Amazon took on $9 billion in goodwill when it acquired Whole Foods in 2017. Photo by Mike Mozart.
My elder daughter used to like it when I helped her drive to and from college between academic years. The route from New York to Georgia afforded us plenty of time to exchange fatherly advice and daughterly declarations of independence.
“Dad,” my 19-year-old said to me as we cruised toward her sophomore year, “I promise to tell you if anything is seriously wrong. Otherwise just assume everything is OK.”
As a parent, you have to accept that at a certain point you are no longer in charge of everything, with a corresponding right to unlimited information. But as a business owner, you should not have to accept any such thing.
The Wall Street Journal reported earlier this week on a similar assume-everything-is-OK argument. But this one does not come from an adult (or nearly adult) child. It comes from the hired help.
This is the argument that corporate managers and their consultants are making to shareholders. At issue is the concept of “goodwill.” Goodwill is the asset that is recognized for accounting purposes when one company acquires another company, and the acquirer pays more than the amount that the target company’s identifiable assets indicate that it is worth.
The theory is that everyone behaves rationally in such a transaction. Managers will not pay more than the target will really be worth once they get their eager little paws on it, right? So even if the company is worth $10 in the hands of its current owners, if someone is willing to pay $15 for it, then it must be worth $15 in the hands of the new owners. If the target’s assets are worth only $10 when the acquisition closes, then the acquirer attributes $10 of the purchase price to the target’s assets. The remaining $5 becomes an asset called “goodwill.”
Anyone who believes human beings always behave rationally has never raised a teenager.
Under current accounting rules, set by the Financial Accounting Standards Board, the managers who run publicly traded companies must “test” the value of this goodwill every year. Maybe, at the time of the acquisition, they expected to create cost savings or gain market share in ways that justified paying a goodwill premium. Fair enough. But suppose, after one, or two, or five years, it turns out that those benefits have not actually been realized, and that the prospect of achieving those benefits in the future is reduced or nonexistent. Under today’s rules, the company must reduce the associated goodwill value on its books, potentially all the way to zero. This is shown as a reduction in earnings. Then, of course, managers have to explain to shareholders why things are not as peachy keen as everyone expected.
Managers don’t like to do this. In fact, I had more confidence in my college-sophomore daughter to actually tell me, promptly, when something was wrong. She earned my trust with a track record, such as calling me if she got into a fender bender. Not all corporate managers have such a sterling track record of being forthcoming with bad news, at least not until they have no other choice.
The current rules don’t allow them much of a choice. The old rules, to which the managers are advocating a return, did: Managers could simply reduce goodwill gradually over a 40-year period, with no explanation to owners necessary beyond a simple “that’s what the rules tell us to do.” Of course, when things went disastrously wrong, they sometimes had to write off greater amounts of goodwill sooner. In those cases, they had to fess up. But managers retained considerable control over whether and when to do that. Outside auditors who are supposed to be a check on such manager discretion ... well, they don’t have as good a record as my teenage daughter did, either.
Deciding the degree to which goodwill is impaired on a year-by-year basis is, as managers argue, a subjective judgment. Making such judgments is what they are paid to do. And trying to create a quantitative basis for such judgment by applying mathematical tests and market research costs money. If owners thought the benefits were not worth the cost, it would be shareholders and investment managers arguing for a change – not their hired hands.
Some accounting rules really are so subjective, or provide information of such questionable or transitory value, that I believe they are more trouble than they are worth. Other types of “mark-to-market” rules frequently fall into this category, in my opinion. But I have no quarrel with imposing a discipline of annual goodwill reviews on managers of companies whose shares are sold to absentee owners. I’d call it truth in labeling.
As for my daughter, I trusted her then and I trust her now. If she were running a public company, I have no doubt she would be forthcoming if everything turned out not to be OK. But that sort of trust has to be earned, which is why we have rules to govern company managers in the first place.