The Reflexivity Of Goodwill

The question of how to treat Goodwill has confounded accountants and investors alike. Clearly, Goodwill has some value in most cases, but exactly how much it's worth is not known, and therefore how much of it should be reflected on the balance sheet is a difficult question to answer. A few years ago, a substantial change was made by the two global accounting authorities on how Goodwill is to be treated. As a result, changes in market prices can actually cause Goodwill writedowns, which can lower earnings and potentially cause further Goodwill writedowns as a result! Investors should be aware of this potential for a virtuous cycle of declining earnings and declining stock prices.

Once a year, companies are required to test Goodwill for impairment by comparing a reporting unit's fair value (for public companies, this is generally taken to be the market value) with its carrying value (book value). So if that market value drops considerably, market value may fall below book value, triggering a potential writedown.

As such, you are likely to see a number of companies write down their Goodwill when the market turns south. Individual companies that see their share prices hammered are also likely to have to write down their Goodwill accounts. For example, SuperValu has seen massive share price declines in recent years, which have led to massive Goodwill writedowns, which in turn may have led to further share price declines, which would have led to more Goodwill writedowns in a virtuous cycle.

Of course, in an efficient market, shareholders wouldn't react to Goodwill writedowns, recognizing that they do not affect cash flow and are only occurring because of previous share price reductions. But we know that in real life, shareholders do focus on earnings, which is why, for example, managers fought so hard to keep stock options from being recognized as expenses for the purposes of EPS. Indeed, sticking with the SuperValu example, consider this article on the company following its third quarter release, which focused on SuperValu's losses without even mentioning the $450 million writedown that was the cause of the losses! (The article instead blames high food costs, a cautious consumer, and turnaround costs for the losses!)

About the author:

Barel Karsan

Charlie Tian, Ph.D. - Founder of GuruFocus. You can now order his book Invest Like a Guru on Amazon.