Sorting Out the Recent Changes

In 'Goodwill' Accounting Rules

AOL Time Warner is everywhere. Whether you hold it in your 401(k) or you're a huge Madonna fan, the company has infiltrated our lives.

That's why everyone was floored when the company announced it might get smacked with a write-off of as much as $60 billion this year. What's going on here? Hint: It is not the result of punitive damages from the Gerald Levin-Ted Turner boardroom brawls.

The charge is from the impairment of goodwill. The Financial Accounting Standards Board created an "impairment" test that must be applied annually to see if a company's acquisition is still worth its purchase price.

And AOL Time Warner is not alone. Any company that has been involved in M&A activity will have to apply this test to its acquisitions. If the acquisition is not worth the purchase price -- and what is these days -- the company will have an impairment charge. So be prepared to hear about these charges regularly.

But don't panic. In order to understand how this new accounting treatment might impact your investments, you'll need to think like an analyst. Let's walk through the logistics.

Accounting 101

These days, when two companies merge, the buyer goes out and appraises the fair market value of the target company. Let's assume the buyer likes the target and is willing to pay a higher price. That's great. But this makes the accountants jump to attention. They need to keep track of that premium. When the numbers from this acquisition are reported, the fair market value of the company and the premium will be reported (as two separate numbers) separately in the asset section of the balance sheet. That premium is dubbed "goodwill," in accounting-speak and the method of reporting the (purchase) appraised price and goodwill separately is called the "purchase method" of accounting.

So now the buyer has a big asset called goodwill on his books. Why doesn't everyone pay more? Because nothing good lasts forever, not even goodwill. Before this new accounting rule, goodwill was amortized -- or gradually eliminated -- over 20 years. That meant each year, a piece of that goodwill balance was recorded as an expense. Remember, expenses eat into revenues and reduce earnings.

But the new rule, approved back in July 2001, changed all this. Now, companies, beginning with firms whose fiscal years end this December, don't have to expense a piece of goodwill each year. Instead, they must use this new "impairment" test on each of their purchases to see if the acquisition is still worth what they paid for it.

How do they do that? Say Byrnes Industries reported $20 million as goodwill after the acquisition of Tracy & Co. If the new division is still prospering a year later, then the goodwill amount needn't be adjusted, because that extra $20 million was obviously well spent. In this case, they will have a fat asset on their books, at least until they apply the test again the following year.

But if the acquired division is in the toilet, Byrnes Industries can't continue to say it has a $20 million benefit. So the goodwill balance needs to be lowered to, say, $5 million. Byrnes Industries then will take a $15 million hit for buying a loser company.

The $15 million isn't a "cash charge," notes Robert Willens, a tax and accounting analyst with Lehman Brothers. The accounting treatment has nothing to do with how much cash comes in through sales and investments and how much goes out from expenses, a.k.a. the company's fiscal health. So it has no bearing on whether the company is producing a product that people want to buy. It's just the result of an accounting change. It does not necessarily foretell impending doom.

On the plus side, if companies follow the rules and test for impairment by the end of the second quarter, any charge will show up on the financial statements as a "change in accounting policy." That's a below-the-line charge. That means first operating income is computed, then this charge is subtracted. And operating income is the number that tells you how the company's day-to-day business is doing. That's what you should care about.

If they don't test until later in the year, the charge will be reported as income from continuing operations. That shows up "above-the-line" so it will appear that there's a problem with the business.

Should You Care?

OK, you know the fundamentals. Use that info to make informed decisions.

Why is your company taking this hit? Was it caught up in the M&A frenzy of a few years ago? If so, one of two things might've happened:

1. The acquired business is still sound, but the market just bites or

2. Once you bought the acquisition-with-the-supposed-sunny-future, it flopped (kind of like appearing on the cover of Sports Illustrated).

Many impairment charges can be blamed on the market. Say you bought a company that was trading at $30 in 1999 and paid $10 in goodwill. Now it's appraised at $2 a share, although the business still seems viable. That $10 premium no longer exists so you have to take an impairment charge for it.

That's a big reason for the AOL-Time Warner write-down. The value of merged companies had fallen dramatically since its January 2001 marriage, forcing it to write-down almost half of its current goodwill balance of $127 billion at September 30, 2001.

Others will argue that you could use these charges as a test of management's decision-making, suggests Jack Ciesielski, publisher of The Analyst's Accounting Observer. Did the folks up top buy a rotten company? That's worth investigating further.

So look at your portfolio. Any company that participated in M&A activity may fall victim. About 75%-80% of impairment charges will fall within the tech and telecom stocks, says Mr. Willens.

Also expect to see these charges from companies that used purchase accounting in the past. (Big note: Pooling accounting used to be an option for companies that merged. It did not create goodwill and is no longer allowed.) AT&T used purchase accounting when it merged with MediaOne and TCI. So expect pretty substantial write-offs from Grandma Bell.

There's an Upside

On the plus side, since goodwill no longer needs to be expensed each year, companies that don't have impairment charges will be looking prettier than their impaired brethren. Why? Their bottom line may appear to be higher since goodwill expense is gone. So a company like PepsiCo, which purchased Tropicana a few years ago, probably will be just fine. Orange juice still sells like liquid gold in supermarkets across the country. So no impairment problems are likely there.

But again, don't be fooled. It's just an accounting change. It has nothing to do with the sales of pulpy Vitamin C-laced drinks.

That is also why you shouldn't see any major stock-price dips when these charges are announced. These charges should come as no surprise to the pros.

Ideally, companies will recalculate prior years numbers to show the affects of this new test. Then it will be easier for investors to do comparisons of each year. Unfortunately, companies are only required to show this restatement in the footnotes to the financial statements. So be sure to read them.

Updated January 31, 2002 6:54 p.m. EST