US should embrace reform of goodwill accounting

From The question of how companies treat goodwill in their accounts has engaged the attention of America’s accounting standards-setters several times over the past seven decades.

It has not been a comfortable journey. Twice goodwill-related wrangling has contributed to the standards-setters’ own demise; first in 1959 when the Committee on Accounting Procedure was axed after accusations of bowing to Wall Street by watering down acquisition accounting, and then in 1973, when the Accounting Principles Board had the temerity to try to toughen it up.

The present standards-setter, the Financial Accounting Standards Board, was pushed around by bankers and their friends on Capitol Hill when it last tried to look at the subject at the end of the 1990s. Which suggests it is worth paying attention if it is looking once again.

Goodwill bothers accountants because it is such a nebulous concept. Defined as the amount one company pays for another over and above the appraised value of the target’s assets, less any assumed liabilities, it eludes easy classification. It is not really an asset, being both unsaleable and almost certainly worthless in a liquidation. Nor does it have anything useful to say about the current valuation of a company.

According to Karthik Ramanna, professor of business and public policy at Oxford university’s Blavatnik School of Government, it represents little more than “the conjectural future profits that an acquiring manager hopes to realise through an acquisition”.

Yet thanks to the long M&A boom, US balance sheets are awash with this hope value. Since 2007, the goodwill on S&P 500 balance sheets has risen from $1.8tn to $3.5tn last year. Despite periodic impairments, such as General Electric’s monster $22bn writedown of its acquisition of Alstom’s power business, that tally keeps shooting up.

The FASB may be taking its life in its hands by reopening the question of goodwill accounting. But it is right to do so. The current regime not only lacks coherence; it flouts the fundamental accounting principle that revenues should be matched with associated expenses.

Companies used to amortise goodwill annually with a view to writing off the whole amount over a fixed period — generally about 20 years. True, that might sound arbitrary. But it allowed investors to see whether the gains from the transaction justified the outlay associated with doing the deal, making bosses more accountable. It was also prudent given all the uncertainty about the worth of this purchased “asset”. After all, companies still amortise other intangibles such as software and customer lists because of their uncertain value, and the need to renew them over time.

Compare that with the system in place since 2001 (and mimicked round the globe by the International Accounting Standards Board from 2004). Managers are able to treat goodwill as a permanent asset, only writing it down if it is deemed “impaired” by the company and its auditors. This is established by an annual impairment test.

The problems with this are obvious. First, it allows managers to use discretion to avoid impairments when they should really be taken. Take a 2009 study of US banks after the financial crisis. It showed that of the 50 largest American financial institutions, only 15 wrote down any goodwill in 2008, although nearly 40 of them were trading well below book value at the time. The British outsourcing group Carillion barely impaired any goodwill on its costly and unsuccessful acquisitions before it failed in 2018.

And it is not just a case of managers marking their own homework. By allowing bosses to count the profits from acquisitions while ignoring some of the expenses, the current regime permits a “double count” that lowers the bar on M&A deals, encouraging wasteful transactions to the double detriment of investors, who pay both unjustifiable premiums and high fees to intermediaries.

Investors often glaze over when goodwill is mentioned, taking refuge in the idea that it is a “costless” item. But accounting values not only drive counterparties’ and employees’ decisions; they can trigger the payment of big bonuses to bosses.

Balance-sheet overstatement can deceive creditors about the solvency of a company and permit the extraction of unjustifiable dividends. With every extra trillion-odd of goodwill, the risks mount up.

Investors might reasonably ask who benefits from the current system. Many companies are agnostic, disliking the cost and faff of annual impairment tests.

The answer, of course, is the vast financial services lobby. In the 1990s, Wall Street led the charge against the FASB’s abortive reform, which would then have forced all companies to amortise goodwill, abolishing a loophole for mergers of equals. Big banks are already shaping up as critics of any putative shift to amortisation, with Bank of America warning with admirable candour that it could disrupt the US deals market. A less worthy objection is hard to conceive.

Now not all goodwill is moonshine, and many companies can doubtless justify the carrying values of their subsidiaries. But that is no reason to shirk accounting prudently for intangibles. Past standard-setters may have struggled with goodwill accounting. But the FASB shouldn’t pass this opportunity up.

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