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The Impact of Acquisitions on Earnings Quality- Part 1
A look at the CFA Institute’s comments to the FASB on goodwill accounting
Over the next series of free installments of Peek Behind the Numbers, we are going to be examining the impact of acquisitions and the related accounting on company results. Key to this is the treatment of the goodwill and intangible assets that arise from acquisitions. The CFA Institute recently published results of a survey of over 22,000 of its members on their viewpoints regarding the current state of accounting for goodwill and the Financial Accounting Standards Board’s (FASB) consideration of returning to goodwill amortization. Both the FASB and the International Accounting Standards Board (IASB) are considering changes to their prescribed method of accounting for goodwill and intangibles resulting from business acquisitions. We thought the results of the survey and the issues discussed provided a perfect backdrop to introduce our exploration of the impact of acquisitions on company results.
We have always found the prospect of analyzing financial statements much more engaging than preparing them so we will say from the start that our purpose is not to propose the perfect accounting treatment for goodwill that will capture all the complexity of valuing an acquisition. One simply doesn’t exist. Instead, we will focus on the factors goodwill accounting must address as well as our concerns about how the market tends to view the cost of acquisitions.
What Is Goodwill?
Goodwill arises as a result of an acquisition. When Company A acquires Company B, it calculates the fair value of the tangible assets (i.e., inventory, receivables, plant and equipment) and subtracts the value of liabilities (i.e., accounts payables, taxes payable, debt) of company B to arrive at an implied tangible book value of Company B. The excess of the price paid for Company B above its tangible book value is recorded as either “goodwill” or “intangible assets.” The difference between what gets booked as goodwill versus what gets booked as intangible assets can get a little murky. Accounting guidelines indicate that amounts booked as intangible assets (distinct from goodwill) should be capable of being sold or arise from a legal or contractual right. Most companies break out categories of intangible assets which typically include items like “acquired technology” and “customer lists.” Goodwill is more abstract and represents items such as synergies that can be gleaned from combining the two businesses, management experience, or company reputation.
We would point out here that the lack of clarity in the distinction between goodwill and intangible assets already clouds the picture and introduces the potential to manipulate GAAP earnings given that intangible assets are amortized under current accounting guidelines while goodwill is not. Therefore, a company assigning a greater amount of the excess purchase price to goodwill will enjoy higher GAAP earnings.
The very question of whether goodwill should even be recognized on the balance sheet is controversial and there is considerable disagreement among professional analysts and portfolio managers on the subject. Here is a summary of some of the basic findings of the CFA Institute survey which illustrate the lack of consensus on even big picture points.
Is goodwill an asset to be recognized on the balance sheet?
Strongly Agree or Agree 75%
Neither Agree nor Disagree 9%
Strongly Disagree or Disagree 16%
Goodwill does not necessarily decrease in value over time.
Strongly Agree or Agree 53%
Neither Agree nor Disagree 15%
Strongly Disagree or Disagree 32%
Should goodwill immediately be written off against equity?
Strongly Agree or Agree 21%
Neither Agree nor Disagree 18%
Strongly Disagree or Disagree 61%
The responses above indicate that most investors do view goodwill as at least some form of asset with varying degrees of “realness.” However, that view is far from universal with a meaningful number of professional investors willing to totally disregard the shareholder capital spent on intangibles in the pursuit of acquisitions.
If Goodwill Is an Asset, Should It Be Amortized?
All assets come with a cost and accounting convention generally dictates that the cost must eventually be recognized on the income statement. While most analysts agree that goodwill is an asset that should be on the balance sheet, there is an ongoing debate as to how the expense should be recognized. In the case of long-lived assets such as property plant and equipment, the cost of the asset is recognized as an expense on the income statement over the time the asset is expected to produce value for the company. However, the trick is determining how long the asset will add value. It is a relatively easy task to arrive at a reasonable estimate of the service life of a delivery truck by looking at past experience. However, deciding how long a brand will remain popular with consumers, how long a relationship with a customer will generate revenue near its current level, or how much growth and synergies that can be obtained through cross-selling to existing customers are all much more difficult to ascertain.
Accounting rules have taken two different approaches over the years- amortization and impairment. We will take a quick look at each below:
The amortization model reflects the idea that all goodwill is a “wasting asset.” In other words, its fair value degrades over time. Companies are given a set number of years or a range of years they can choose from over which they must amortize the goodwill balance. Proponents of this method argue that it recognizes the cost of the acquisition and minimizes the chance that an overvalued asset remains on the balance sheet overstating the book value of the company. From a practical perspective, it is also much easier to implement.
The impairment model does not assume goodwill is a wasting asset. Instead, goodwill is viewed as maintaining its original value until there is evidence that the value has declined at which point the decline is recognized as a charge to income. Proponents of this model argue that it allows for companies that make acquisitions that produce value over the long term to be rewarded with a higher equity value. However, implementation is expensive and difficult. More importantly, it relies on management assumptions such as discount rates and expected growth rates which open the door for manipulation. In our experience, managements are generally reluctant to admit that the deal they promoted as a stroke of genius just a few years before has proven to be a huge waste of shareholders’ money. Agreement among professional investors to this point can be seen in the following responses to the CFA survey:
Goodwill impairments are not recognized by companies in a timely manner
Strongly Agree or Agree 72%
Neither Agree nor Disagree 23%
Strongly Disagree or Disagree 5%
Impairment of goodwill is often reflected in share price prior to when the actual write-off occurs and is announced by management
Strongly Agree or Agree 52%
Neither Agree nor Disagree 25%
Strongly Disagree or Disagree 23%
We agree that in some instances, the market is anticipating a goodwill write-down so the negative stock price reaction at the announcement can be muted. However, there are also many instances where goodwill impairments have led to significant share price plunges- just look at Kraft Heinz’s (KHC) 2019 chart.
The Road to the Current Debate on Goodwill Accounting
Accounting standards issued in the 1940s took the impairment approach. Goodwill was considered a permanent asset not subject to amortization. This changed in 1970 when the FASB began requiring companies to record amortization expense to reflect the cost of acquiring the asset on profits over time. Companies were allowed to choose the amortization period with a maximum of 40 years. The longer the time frame, the smaller the expense would be. Not surprisingly, most companies elected the maximum period.
In 2001, the FASB changed the rules for goodwill via SFAS 142 which again eliminated the practice of amortizing goodwill. Companies are now required to at least annually estimate the fair value of the reporting unit utilizing a discounted cash flow approach. If the fair value is ever estimated to be below the carrying value of the goodwill, the company must take an impairment charge in the amount of the difference. Companies alert investors when the fair value of operations underlying the goodwill fall close to carrying value and are at risk of impairment if conditions deteriorate. They often report the assumed growth rates and discount rates utilized in arriving at the fair value estimates. However, the disclosures are typically sparse and inconsistent from company to company.
After issuing SFAS 142, the FASB began receiving complaints about the cost of performing regular impairment testing. These prompted the FASB to scale back various requirements of the testing practice to ease the burden. In 2012, it even moved to allow private companies the option to amortize goodwill over 10 years. Still, the complaints continued. Finally, high profile goodwill impairments sinking the stock prices of Carillion in the UK and GE and Kraft Heinz in the US added further motive for the accounting governing bodies to revisit accounting for goodwill. Still, the FASB’s 2019 invitation to comment (ITC) letter which led to the CFA Institute survey began over concerns of cost to implement rather than motivation to ensure the most realistic representation of economic reality.
At this point, it appears that FASB is leaning towards reinstituting goodwill amortization over a set 10-year period while the IASB is favoring foregoing amortization and sticking with an impairment testing process. The logic behind the impairment testing method stems from the idea that not all goodwill is the same. Some managements may execute acquisitions that create permanent value to shareholders which does not dissipate. However, many acquisitions are flops and the promised value never materializes or fades quickly. In this case, the lost value can be reflected by a charge to earnings and a reduction to assets and equity on the balance sheet.
What Do the Survey Respondents Want?
Despite expressing concerns over weaknesses with the current system, the majority of professional investors surveyed favor making improvements to disclosures under the current impairment system rather than returning to an amortization model:
How should the FASB proceed?
Retain impairment with improved disclosures 58%
Require amortization 31%
No preference 11%
Respondents offered several different objections to the amortization model including:
“It does not allow for discernment between good and bad managers and their acquisitive abilities.”- (63% of respondents)
“Amortization distorts financial ratios.” (60% of respondents)
“It does not provide decision-useful information for the investment process.” (50% of respondents,)
This is not surprising given that by in large, most investors today tend to ignore amortization expense in their analysis anyway. Consider some of the comments regarding amortization published in the survey:
“Ultimately, investors will add back goodwill amortization to determine cash earnings, so this debate is form over substance. Easier for everyone to simply not have to take another adjustment into account and leave goodwill accounting as it is today.
“The amortization is non-cash charge and we are going to add back in valuing companies on an Enterprise Value/EBITDA basis anyway. Therefore, the work to bring back amortization expense isn’t worth it. Leave as is and focus on more important issues… Don’t waste time with bringing back goodwill amortization expense.
What Do We Think?
As we noted in the opening paragraph, our purpose is not to propose a policy that will completely solve all the accounting challenges posed by goodwill and intangibles. There is no uniform practice or amortization period that can completely reflect all the nuances of each acquisition. The fact that the market already accepts non-GAAP results with the amortization of acquired intangibles added back demonstrates that analysts do not stick to the GAAP viewpoint anyway.
However, the questions raised by goodwill accounting form the perfect framework under which to move forward in our series examining the impact of acquisitions on the quality of a company’s results. These are the key points we will be exploring over the next few free installments of Peek Behind the Numbers:
Acquisitions have a cost
One of our biggest pet peeves is the almost standard practice among acquisitive companies of adding back amortization of acquired intangible assets to non-GAAP earnings. Declaring goodwill as an indefinite-lived asset that has no cost associated with it follows in the same line of thinking. Wall Street’s focus on EBITDA as the end-all measure of company performance has led to the overwhelming acceptance that amortization is a “non-cash” cost. The comments from professional analysts and portfolio managers quoted in the survey were full of references to amortization as a non-cash cost that they are going to automatically add back. We find this view very alarming. Companies acquire other companies with either cash on hand, cash they got from a debt offering, or their own stock which could have been sold for cash rather than be used to fund the acquisition. One objection to amortization in the survey was that it distorted financial ratios. We would argue it is a distortion to ignore the impact of what is most decidedly a cash cost, particularly for companies that rely on acquisitions as their chief source of growth.
You can buy it or build it
We think it is important to always remember that a company has a choice to either acquire its way into a new market or geography or to build it from scratch. If a company builds it, it will have to expense wages and record depreciation against the assets. Ignoring the cost of acquisitions by never recognizing amortization essentially allows a company that acquired growth to never record an expense.
Goodwill is not as durable as some seem to believe
We completely agree with the observations made by some in the survey that not all goodwill is created equal. Some companies do make good acquisitions that may generate long-term value. However, at present, all goodwill is considered eternal. That may be true for Oreo cookies or Mickey Mouse, but is it true for a 4-bit microchip when that product has been replaced 12 months later with a 16-bit microchip built via a new process? How about the value of a heart stent company if a second heart stent company is acquired by a distributor that boosts the sales of its new acquisitions? We are reminded of Jim Chanos’ response to the criticism that short selling is risky because stocks can rise to infinity and only fall to zero- “I’ve seen a lot more go to zero than infinity.” Likewise, we have seen a lot more New Cokes than we have seen original Coca-Colas.
To this point, we will examine the evidence indicating most acquisitions never deliver on their original promise and include closer looks at some glaring examples of shareholder capital being lost to write-offs.
Accounting rules can be bent
We already mentioned that the distinction between goodwill and intangible assets can be blurry. It is possible to find companies in similar industries who sell to the same customers, but one puts 80% of acquisitions into goodwill and 20% into customer lists that it amortizes over 20 years. The other may only put 50% of acquisitions into goodwill and 50% into customer lists and amortize them over 10 years. There are also plenty of levers to pull in estimating a unit’s fair value in an impairment test. One company may use a discount rate of 8% in estimating the fair value of future cash flows while a peer with similar assets uses an 11% discount rate which results in a higher value.
A host of internal and external factors can diminish the value of goodwill
We will examine the factors that lead to the erosion of fair value supporting goodwill and point out a few companies that seem more at risk for incurring an impairment in the year ahead.
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