The problem with "Goodwill"

Is it real or is it ... (to paraphrase an old commercial).

The Wall Street Journal has a piece today about accounting and "goodwill" ("Buyers Beware: The Goodwill Games"). Goodwill is considered that part of the purchase price of a company that is left over once you accounted for everything you can account for. Usually that means once you have subtracted out "hard assets" and those intangibles that you can put a value on (e.g. patents). According to the Journal, a number of companies have high levels of goodwill including six where the value of the goodwill on the books is greater than the market capitalization. The story says that this is an indicator of a future loss in the value of the company as the goodwill is written off.

Not so fast.

There is a lot going on in goodwill accounting. Yes, there have been some big write downs lately (such as HP's $8 billion write off). But large good will doesn't necessarily mean write downs are coming. Maybe the company is simply undervalued in the market and is a candidate for value investors. On the other hand, what gets thrown into the category of goodwill is mishmash. Some of it is intangibles that accountants don't bother to break out. Some of it is important intangibles that are difficult to break out. Some of it is just buyer expectations (from "synergy") that may or may not play out. Some of it is simply overpaying.

As I noted in an earlier posting, accountants routine attribute most of the cost of an acquisition to goodwill. A study from Ernst & Young (Acquisition accounting: What's next for you) of over 700 acquisitions across a variety of industries as reported in 2007 annual reports noted that "many companies were reluctant to fair value tangible assets bought and to provide detailed information on intangible assets they acquired and how they were valued." That insight is borne out by the fact that "goodwill" continues to be the convenient catch all category for acquired assets. Goodwill accounted for 47% of total enterprise value, compared with 23% for recognized intangible assets and 30% for tangible and financial assets. In other words, almost half of the total value of the acquisitions and over two-thirds of the intangible portion of the acquisition where labeled as goodwill. In almost a quarter of the transactions, goodwill was the only type of intangible -- no other type of intangible was reported.

So I take the Journal's finding of a high level of goodwill not as a sign of pending doom -- but as an indictment of the failure of our accounting system. Solving the problem of accurate accounting for intangibles will go a long way to solving the "problem" of goodwill. Granted there will always be over expectations/overpayment. And not all intangibles that make up an acquisition can necessarily be valued in dollars and cents. But being able to understand the difference between monetizable intangibles, other intangibles and market froth will help investors and others (i.e. managers) better understand what the company is really worth.