GOODWILL GAMES
Anthony H. Catanach Jr. and J. Edward Ketz
Grumpy Old Accountants, May 2011
There is no question that trade names, trademarks, and research and
development have value. Goodwill, maybe. If we didn’t care about
relevance and representational faithfulness, we suppose no one would care
how managers valued these items or whether they displayed them on the
balance sheet.
But, investors and creditors do care whether these numbers are meaningful
and useful. When they witness a line item in the asset section of a balance
sheet that shows a certain account with an associated dollar amount,
investors and creditors want to be reasonably sure that the asset exists and
that its measurement is reasonably precise given the method employed and
given the limitations of accounting in the real world. They don’t need fluff or
ocean spray.
Measuring intangibles at their fair market value is appealing. Current
market values would give some idea of what the asset is worth to the
company. Unfortunately, fair values depend on a market that encompasses
trading of intangibles and such markets either don’t exist or are quite thin,
causing the valuation method to have significant measurement error. And
measurement by model is proving laughable. Impairment tests face the
same problems.
Another way of saying this is that the numbers are virtually unauditable. If
we were the partners in charge of an audit, we would have some trepidation
signing off on the valuation of intangible assets because, if the firm faced
financial distress in the future, our reputations would be on the line. Who
would relish the prospect of defending the valuations in a court of law?
Current macroeconomic conditions have not been great. It certainly does
not feel like a recovery and it is understandable that some people question
whether the American economy is really out of a recession. Washington has
been known to stretch the truth for political reasons. Even if the U.S. is in
recovery, the dangers of dipping back in to recession are high. And the
tragedy in Japan and the continued unrest in the Middle East have increased
the probability of economic problems at home.
In such an economic environment, we question the value of corporate
intangibles in general and goodwill specifically. We are heartened that at
least some companies are writing down goodwill in the substantial amounts
we think appropriate. Eastman Kodak, for example, wrote down its $1,681
million of goodwill by $785 million. That looks realistic.
On the other hand, we tire of companies such as Dex One, which focus on
EBITDA instead of GAAP because GAAP involves write-downs of intangibles.
Former SEC Chief Accountant Lynn Turner once referred to EBITDA and
similar measures as “everything but the bad stuff.” He was correct, and
managers need to accept the fact that expenses and losses belong on the
income statement just as much as revenues and gains. Another example is
Kenexa, which not only adds back goodwill impairment but also quite a few
other negative accounts. You might as well play these games when your
retained earnings is a deficit.
We also tire of companies like Federal Signal who refer to goodwill as a noncash charge. If one is wearing tightly fitting blinders, yes, goodwill writedowns do not involve cash disbursements, but that is a misleading
observation. Goodwill involves cash disbursements when the corporation
acquires other firms and pays top dollar for these acquisitions, perhaps even
paying too much. At any rate, the acquisition of goodwill requires cash
disbursements directly or indirectly via the issuance of stock.
We find interesting the case of Dicks Sporting Goods, which recorded $111.3
million goodwill in 2007 because of its acquisition of Golf Galaxy. In 2009 it
revalued its goodwill and “based on macroeconomic factors” decided that the
goodwill was worthless. It took a charge for the full $111.3 million in 2009
and suggests that it paid too much for Golf Galaxy.
We wonder how many firms should have done this in their 2010 annual
reports. Given asset values in the market place and given carrying amounts
for goodwill, we think quite a few should have.
It remains debatable whether goodwill is really an asset, but if it is, one
must be careful in its measurement. We are skeptical about the balance
sheet values of intangibles assets, especially for goodwill. Maybe it is time
to recognize the precariousness with which these assets are measured and
either write them off immediately or amortize them over a short period of
time, such as five years.
This essay reflects the opinion of the authors and not necessarily the opinions of The
Pennsylvania State University, The American College, or Villanova University.