Goodwill is a Metric of the Failure of the Accounting Model

At least once a week, I see articles or blog posts bemoaning goodwill. One of the latest was an article in Business Week entitled Magic Tricks on the Corporate Books. This article is typical in its interpretation that goodwill represents funny money. It is often also assumed that management teams are playing games with goodwill. While this may sometimes be the case, goodwill usually represents actual, identifiable value. The problem is that no one really knows when and where this value exists. The accountants could produce data but they don’t.

Most of the time, goodwill is created when one company acquires another. When that happens, the purchase price has to be allocated to the balance sheet of the acquiring company. But the problem is that most companies are worth a lot more that the value of the hard assets on their balance sheet. So the “excess” value goes to goodwill as a plug number.

Ernst & Young recently published a study of mergers and acquisitions in 2007. It showed that 47% of the average purchase was booked to goodwill and 23% was booked to identifiable intangibles such as customer lists. That means that 70% of the average purchase price was intangible.

Mergers are not out of the ordinary. This issue exists across the entire economy. It’s visible in stock market data such as this white paper from Ocean Tomo that shows a widening gap between corporate value and fixed assets (ranging from 60-80% of total value).

The reason that companies are worth more than their book value is that in the knowledge economy, intangible capital is the dominant source of competitive advantage and earnings. Intangible capital includes the knowledge of your human, relationship and structural knowledge capital. The latter includes all the knowledge that stays in your organization when your people go home at night such as business processes, training materials, shared knowledge and intellectual property. We call the unique combination of a company’s intangible capital the knowledge factory.

Intangible capital didn’t just appear magically. Over the past several decades, companies have spent an increasing amount of money to build their knowledge factories. A recent estimate for 2007 on a macro level was that U.S. businesses invested $1.6 trillion in intangibles versus $1.2 trillion on tangibles (it’s in the middle of this article on the GDP). That puts intangible investments at 59% of total annual investments.

Are you getting the picture? The goodwill number makes it look like the purchase is all fluff. Yet the spending number tells us that companies are spending money to create that value. And the stock market data tells us that investors see earning coming from the companies to justify the value of the company.

So here’s my modest proposal: start tracking how much is invested every year in intangibles. We call this intangible capital expenditure. It will be experimental at first. Figuring out how long to leave an investment on the cumulative list will take some time (although I think it will not be as hard as people think). The knowledge economy is not going away. So we have to start learning about how this kind of investment works.

This kind of list could help:

• Management teams make better decisions
• Investors understand where the value is in your company
• Accountants better assign the value in a merger to specific assets rather than goodwill

I do not advocate changing GAAP (or IFRS which has the same problem). It’s too early for that. But it’s not too early to get busy identifying the source of 50%+ of the average company’s valuation.