Given the practical obstacles and, more importantly, the conceptual issues, I urge caution against performing a major elective procedure on the treatment of goodwill. It is easy to get sucked in; the markets have been strong over the past ten years, so it is easy to think of goodwill as a nuisance. But, goodwill is still the best attribution we have to explain why companies with very little in the way of working capital and fixed assets trade above book value on an ongoing basis. To amortize it would create a disconnect from this reality with minimal benefit for users of financial statements.

At a minimum, I urge those who will be most affected by the proposed changes to take advantage of the comment period that runs through October 7th and offer the FASB many second opinions.

The Current State of Goodwill & Impairments

The Current State of Goodwill & Impairments

PJ Patel, Co-CEO and Pranav Ghai, co-Founder and CEO of Calcbench, discuss corporate goodwill, goodwill impairment, and financial analysis techniques that analysts can use to assess the value of goodwill assets on the corporate balance sheet.

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