Peeling away financial reporting issues one layer at a time

A Sampling of What Lurks at the Bottom of the Goodwill Garbage Heap

I have already reported stumbling upon a fascinating interview of Clarence Sampson, SEC Chief Accountant for more than a decade starting in the mid-1970s. Of his many tales of peculiar interactions with special interests, this one struck me right in one of my biggest pet peeves:

"In the process of recording … [a business combination transaction] … they discovered, by golly, that in a $300,000,000 acquisition, $100,000,000 of assets they thought they had didn't exist. And so the company tromped in with their auditors and said, the rules say the difference between what we got and what we paid is goodwill. I simply wasn't able to accept the fact that there should be $100,000,000 goodwill on their books, which didn't exist, and we told them to write it off."

I have explained in a previous post many months ago why I think the process of measuring goodwill and periodically testing it for impairment is a shameful waste of time and money. I would be hard pressed to think of a better example than Clarence's story to back that up. But, I also want to explain why Clarence's story is more than merely an interesting anomaly.

Goodwill (I despise the term, but will use it here for the sake of clarity and with the understanding that it's meaning as a term of art bears no relation whatsoever to what regular folks think it means) arises from two sources. One source is genuine assets that have been acquired, but for various and sundry good reasons those assets are never separately recognized under GAAP. Even the management that bought those assets probably can't adequately explain to you what those assets actually are in anything but very general and vague terms. Yet, in a business combination, we recognize them all together (and mixing them in with liabilities of a similar ilk as part of the process) as 'goodwill.'

The second source of goodwill are 'mistakes.' In other words, paying a price to acquire a company greater than its value. Although the amounts of money in Clarence's story are extreme, the fact of the matter is that mistakes happen all the time. There are business school academics who spend virtually their entire careers trying to explain why it is so often the case that an acquiror's stock price goes down after they have proudly announced their plans to acquire another company. During my part-time career as litigation consultant, I can recall at least four cases where acquirors have claimed that assets they purportedly purchased either didn't exist, or those assets were worth less than they were represented to be worth by acquirees. In all of those cases I was involved in, how did a mistake get accounted for? Capitalized as goodwill, of course! No Clarence Sampson or auditor suggested they do otherwise.

I suppose that one could justify initial capitalization of mistakes as goodwill, because they are impossible to detect at the time a transaction takes place; if they could have been detected, then the purchase price presumably would have been adjusted. But, don't business combination accounting rules give one a full year to adjust the values of assets acquired and liabilities assumed? Sometimes they do, but the rules don't mention that mistakes aren't supposed to go to goodwill; so that's where they go.

But, won't impairment testing eventually catch the mistakes and chase them out of goodwill? Not usually. If it ever should happen that a mistake pops out as an impairment charge, it's usually years after the mistake has become known to management. The goodwill impairment tests allow companies to aggregate subsidiaries into 'reporting units,' which are usually large enough to allow any mistakes to be offset by goodwill from other acquisitions that have accumulated a successful enough track record over time to protect their own goodwill, plus the goodwill generated by any recent mistakes.

At least the big mistakes will get caught by the Chief Accountant, right? Ironically, I doubt whether the current chief accountant or his predecessor would have the gumption Clarence did to stand up to a registrant and its auditor like that. Unlike Clarence, who spent decades coming up through the ranks of the SEC, these guys spent their distinguished careers chest bumping their fellow Big Four partners. When an erstwhile comrade-in-arms "tromps" into the SEC as his client's Doberman Pincer, will he be welcomed with the secret Big Four handshake? But to be fair, today's SEC staff may not have the technical ammunition Clarence did; the FASB's sausage factory has created a new line of business combinations rules; their literal application has come to be the generally accepted method for leveling the M&A playing field…

… as opposed to Clarence Sampson's application of common sense principles:

"And that's the kind of thing that the Commission can say – look that's just too far; you can't look at the written words and try to apply them to a situation where it just doesn't make sense. And as a matter of fact there's some language, and I'll bet you can tell me where it is, which says if it doesn't make sense, you can't do it."

Those "written words" (principles-based rules?) Clarence couldn't specifically recall are still in the cupboard (see Exchange Act Rule 12b-20, and AICPA Ethics Rule 203-1), but they haven't been taken off the shelf in a real long time.

Anyway, I hope you enjoyed Clarence's story as much as I did.


  1. Reply Raza September 8, 2009

    Hi Tom, what an excellent post, and in deed thanks for sharing with us the stature of Clarence Sampson. It appreas though we still could not get away from the remnants of “merchant-based accounting.” GW at best results from when you don’t know what you are doing, and then is treated subsequently on ad hoc basis from year to year as though you know what you are doing. I think this is what you (eloquently) alluded to when you said it arises out of mistakes : )I really don’t know whether we (I mean standard setters) are trying to base principles on rules or rules on rules [assuming there is no such thing as rules on principles, albeit one may debate on this notion as well]- it is clear that prevalent system of accounting is a system of superimposition of tactic that might give the pretense of when you think you do know what you are doing 🙂 I could not agree with you more on this, Tom.

  2. Reply Independent Accountant September 9, 2009

    I’ve got a post at my website you will barely believe. But it’s true. The issue: what is the cost of an acquisition. I’ll get you the post.

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