Talk

Accounting charges and goodwill

Recently companies have been writing down their goodwill in lump some amounts shocking the world with the losses they've accumulated. AOL recently reported the greatest lost in the history of business at $54 billion. The company broke even on a cash flow basis but was forced to write down the good will acquired (via the TimeWarner-AOL deal) in one quarter.

Geoffrey Colvin in his article explains how the new accounting rule has required that goodwill no longer be amortized over 40 years (as was previously the case) but be evaluated and written down each quarter.

An excerpt:

The rule change is simple in concept. When a company buys another company, the price it pays in excess of the target company's book value is deemed goodwill. Under the old rule, it had to be amortized over a period of up to 40 years; that is, every year a little bit of it had to be deducted from the company's profits and also from the "goodwill" asset on its balance sheet. But this rule assumed unjustifiably that goodwill is a so-called wasting asset, like a machine that inevitably wears out. In reality it may not lose value at all, and sometimes it even gains value.

So the new rule requires companies to evaluate their operating units at least annually and ask if their fair value to an outside buyer today is greater than their recorded value, including goodwill. If so, all is well. But if not, the company must take a charge for the difference, all at once. The companies that have taken the hugest charges all made major acquisitions near the height of the stock market insanity. The charges are in effect their confession of being terrible investors.

The positive side of this write down is that we no longer have to suspiciously watch the assets of a company as they carry a ton of good will. The Return on Capital calculations also work out favorably for companies.