Investors should carefully examine a company’s goodwill account

They can reveal the costs of a corporation’s growth strategy, and also affect earnings and profitability.

Imagine yourself as the CEO of a tech company that has pinned its hopes on the development of a new software system that will revolutionize, say, the way retail stores forecast product demand. Your development team, though, has hit a stone wall.

You meet with the team and the consensus is that they can solve the problem, probably, but you realize that vagueness of how long it would take would scare away creditors and investors to the point where the company’s very existence would be questionable.

One of the software engineers speaks up — something he rarely does — and says that he has heard that the guys at a nearby small software development company have solved the problem but haven’t figured out how to market it yet and are coming to the end of their financial string. It sounds like a perfect marriage and, after meeting with the other business, they agree to a deal where your firm will acquire theirs. And, after negotiating the price, the acquisition, your company’s first, is completed.

Some weeks later, your chief financial officer, a very bright and competent young woman, stays after the regular early Monday morning staff meeting and says, “Can you spare a few minutes to talk about depreciating our goodwill?”

You reply that you spend half your life building goodwill with investment bankers, creditors, investors and regulators, and add, “Why on earth would we want to depreciate our goodwill?”

She smiled and said, “Not that kind of goodwill. I’m talking about accounting goodwill, the kind that came with the acquisition. We need to treat it in a way that will satisfy the auditors and the IRS.”

You reply, “I’m betting that you have already worked out a plan. Can you brief me on it soon? How about we go over it at 2 p.m.?” “Perfect,” she replies.

If we could sit in on that briefing what we would hear would be a thumbnail description of how accounting goodwill has nothing to do with the company’s reputation. It is an accounting byproduct of buying a company for more than its net worth. It is not a judgment on the merits of the acquisition, but simply a way to balance the books.

Net worth is calculated by subtracting liabilities from assets, and many companies have a net worth that does not reflect their value to an acquiring company. Startup software development companies, for example, often have zero net worth. High growth companies also often have lower net worth because their profits are used to expand their market footprint rather than buy hard assets.

If your company pays, say, $5 million to acquire the other firm, which has a net worth (assets minus liabilities) of $2 million, your new, after purchase, balance sheet suddenly has a $3 million hole in it. It doesn’t balance.

In order to balance your company’s books, an artificial, accounting asset is created, and for some reason lost in history, it is called “goodwill.” In our example, it might include such things as the value of the acquired company’s completed work, and any patents it held.

The goodwill account doesn’t really have to contain any identifiable assets, though, beyond its value to your company as a key element in your business strategy. In most cases, including our example, there is a lot of subjective judgment and guessing about the future involved in assigning values to these intangibles.

Satisfying the different parties interested in these intangibles can be a difficult balancing act. Investors, financial analysts, creditors, banks, and the IRS all have different perspectives, but each is keenly interested in how you treat and report goodwill in your financial statement.

Investors should bear in mind that additions to goodwill will reduce a company’s return on assets (ROA) because it increases total assets while leaving earnings unchanged. Goodwill also reduces profitability because it usually has to be amortized over a 15-year period in order to comply with IRS rules.

Among its other problems, the goodwill account suffers from a fundamental difference in perception. CEOs tend to view the payment for an acquisition as a cost of doing business, not a pretend asset. Regulators sometimes view the same account as a potential source of financial finagling and deceptive reporting.

For CEOs, it is important to realize that goodwill is an area that requires specialized knowledge and you should be prepared to manage the experts’ efforts in its accounting, financial reporting, tax, and legal dimensions.

Investors should be aware that goodwill accounts can reveal the costs of a corporation’s growth strategy, and also affect a company’s earnings and profitability. It wouldn’t hurt to take a look at the goodwill account before betting your money on a company’s future.

Talk to us

More in Herald Business Journal

Striking Starbucks employees talk to a woman who wanted to use the drive-thru but was turned away due to the strike on Wednesday, June 15, 2022, on Broadway in Everett, Washington. Workers at the 37th and Broadway store spent their morning picketing because a fellow employee had been fired the previous day in what the workers believe is an act of union busting. (Ryan Berry / The Herald)
Everett Starbucks workers go on strike after employee fired

The employee and her fellow union members claim she was fired for supporting the union. Starbucks denies it.

Property values soar 32% in Snohomish County due to hot housing market

Assessed values are up all across the county since last year. The impact on tax bills won’t be known for a few months.

Port of Everett hosting annual open house after pandemic hiatus

Also, Rustic Cork Wine Bar plans to open a second shop at Fisherman’s Harbor — the latest addition to the port’s “wine walk.”

Holly Burkett-Pohland, the owner of Burkett’s Home & Gift, outside of her new store front on Friday, June 17, 2022 in Everett, Washington. (Olivia Vanni / The Herald)
New Everett gift store debuts in former J. Matheson space

For years, Holly Burkett-Pohland wanted to expand a business founded by her mother in 1978.

A Kenmore Air Cessna 208 Caravan. (Kenmore Air) 20220613
Kenmore Air to start daily flights from Paine Field to San Juans

Service begins July 14. Flights to Friday Harbor and Orcas Island airports take about 25 minutes.

Seattle Space Needle sues coffee chain over use of logo

The logo for Local Coffee Spot features a mug of hot coffee whose rising steam bears striking resemblance to the iconic tower.

Logo for news use, for stories regarding Washington state government — Olympia, the Legislature and state agencies. No caption necessary. 20220331
Foes of state’s capital gains tax drop plans for initiative

I-1929 sponsors say they are confident a lawsuit challenging the legality of the tax will be successful.

Smoother sailing: Arlington airport gets grant to fix runway

A $2.3 million federal grant will pave the way for a project to resurface the airfield’s main runway.

Workers build the first all electric plane, the Eviation Alice, on Wednesday, Sept. 8, 2021 in Arlington, Washington.  The plane is designed for regional travel and to carry nine passengers. (Andy Bronson / The Herald)
Eviation moves tests of electric passenger plane to Moses Lake

The Arlington company said a bigger runway and flatter terrain are better suited to early testing of the commuter aircraft.

An artist's rendering of the new Funko warehouse in Buckeye, Arizona. (Funko) 20220407
Funko warehouse layoffs begin this week in Everett, Puyallup

The layoffs, announced in April, are part of a plan to move distribution operations to Arizona.

Rendering of the front entrance of Spruce Elementary School in Lynnwood. (Edmonds School District)
Police: Edmonds schools sent $2.7 million check to fraudster

Police say the fraudster posed as a contractor for a new elementary school. A bank caught it at the last second.

Looking north, an aerial view of Paine Field in Everett. (Paine Field / Snohomish County) 20220605
Paine Field development plan envisions an expanded terminal

Once Sea-Tac Airport reaches capacity, the Everett airport is on the short list to absorb unmet demand by passengers.