Bob, Here is a general article about goodwill writedowns. I don't know that this has already been posted here (apologies if it has), but it makes for an interesting read.
From briefing:
Hunting Goodwill
02-Aug-01 00:10 ET
Massive goodwill writedowns by companies such as JDS Uniphase (JDSU), Nortel (NT), and Verisign (VRSN) have brought a relatively arcane accounting issue to the fore. And with recent accounting changes announced by the FASB (Financial Accounting Standards Board), investors had best come to grips with the ins and outs of goodwill, because these writedowns could be commonplace in the future.
We'll approach the thorny goodwill issue in four parts: what goodwill is, the old accounting rules pertaining to goodwill and business combinations, and the new accounting rules, and the implications of the new rules.
Definition
The definition of goodwill can be attacked from multiple angles, none of which will prove to be completely satisfactory, but perhaps a combination of two will paint a clearer picture of this opaque concept.
An intangible asset that is made up of the favor or prestige which a business has acquired beyond the mere value of what it sells, due to such things as the personality or experience of its employees, their reputation for skill or dependability, the business's location, or any other circumstance incidental to the business that tends to draw and retain customers. (Merriam Webster)
The excess of the purchase price of a business above the value assigned for tax purposes to its other net assets
Tangible assets are such things as cash, factories, equipment, etc. Intangible assets can include intellectual property (patents) and goodwill. Goodwill is that chunk of intangible assets that represents some of the incalculables noted above: reputation, location, experience. Essentially, goodwill is the difference between the value or purchase price of a company and the sum of all its assets.
The Old Rules
Goodwill becomes a particularly tricky issue when it comes to accounting for mergers and acquisitions. In the past, there have been two types of acquisitions: a pooling of interests, and a purchase. Under pooling of interest rules, companies could simply add together the old book values of their net assets, in effect acting as if they had always been one company. Put another way, in a pooling transaction, the acquirer could list the acquiree's assets at their original cost rather than the purchase price.
Under purchase rules, the excess of the purchase price over the current market value of the acquiree's assets was counted as goodwill, and goodwill was then amortized over a period of no more than 40 years.
While there was no difference in future cash flow under the two options, pooling offered a significant advantage in terms of reported earnings as there was no goodwill amortization that counted against GAAP (generally accepted accounting principles) earnings. Many companies therefore jumped through hoops to make "pooling" rather than "purchase" acquisitions.
Some companies could not meet the pooling rules: foreign companies (JDSU and NT were prime examples) were not eligible for pooling, and others couldn't meet the numerous criteria, which ranged from requirements that the deal be all-stock or that the ownership and assets of the target company could not be modified in anticipation of the merger.
Though pooling did not require goodwill amortization, acquisitions made in this manner were often accompanied with one-time charges nonetheless. Most frequently written off was in process research and development. Furthermore, companies forced to go the purchase route would typically report pro-forma earnings that excluded the goodwill amortization of acquired companies.
The New Rules
As of June 30, pooling acquisitions are no longer an option. Only purchase accounting is accepted in business combinations. So you might expect potential acquirers to be moaning that their favored pooling trick is gone. Wrong. Another change implemented by FASB is that acquired goodwill will be tested at least annually for impairment, but will not be treated as a wasting asset and will thus not be subject to any arbitrary amortization schedule.
Bottom line: companies will not miss the pooling of interest option, because reported earnings will no longer be reduced due to the goodwill amortization that was required under previous purchase rules.
Without getting into a prolonged debate on the merits of this change, the quick explanation is this: an arbitrary 40-year period for goodwill amortization made little sense. Testing goodwill annually for impairment is more consistent with business realities, as goodwill from some acquisitions lasts well beyond 40 years, while goodwill in other cases doesn't even last 40 days.
The Implications
For companies that had been acquisitive in the past using pooling rules, the changes are not dramatic. Because past acquisitions carried the acquiree's goodwill at historic rather than market levels, the risks of impairment are quite small. Serial poolers such as Cisco (CSCO) are therefore unlikely to have massive goodwill writeoffs similar to JDSU and NT.
Future acquisitions, such as Cisco's purchase last week of privately held Allegro Systems, will now have to be accounted for under purchase rules, but goodwill will not have to be amortized. As a result, reported earnings will generally not be affected, aside from R&D writeoffs which will undoubtedly be claimed as one-time charges and excluded from pro forma numbers (Cisco has these "one-time" charges repeatedly, so it calls into question how one-time they really are, but that's another story).
We say reported earnings will "generally" not be affected because goodwill will not be amortized, which would have ensured an earnings impact. But there is still a risk to future earnings, as the annual review of goodwill will sometimes result in impairment. Enter JDSU, NT, and VRSN. In each of these cases, huge acquisitions in recent years were made under purchase accounting rules, and therefore a massive amount of goodwill was added to the balance sheet.
As business prospects for these acquisition targets deteriorated, the companies could no longer justify the goodwill associated with these acquisitions. In other words, goodwill had been impaired. New accounting rules require goodwill to be assessed at least annually, and the three aforementioned companies chose to bite the bullet quickly given that there was little doubt that the value of acquisitions such as SDL, Qtera, and Network Solutions had plunged.
The result: huge goodwill writedowns that reduced reported earnings. The magnitude of the writedowns was certainly eye-popping: nearly $45 bln for JDSU, $12.3 bln for NT, and $9.9 bln for VRSN.
We received many questions concerning these writedowns: most notably, what do they mean, and why haven't the stocks reacted more negatively to them. The fact is that they don't mean much, for two reasons, 1) they are old news, and 2) they have no bearing on future cash flow, which is the key to valuation.
Point number 1 answers the question of why stocks such as VRSN rallied even after a $9.9 bln writedown. These writedowns reflect declining market valuations for tech companies -- anyone who has paid any attention to the Nasdaq over the past year knows something about declining valuations. And all of these companies that are taking big writedowns have suffered severely as a result. Making the writedowns official is just an acknowledgement of what has already occurred in the market.
Point number 2 is really all that matters. The value of a company is determined by the discounted value of its future cash flow. Since goodwill is only a balance sheet entry that has no impact on cash flow, goodwill writedowns should not affect a company's valuation.
Bottom line: pooling of interest is gone, goodwill amortization is gone, and goodwill writedowns will become more common. Impact on M&A activity and future cash flow? None. |
