Investors should carefully examine a company’s goodwill account

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.