This year, Corporate America will slash at least $500 billion in shareholder equity from its collective balance sheet--and that has nothing to do with cooked books. What's going on is a massive readjustment in how companies account for an asset called goodwill.
Goodwill arises when one company buys another for more than the latter's assets are worth. For example, if you pay $1,000 for a business and its net assets, including plants and intangibles such as brand names, are valued at $500, you have paid $500 for goodwill. Why pay a premium? Management believes the target and acquirer can earn more together than separately.
Up until now, generally accepted accounting principles (GAAP) have required companies to write down--or amortize--their goodwill by deducting a portion of it from net income every year for up to 40 years. These annual write-downs take no cash from the company, but they do deflate reported earnings.
Now, though, the accounting rules governing goodwill have changed. Companies can--indeed, must--skip the annual goodwill write-downs. But there's a hitch: Goodwill must be evaluated every year and written down when it is deemed to be worth less than the company paid for it. Starting this year, companies on calendar fiscal years have until Dec. 31 to take a hard look at their accumulated goodwill and determine what--if anything--needs to be written off.
Goodwill write-offs are an acknowledgment of what many people already know by looking at today's depressed stock prices: that many 1990s megamergers haven't lived up to expectations and so aren't worth the prices the acquirers paid. Some companies, including AOL Time Warner (AOL), Boeing (BA), and Qwest Communications International (Q), already have taken big hits. But only an estimated 20% of the companies likely to take goodwill write-offs have announced them so far, says Robert Willens, accounting analyst at Lehman Brothers.
Because many more write-downs are coming--both this year and in the future--it's a good idea to familiarize yourself with the accounting for goodwill. Indeed, even though goodwill write-downs are widely anticipated this year, they still can clip a stock. Look at AOL Time Warner, Boeing, and Qwest. Someone who bailed out as late as the day before they announced their goodwill write-downs would have avoided an average decline of 5.8% in the following week.
How can you tell if a company's goodwill is damaged and heading for a write-down? The Financial Accounting Standards Board, accounting's rulemaking body, requires companies to implement a two-step test. But to replicate it, you need information that is not publicly disclosed, such as the current value of each of the company's business units. Still, there's a shortcut--devised by accounting experts at Bear Stearns--that you can use to get an indication of whether a write-down is likely. All you need is a company's balance sheet and its market capitalization--the share price times the number of shares outstanding.
To see how it works, look at Solectron (SLR), a Milpitas (Calif.) service provider to electronics manufacturers (table). Start by calculating the company's market value: On Sept. 3, it was $2.932 billion. Since that's below the $7.4 billion of shareholder equity shown on the most recent balance sheet, for the quarter ended May 31, Solectron is a candidate for a write-off to bring its books more in line with its current value.
Before concluding that a write-off is likely, you need to go through another step. Go back to the balance sheet. Add the assets, except for goodwill, and subtract the liabilities, to determine what the company would receive if forced to liquidate today. Compare that figure--$2.9 billion in Solectron's case--to the company's market value of $2.9 billion. The difference--zero--is what the market believes Solectron is worth, above and beyond the sum of its parts. In other words, the market attaches no value to Solectron's goodwill.
Glancing at Solectron's balance sheet, though, you can see that the company paid $4.5 billion for goodwill. By this rough calculation, the company would need to write off that entire amount to adjust its books to reflect the estimated value of goodwill today. This method shows that AOL Time Warner is also a candidate for further write-offs. Both AOL Time Warner and Solectron declined to comment.
The change in goodwill accounting also distorts year-over-year earnings comparisons in 2002 and 2003. To get a fair comparison between the current and previous years' bottom lines, bypass the income statement and turn to the footnotes, says Janet Pegg, accounting analyst at Bear Stearns.
To see why this is necessary, consider AT&T (T). Its income statement for the quarter ended on June 30 shows that it lost $12.8 billion, or more than five times its $2.27 billion loss in the same period of 2001. But now flip to the footnotes. There you'll find that once AT&T's 2001 results are recalculated using the new accounting, its 2001 loss turns into a $317 million profit. The upshot: Over the past year, AT&T's bottom line has deteriorated more sharply than the income statement reveals.
To put 2001 and 2002 results on an equal footing, AT&T's footnote adds back the amount of goodwill it deducted from net income in 2001--2002's results already exclude goodwill. Like goodwill, other intangible assets are no longer subject to amortization. As a result, AT&T also adds back its 2001 deduction for franchise costs.
The goodwill footnotes also can help you guard against accounting games. Watch for acquirers whose footnotes reveal sharp increases in goodwill relative to other intangibles that must still be written off in annual installments. Although the company may not be doing anything wrong, it could be minimizing the assets subject to amortization to make earnings seem better than they really are, says Charles Mulford, accounting professor at Georgia Institute of Technology.
With the stock market in turmoil, the last thing you need is for one of your holdings to be hit with an unexpected write-down. But luckily, when it comes to goodwill, a little number-crunching can go a long way toward protecting your portfolio from unpleasant surprises. By Anne Tergesen