Accounting for goodwill impairments: An ROA approach

The Financial Accounting Standards Board has a project to review accounting for goodwill subsequent to its acquisition — again. The issue is whether to continue goodwill impairment testing as required by Statement of Financial Accounting Standards 142 (2001) or to return to goodwill amortization as mandated by Accounting Principles Board No. 17 (1970). Either way, the board will consider and, most likely, alter the details of implementation in either of those standards.

There appears to be a need for a more objective measurement or gauge by which to assess the carrying value of goodwill on the balance sheet than the treatment currently mandated by FASB. In terms of FASB’s Conceptual Framework, accounting information that is useful to decision-makers, e.g., investors and creditors, ought to have specific qualitative characteristics. One such characteristic is neutrality, i.e., unbiased information. Goodwill impairment charges are invariably based on management’s assessment of impairment, which is derived from their projections of future cash flows that underpin the validity of the carrying value of the goodwill asset on the balance sheet. The lack of neutrality is apparent.

The information should also be verifiable. Apart from the auditors verifying the related charges and carrying values, it is difficult for investors to judge the reliability of the numbers, especially as these numbers are divined by management’s estimates of future cash flows. This brings us to another characteristic in the framework — representational faithfulness. If goodwill is in fact impaired but not so according to management’s assessment, the carrying value of goodwill on the balance sheet is not a faithful representation of facts. Indeed, FASB’s conceptual underpinnings of accounting for goodwill subsequent to acquisition do not seem to accord to economic facts, thus obviating representational faithfulness.

Accounting information should also be comparable, not only on a year-over-year basis but also compared to other companies in the same industry. The cash flow models used by one set of executives to determine goodwill impairment may not be comparable to the models used by others.

FASB also considers the costliness of an accounting method. In this case, managers have asked the board for help in this area because fair value measurements are burdensome to implement.

One could make a strong case that under current FASB rules, goodwill impairment never occurs on a timely basis, another qualitative characteristic. Goodwill impairments invariably appear after a significant sell-off in the market. In other words, the charges come in reaction to a market event that undermines management’s rosy assessment of future cash flows. The charges often coincide with other non-related events. For example, a company might sell a business on which it booked a sizable gain that could distort past and future comparatives. Writing off goodwill in the same quarter in which the gain was booked could have a levelling effect on earnings. In some cases, a loss on the sale of a business could also give rise to an unrelated impairment charge, based on, “Let’s throw the kitchen sink into this quarter, and then we spare future quarters the burden of goodwill charges.”

We propose a model for the measurement of goodwill impairment that meets the qualitative characteristics of useful accounting information as per FASB’s Conceptual Framework. It is a relevant, objective, unbiased, verifiable, inexpensive to implement, representationally faithful, and comparable gauge that results in timely charges. This method involves comparing the firm’s return on assets with those of industry or peer group companies.

The ROA approach has another significant benefit: Analysts can employ it to predict when an enterprise should write down goodwill. We have used this approach in our consulting practices and in our recommendations for investment portfolios. It helps to be ahead of the curve.

The rationale for a ROA model

Goodwill measures the premium an enterprise pays to acquire a target firm in excess of that company’s fair value of its net assets. But why would a rational firm pay a premium? The traditional and still relevant answer rests in the presumed increase in earnings power.

In 1927 J. M. Yang wrote that goodwill arose because of “factors and conditions which contribute to or accompany unusual earning capacity.” In 1953 George Walker argued in a Journal of Accountancy article, “Goodwill has no accounting significance except in terms of an earning capacity which is estimated to be above normal.” Catlett and Olson, in the 1968 AICPA Research Study No. 10 “Accounting for Goodwill,” based their monograph on this supernormal earnings concept. They wrote, “Goodwill thereby becomes associated with the variety of interrelated intangible attributes which in the aggregate derive value from an evaluation of future earning potentialities of the business enterprise.”

Textbook authors concur with these notions. For example, Brigham and Houston consider the rationale for mergers in their 1998 “Fundamentals of Financial Management.” The primary motivation, they argue, is synergy which arises from operating economies that produce economies of scale, financial economies that reduce transaction costs, differential efficiency so that the resultant combination can produce their products at lower costs, and increased market power that increases sales. Note that all of these factors either increase revenues or decrease costs so that there is increased earning power. In her 2018 “Advanced Accounting,” Hamlen offers the following items as motivations for mergers and acquisitions: to control supply, to expand production, to grow sales and earnings, to reduce costs by eliminating duplicative activities, and to reduce competition. The result of these activities is either increased revenues or lower costs, so that they all lead to greater earnings.

This focus on supernormal earnings is further seen in explications where a business combination is justified with a net present analysis. The usual method for doing this is to forecast the future cash flows generated by the transaction and then compute their present values. The decision rule is to proceed with the merger or acquisition only if the present value of the future cash flows exceeds the cost of the business combination. These cash flows translate into greater earnings so that the enterprise would recognize future earnings and therefore higher rates of return whenever the business combination materializes the forecasted synergies. An alternative, but equivalent, technique is to compute the internal rate of return of the proposed transaction. The decision rule is to accept the proposed merger if the internal rate of return is greater than the cost of capital. If this occurs, the firm should expect excess returns.

Since business combinations are motivated by presumed excess earnings that give rise to excess returns, it seems only natural to test the value of goodwill with these same concepts. Goodwill is not impaired if excess earnings are actualized, but is impaired if they do not materialize. In other words, does the merger pan out as predicted by managers? Do the excess earnings and excess returns actually occur?

Given this conceptual basis for goodwill, we focus on the earnings of the combined entity in order to evaluate whether goodwill is impaired. In particular, we focus on return on assets. If the return is high enough to provide evidence of synergy, then goodwill is not impaired; otherwise, we argue that total assets are overstated. We adjust the assets downward, specifically the goodwill account, until the total assets rationalize the rate of return. Any such adjustment is the impairment charge that should be recognized. The major advantage of this approach to measurement of goodwill impairment is that it ties with the conceptual underpinnings of goodwill as recognized over many decades.

Illustration of the ROA approach

We shall illustrate this ROA approach with AT&T. We do caution that this is an exercise solely for the purpose of explaining our thoughts about how to approach goodwill impairment and does not constitute a full and rigorous financial statement analysis or evaluation of AT&T.

AT&T’s 2019 10-K displays a goodwill balance of $146,241 million. Is any of this goodwill impaired? We proceed to analyze AT&T’s numbers to assess whether it does indeed have ex post excess returns that justify its ex ante decisions to acquire a variety of businesses and thereby substantiate the goodwill balance.

Exhibit 1 below displays AT&T’s ROA for several metrics over a five-year period 2015-2019. The denominator is average total assets or the beginning total assets plus ending total assets divided by two. Several possibilities exist for the numerator and we performed the calculations with operating income and net income. (We also examined income before taxes with similar results.)

To eliminate the impact of extraneous items and any unusual shocks in one particular year, all calculations will be based on a three-year moving average and a five-year moving average. We also use moving averages for the total assets figure. Our initial observation is that AT&T’s returns do not look supernormal to us.

EXHIBIT 1
Return on assets for AT&T

To better assess AT&T’s returns, one should employ a reference group. This group could be some industry average or use the company’s peer group as listed in its proxy statement. For this exercise, we have identified as AT&T’s peer group: Comcast, Discovery, Sprint, Verizon, and Walt Disney. Exhibit 2 presents their ROA over the period 2015-2019. Casual observation of this exhibit reveals that Comcast, Discovery, Verizon, and Walt Disney generally seem to have higher ROAs than AT&T, but Sprint generally has lower ROAs.

EXHIBIT 2
Return on assets for peer group of AT&T

We then obtain the average ROAs for this peer group and these ratios are given in Exhibit 3. These means are computed for each year of the five-year period 2015-2019. We continue to present the ROAs for operating income and net income averaged over either a three- or five-year period. Notice that every metric is higher for AT&T’s peer group. The unmistakable conclusion is that AT&T’s goodwill is impaired because the supernormal earnings and the supernormal returns have not emerged. As most of the goodwill arises from the 2018 acquisitions of Time Warner, AppNexus, and Otter Media, we further conclude that AT&T paid too much for them. The investments in these entities have not generated supernormal earnings.

EXHIBIT 3
Mean return on assets for peer group of AT&T

How much is the impairment? Our analysis is seen in Exhibit 4. We take the earnings numbers of AT&T for 2019 and the peer group’s ROA for 2019. We then work backwards to determine what total assets should be in order to rationalize these returns (i.e., adjusted total assets equals the earnings divided by the peer ROA). The amount of the impairment is the average total assets minus the adjusted total returns. In three cases, the computed impairment is greater than the balance in goodwill, so the impairment is $146 billion, the whole amount. In one case, the indicated impairment is $134 billion.

Implementation issues

The example in the previous section illustrates the general approach that we suggest FASB mandate to account for goodwill impairment.

Various considerations must be examined before it is actually adopted. For example, which earnings number should one employ? Over what period of time should the numbers be averaged? Who constitutes the peer group?

One might expect a huge loss in the year of adoption. FASB should therefore consider how to transition into this method. The method might produce big losses in later years as well, and FASB might contemplate capping these losses, as it did with pension accounting and the corridor method.

FASB might also consider timing issues. For example, AT&T acquired Time Warner, AppNexus, and Otter Media in 2018. Maybe the company needs more time in which to generate those excess profits, recognizing that the entity must integrate those subsidiaries into its culture.

Furthermore, we recognize that many uncertainties are reflected in the goodwill number, changes that could transpire into events that could massively boost earnings, or cause earnings to crater. Nothing illustrates this better than the impact COVID-19 had on companies in the airline and hospitality sector. On the other hand, companies like Zoom, Amazon and Netflix appear to have benefited from the lockdown enforced by the virus. In light of this, it would be acceptable to, say, impose a goodwill impairment charge that for each year would be equal to (say) only one-fifth of the lowest suggested impairment as reflected in Exhibit 4. Using AT&T as an example, the charge in 2020 would have to be one-fifth of $134 billion, namely, $26.9 billion.

EXHIBIT 4
Analysis of AT&T goodwill in 2019 (in $ millions except ROA)

3-year moving average total assets is $484,569. 5-year moving average total assets is $440,941.
The 2019 balance of goodwill is $146,241.

There is a side benefit of tightening the rules on goodwill impairment. It could enforce additional discipline on executives as they contemplate acquisitions. If, in the wake of an acquisition, a company’s ROA declines, the presumption is that management overpaid. Any increases in revenues and net income flowing from an acquisition ought only to be justified if the net income is sufficient to raise a company’s ROA. If not, management’s expectations of generating super-profits were misplaced, and this implies goodwill impairment. Under the current rules, this consideration receives no attention. However, rules by which to judge the efficacy of an acquisition as it relates to post-acquisition ROA could serve investors well.

Summary and conclusion

When analyzing the balance sheets and earnings of corporations, we propose that decision-makers could arrive at an objective assessment of the potential impairment of goodwill on the balance with reference to the corporation’s return on assets — the implication being that if a company’s ROA falls below that of its peer group, the goodwill is impaired. If an acquisition fails to raise ROA, then the presumption is that management overpaid for the underlying assets.

Even if FASB would not adopt this approach, we think it quite useful for accountants working with fair value measurements or working with investment analysis. It gives a rational explanation of what the future may hold.