Where Has All the Goodwill Gone?

It must be year-end house-cleaning time, because we read every day about companies writing off huge amounts of goodwill that originated from an earlier acquisition.

February 2013

By Gerard Zack, CFE, CPA, CIA

 

In 1965 Ray Davies of The Kinks asked, “Where Have all the Good Times Gone?” – a classic song that included the follow-up question, “Will this depression last for long?” Davies wasn’t alluding to the economy. He had other issues on his mind. But over the last few years many of us have asked very similar questions about our personal finances.

 

Decades later we’re asking, “Where has all the goodwill gone?” It must be year-end housecleaning time, because we read every day about companies writing off huge amounts of goodwill that originated from an earlier acquisition. In January alone, reported write-offs included, but were not limited to:

 

General Dynamics - $2 billion  

ArcelorMittal - $4.3 billion  

Cliffs Natural Resources, Inc. - $1 billion  

Rio Tinto - $14 billion  

 

Defining Goodwill 

Wherever there’s goodwill, there’s been an acquisition, since under the accounting rules it is impossible to internally develop an asset for goodwill. Goodwill represents the excess of a purchase price over the fair value of the acquired assets, less the fair value of the assumed liabilities. It’s the premium that a buyer is willing to pay for the intangible value that it perceives it will receive in connection with an acquisition. Or, as many will cynically argue, is goodwill really nothing more than a plug figure to account for the difference between what a buyer paid and the tangible assets it obtained?

 

The answer lies somewhere in the middle. Acquirers often legitimately see real revenue potential in businesses they acquire. And often their vision is accurate. In other cases, the anticipated profits never materialize.

 

In each of the cases noted above, the company previously acquired other businesses, resulting in goodwill. In the case of General Dynamics, its Information Systems & Technology unit has acquired numerous businesses over the past 15 years, and revenue from those businesses is below expectations. ArcelorMittal’s write-down involves its European business acquisitions and was caused by reduced steel consumption. The Cliffs Natural Resources write-down pertains to its acquisition of Consolidated Thompson Iron Mines Ltd for $4 billion two years ago. Lastly, $3 billion of the $14 billion write-down by Rio Tinto pertained to a $3.7 billion acquisition of Mozambique Coal, while the remaining $11 billion brings to $30 billion the company’s cumulative write-downs associated with its acquisition of Alcan for $38.1 billion in 2007.

 

One potential sign of trouble to come is a high ratio of intangible assets (especially goodwill) to total assets. Indeed, going back to 2011, some analysts expressed concern that 45 percent of General Dynamics’ assets were intangible.

 

Where Fraud Begins 

We can all agree that there’s a big difference between failed expectation and fraud, but there are two sets of circumstances in which goodwill can be associated with fraud:

 

1. When a company being acquired misrepresents itself, leading a buyer to overpay for the acquisition, and

2. When a company continues to carry goodwill on its financial statements even though all signs point to the goodwill being impaired and in need of being written down or off completely.

 

The first scenario is what has been asserted in the Hewlett-Packard deal to acquire Autonomy Corporation. Hewlett-Packard purchased Autonomy for $11 billion in 2011. The purchase price represented a greater than 65 percent premium over the price at which Autonomy was trading at the time of the announcement. Hewlett-Packard recorded $6.9 billion of goodwill and $4.3 billion of other intangible assets in connection with the acquisition. Clearly, it was not acquiring anything tangible when it purchases Autonomy. But in November 2012, Hewlett-Packard announced that it was writing off $8.8 billion of goodwill and other intangible assets, mostly in connection with the Autonomy acquisition. It also announced that more than $5 billion of this write-down was due to accounting fraud perpetrated at Autonomy, although HP’s stance on that allegation has subsequently softened. Nonetheless, the U.S. Department of Justice launched an investigation into the allegation in January.

 

In its Oct. 31, 2011 year-end balance sheet, goodwill and other intangible assets made up almost 43 percent of Hewlett-Packard’s total assets. For the year ended October 31, 2012, Hewlett-Packard wrote off more than $18 billion in goodwill and other intangible assets, mostly due to the Autonomy deal and an earlier acquisition of EDS.

 

A more recent and equally interesting case involves Caterpillar. In January Caterpillar announced that it would be taking a $580 million write-down in the fourth quarter after identifying accounting fraud at a subsidiary of ERA Mining Machinery, a Chinese company that it acquired in June 2012 for $886 million.

 

The first thing that strikes us about this write-down is the significance of goodwill to the acquisition itself. More than 65 percent of the purchase price was attributable to the goodwill that is now being written down! Clearly, Caterpillar saw a lot of intangible value in this company. Caterpillar’s purchase price represented a one-third premium over the price at which ERA was trading at the time the deal was announced in late-2011. And now, almost two-thirds of that purchase price is being written off.

 

But what makes this case even more interesting is one of the same things that struck us about the Hewlett-Packard case. Caterpillar uncovered accounting fraud that may have led to the inflated purchase price in the first place. So far, all that has been said about the accounting fraud is that it involved improper and unsupported revenue recognition, as well as improper cost allocation. Each of these fraud schemes, if proven to be true, would have inflated the financial condition of ERA at the time Caterpillar was negotiating its acquisition.

 

Whether fraud was involved on the part of an acquired company or not, a buyer has an obligation under the accounting rules to subsequently evaluate goodwill and other intangible assets to determine whether they are still worth what they paid for them. Since this evaluation inherently involves a lot of judgment, it represents the second area in which fraud can be found in connection with goodwill. If a company desires to issue a strong set of financial statements, perhaps it becomes necessary to avoid having to recognize an impairment charge. And this can lead to fraud.

 

Global Reaction 

Regulators are well aware of the requirement to assess the value of goodwill on an annual basis. The European Securities and Markets Authority (ESMA) recently announced that companies and their accountants who fail to recognize goodwill impairments as they finalize 2012 financial statements will be named publicly. In a sample of 235 companies from EU member states, the ESMA found that just €40 billion out of a total of €800 billion had been recognized as impaired in 2011 financial statements. The 5 percent impairment rate has been met with much skepticism. The ESMA says it will review the 2012 annual reports to determine whether companies and their auditors rigorously applied an impairment test to recorded goodwill. And it plans to publish the results of its analysis.

 

The worldwide economic crisis has certainly directly or indirectly led to many of the goodwill write-downs we are seeing. Revenue projections that once seemed reasonable have evaporated in some cases, as customers, including government agencies, cut back on purchases.

 

But the timing of some goodwill impairment charges seems suspicious. Some of the businesses that are now the subject of a write-down were acquired several years ago. This raises the question of why the huge write-offs are taken all at once. Obviously this is not the case with Hewlett-Packard’s write-down of Autonomy, since that took place only a year after the acquisition. However, wouldn’t one expect that in many of these cases, the intangible value of an acquired company would decline gradually or in steps over a few years?

 

An impairment loss on goodwill should generally be recognized if the fair value of the goodwill declines below its book value. Fair value of goodwill can be measured in many different ways, but most methods involve a projection of future revenues from the acquired business unit discounted to present value using a discount rate that reflects various risks. While this is a very simple explanation of what can be a complicated calculation, it illustrates the fact that the annual assessment of the value of goodwill inherently involves an assessment of the future revenue that the business will likely generate. And if a business was acquired prior to the start of the economic crisis, is it realistic to think that its pre-crisis revenue projections on which the goodwill value was based are just now being recognized as being affected? Weren’t the signs of an impairment loss apparent in the years leading up to the big write-off? Or did it really all happen in 2012?

 

These annual assessments of impairments are likely to be the subject of much additional debate, and even some allegations of financial reporting fraud, in the coming months and years.

 

We will also likely see more discussion of the due diligence process engaged in by companies in connection with an acquisition. Indeed, some of the recent write-downs have resulted in accusations of shoddy work or lack of independence aimed at the buyer’s auditors, who also performed the due diligence for the acquisition. Others have argued that there is so much fee pressure on firms that perform due diligence that the old saying “you get what you pay for” may ring true. Stockholders may begin demanding better due diligence.

 

Whatever the reason, improvements in the due diligence process clearly need to be made, along with improvements to the annual impairment testing process.

 

Mischaracterized Losses 

Finally, some of the announcements involving goodwill write-downs seem to be a bit misleading. One of the things that companies frequently do when they write off goodwill and other intangible assets is to point out to investors that it is a “non-cash” write-down, as though no real money was lost. But make no mistake about it, money was lost. Take a look at Hewlett-Packard’s Oct. 31, 2011 year-end statement of cash flows and you’ll see more than $10.5 billion being reported as cash paid for business acquisitions. That was primarily the Autonomy acquisition. So, while it represents a non-cash charge in the year of the write-down, the losses are very real. That’s why the CEO of Rio Tinto was fired after that company’s $14 billion write-down.

 

Perhaps with age does come maturity, or at least a more realistic grasp of the world. In 1993, Ray Davies asked another question, “Was it real or only a dream?” in “Only a Dream.”

 

Perhaps we should ask ourselves the same question about goodwill. Was it ever real in the first place?

 

Gerard Zack is a forensic accountant and  president of Zack, P.C. and also serves on the faculty of the ACFE. He can be contacted at Gerry@zackpc.com.