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Why Goodwill Amortization is not a real expense

Note: the following article is somewhat out-of date since the accounting rules were subsequently changed to no longer require amortization of goodwill. In retrospect, Nortel was not the best example to use...

Nortel, in 2000, lost a staggering US$3.5 billion as reported under Generally Accepted Accounting Principles ("GAAP"). But they made US$2.3 billion in earnings before acquisition related costs (amortization of goodwill and write-off of acquired research costs), stock option compensation from acquisitions/divestitures and one-time gains and charges.

That's a swing of US5.8 billion dollars depending on which income figure you want to believe.  So it's pretty important to understand the difference between the two figures.

The biggest item of the difference, by far, is the amortization of goodwill. You may have noticed that most companies with an amortization of goodwill expense will report and focus on earnings prior to that expense. It seems that they don't think that amortization of goodwill is a "real" expense.

This is quite confusing for most investors. I must admit that I was rather confused myself, despite being a Professional Accountant and an amateur stock analyst. So I decided to analyse what this is all about.

First we need to understand what goodwill is. It is an intangible asset that arises whenever one company buys another company at a price which exceeds the book value of the assets acquired.

Consider a manufacturing plant that has assets (after accumulated depreciation) of $2 million dollars and total liabilities of $400,000. The net book value or equity of the plant is therefore $1.6 million. ($2 million minus $400,000). Now suppose the plant consistently earns a profit of $800,000 per year. If another company buys the plant they are not going to be able to buy it for its book value of $1.6 million, which is only 2 times the annual earnings. Instead they might have to pay say 10 times the annual earnings so 10 x $800,000 = $8,000,000. The acquiring company would pay out $8 million in cash and receive only $1.6 million in net book asset value. The company then records an intangible asset called goodwill equal to $8 million less $1.6 million = $6.4 million.

The accounting entry might look like this: (assume the land is leased)

Building          $2.0 million                         (increased building asset)

Goodwill        $6.4 million                         (intangible asset purchased)

            Loan                $0.4 million                 (took over the existing loan)

            Cash                $8.0 million                 (paid out $8 million cash)

 

The intangible asset of $6.4 million represents the fact that the assets, although valued at $1.6 million, can generate $800,000 per year in profit. For a variety of reasons such as having an established customer list and proprietary manufacturing methods, the earnings power of the plant is a lot higher than the physical value of the plant itself. So goodwill is the intangible portion of the value of a purchased business or asset which is in excess of the value of the purchased tangible assets.

Under accounting rules the Goodwill is amortized or expensed over a period of no longer than 40 years. For example if a company buys another company and creates a goodwill asset of $40 million, it will expense $1 million in Amortization of Goodwill expenses each year. The value of Goodwill on the balance sheet will therefore decline by $1 million each year until it reaches zero after 40 years.

As an accountant, that seemed fair to me. The Goodwill was purchased in order to earn income and it seems fair to charge it against earnings over a period of time. Amortization of Goodwill is very much like charging depreciation of a building to expense. 

But wait a minute. Goodwill is not like a building, it does not necessarily deteriorate or wear down. And even if it did become worthless, unlike a building, it does not have to be replaced.

And, that most trustworthy and reliable authority and legendary investor, Warren Buffettt has said "To begin with, we agree with the many managers who argue that goodwill amortization charges are usually spurious.     Economic goodwill does not, in many cases, diminish. Indeed, in a great many cases - perhaps most - it actually grows in value over time." (From his 1999 letter to shareholders section of the Berkshire Hathaway annual report at page 12.) 

So, Warren Buffett seems to agree with Nortel that amortization of goodwill is not a real expense and should be added back to the GAAP net income to get a truer picture of reality.

Being an independent thinker, and an accountant who thinks that GAAP matters, I was not completely convinced. How could the accounting GAAP be so wrong?, What does Warren Buffett know anyway? (well I mean besides how to earn a 24% continuously compounded return over 35 years and become a multi billionaire!). Since, I had the greatest respect for Mr. Buffett I thought I had better ponder this some more.

A simple thought experiment convinced me that Warren Buffett was right (surprise!).

Imagine a company that has just one asset, a plant with a book value of $5 million, which earns $1 million per year in profit and is expected to continue to do so indefinitely.  If an average investor requires a 10% rate of return on such an investment it is worth $1 million/ 0.10 = $10 million, or twice its book value. The company has no debt so the company is worth $10 million.

Now if another company with no assets manages to buy the first company in exchange for $10 million of its shares, it would end up with the plant worth $5 million on its books and also an intangible Goodwill asset of $5million. The new company would also earn $1 million per year from the plant. But, under GAAP the new company has to amortise the goodwill at the rate of at least $5,000,000 / 40 = $125,000 per year. So the net earnings of the second company are $1,000,000 - 125,000 = $875,000 per year. If I accept the accountants figure then I would now calculate the acquiring company to be worth $875,000 / 0.10 = $8.75 million. But that does not make sense, the second company is making the same income as the first company was. The amortization of goodwill is not a real expense in economic terms.

The amortization of goodwill should be added back to reported net income to get the "true" net income. Effectively as an analyst, Warren Buffett and others are saying the accountants are mistaken when they deduct the amortization of goodwill, we need to add it back. For the purposes of valuing a company on the basis of earnings, amortization of goodwill is simply not an expense. In fairness, Accountants have other goals in mind when they deduct this "expense". Accountants are being conservative and they want to write-down the value of the intangible goodwill over a period of years.

But this does not mean that the amount paid for goodwill is irrelevant. If Nortel or any other company buys another company, the amount that they pay for goodwill affects the company in another way. Nortel has purchased billions of dollars in goodwill. When they have borrowed money to finance the purchase this has increased their interest expense and lowered their net income. When they have issued more shares to buy goodwill then this reduces their earnings per share since there are more shares to spread the earnings over.

So, when a company buys goodwill, the more they pay for the goodwill the lower their earnings per share will be, all else being equal. So the company has a strong incentive to pay as little as possible for every acquisition.

But the companies are right when they say that amortization of goodwill is not a real expense. The financing of the goodwill has already reduced their earnings per share. If we deduct amortization of goodwill, we are in some sense double counting the expense of the acquisition.

But what if they really paid too much and the goodwill really is worthless? The goodwill was paid for to get earnings. If the goodwill is worthless then the earnings will not be there. The lack of earnings will lower our calculated valuation of the company. Again, we don't need to deduct more for a write-off of goodwill. That would be double counting.

In summary, amortization of goodwill is not a "real" expense. Nortel is correct to focus on earnings before amortization of goodwill.

But there is one quid-pro-quo to all of this. In calculating book value of a company I believe that goodwill should be assumed to have a value of zero. In most cases a company is valued for its earnings. Its book value is important only as a possible safety margin in the event that earnings dry up. We could sell off the assets. But if the earnings have dried up then presumably this would be evidence that the goodwill was worthless. So we should deduct goodwill in calculating book value.

 Shawn Allen, , CFA, CMA, MBA, P.Eng.

March 11, 2001

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