The accountant's art of dealing with goodwill
2001-04-22
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WOULD you pay a dollar for something which you cannot see, which is next to impossible to value objectively, which you have limited control over, and which may just evaporate before you can say Pacific Century CyberWorks?
Well, CyberWorks paid US$22 billion (S$39.7 billion) for lots of it. And then duly eliminated it from its financial statements so that it appears to be lost without trace.
Before we relate the tale as to what, why and when, let's first set the scene. When Pacific Century Regional Developments (PCRD), the Singapore-listed parent company of the Hongkong-based CyberWorks, released its annual results for the year ended December 2000, it set many precedents and records.
PCRD reported what is reputed to be the largest net loss before tax in Singapore's corporate history -- some S$1.6 billion in FY2000. Horrendous losses at its main subsidiary CyberWorks, which as a parent PCRD has to "consolidate", were largely to blame.
Negative shareholders' funds
To make matters worse a US$22 billion write-off to reserves by CyberWorks -- we'll elaborate on this in a moment -- meant PCRD now has the rather dubious honour of having negative shareholders' funds. With negative shareholders' funds, the company's liabilities (what it owes) exceed its assets (what it owns).
Behind the dreadful financial numbers, there is an accounting tale -- there often is. That tale relates to that something which CyberWorks paid US $22 billion for. Something that you can't actually see. Something which DBS and Singapore Telecom will also have to pay for, and account for, should they be successful in their overseas forays. That something is goodwill.
How to account for goodwill has bugged accountants for years. And it has added complications to the task of arriving at company valuations based on earnings multiples.
How did CyberWorks' accounting for goodwill cause PCRD to report negative shareholders' funds? The main reason for the "black hole" in PCRD's balance sheet is the choice it made regarding the treatment of goodwill. Goodwill is a catch-all term commonly used to describe the collection of intangible assets of a company. Basically, that includes all those assets you can't physically touch, such as reputation, customer loyalty, management expertise. In other words, the very assets that are the primary driver, and source, of a company's future profits in the "knowledge economy". Or so the theory goes.
When CyberWorks bought Cable & Wireless HKT, it paid US$22 billion for goodwill. In other words, it paid US$22 billion more for HKT than its balance sheet said it was worth. Balance sheets tend only to report tangible assets -- telco networks, buildings, vans, cables, and so forth. US $22 billion was thus the "price" paid for intangibles.
What then does a company do with this "purchased goodwill" in its financial statements?
Well, until recently, Singapore companies had a choice. They could "write it off to reserves". Effectively, this means deducting it from shareholders' funds in the balance sheet. This is what we'll call the "balance sheet hit". CyberWorks did just that. Unfortunately, the amount was so large it exceeded CyberWorks' shareholders' funds (sometimes called "equity") and duly tipped CyberWorks, and hence PCRD, into negative equity territory.
The other approach is to capitalise it as a fixed asset, and then amortise it. This mirrors the conventional treatment of tangible assets which are put on the balance sheet and then depreciated.
Proponents of this method note that purchased goodwill is much like purchased tangible assets in being of continuing benefit to the company. A good reputation should deliver higher profits to a company than a bad one. Amortisation, just like depreciation, involves allocating, say, 5 per cent evenly spread over 20 years, of the US$22 billion goodwill figure to each year's profit and loss statement as an expense.
For CyberWorks, this would have translated to a US$1 billion plus expense a year.
But the balance sheet approach is easier to stomach for CyberWorks, as well as many other companies. CyberWorks is already making huge operating losses. Add to these an amortisation expense and not only would losses balloon, it would also put back the day it breaks even by several years. Better to save the profit-and-loss statement from yet more pain by just writing off the goodwill. That way, it disappears almost without trace.
Future profits unaffected
So it's easy to see why CyberWorks, already showing huge operating losses, decided to save the bottom line from more red ink. Essentially, CyberWorks paid US $22 billion for goodwill and then proceeded to eliminate it. That way, its amortisation would not weigh down future profits in the same way interest charges on its burgeoning debts do.
As chance would have it, accountants have moved the goal posts since CyberWorks bought HKT. The Statement of Accounting Standard 22 (Revised) on Business Combinations is now effective. It recommends that from now on, companies should adopt the profit-and-loss approach and take an expense for amortisation to the profit-and-loss statement. This is in line with global practice.
CyberWorks' decision to take a hit on its balance sheet rather than go for the amortisation treatment may seem like re-arranging the deck chairs. But then, if all eyes are on reported profits -- while the balance sheet is largely ignored -- the decision may convince investors to stay on board with the promise of calmer waters just around the headland.
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