When Goodwill Isn't

Unlike apparently most of Wall Street, I am not at all ambivalent about goodwill amortization.
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Medora Lee's article from Monday on Wall Street's apparent ambivalence to SEC changes in how companies amortize goodwill that arises from acquisitions has gotten me so riled up that I feel compelled to sound off on the matter.

Not about the article -- which did a nice job of detailing exactly what the issue is about -- but about the subject. This requires some explanation, because there is little about goodwill amortization that is intuitive, unless you do this for a living.

At the heart of the matter is how different ways of calculating earnings are lost in the effort to present standardized numbers. As I have noted many times in this space, there is a world of difference between the "reported earnings" and the real cash earnings of a company. And simply following a service --like

First Call

or

I/B/E/S

-- that spits out "consensus" earnings numbers with no background as to what these numbers represent is no way to intelligently run an investment portfolio. (I'll forgo, for now, the more important question: Why in God's name should a multibillion-dollar company -- or any company -- contort itself to meet these estimates to the penny on a quarterly basis?)

But I digress. Goodwill amortization is a misleading and annoying part of

GAAP

, or generally accepted accounting principles, the accounting convention that amounts to a necessary evil: It gives an investor some chance to look at the history of a company's acquisition strategy -- and possibly attach some numbers that will identify what return on investment a company is earning on these purchases. It is also a mechanism by which investors can compare apples to apples.

Unfortunately, the notion of creating and then expensing goodwill also carries with it two big issues. First, amortization is a noncash expense, and thus an accountant's invention -- so it does not matter a whit in how a company makes or sells its products or how it takes in or pays out cash. Secondly, as a concept, it is not clear that goodwill should always be considered an expense.

Goodwill was an attempt by an accountant a long time ago to figure out what to do on the ledger when someone purchases a company for more than its stated book value. It was decided that this premium over book value should be amortized over a standard length of time -- a number that usually comes out to be 40 years. That is the most time the accountants will let you amortize it -- and so creates the smallest annual charge.

This figure is not paid out in cash. But it is very different than depreciation expense, which while also a noncash annual expense, can be considered a rough proxy for the maintenance capital expenditures that truly are necessary for many companies to stay in business. No, goodwill is simply the manmade plug number for accountants to move numbers from the balance sheet to the income statement in accounting for acquisitions.

Annoyingly, a number of very highly educated and well-trained professionals do not seem to understand this. If you don't have much time for thorough analysis and you are looking at earnings per share exclusively (despite how many times I have said don't), the least you should do is add back the amount of goodwill amortization per share to earnings per share. This will neutralize the effect of goodwill amortization and can have some big effects on companies that have made a number of purchase accounting acquisitions, such as

Disney

(DIS) - Get Report

, Wells Fargo,

Fortune Brands

(FO)

and

PepsiCo

(PEP) - Get Report

. In each case, the "cash earnings" -- which sums up both earnings per share and goodwill amortization per share -- is significantly higher.

A number of companies make it easier for the investor by already separating amortization of goodwill as a separate line item on their income statements. But some make you work by lumping it in with other expenses. Given some of the confusion Medora noted in her column, companies should report it as a line item, report a number for earnings per share GAAP style and then provide a nice line underneath for "cash earnings per share." It is important to note that this is a different number than "cash flow," which is a more complete tally of the cash in and out of a company.

It is also important to note that in my opinion, this is not a matter of opinion: It is simply

wrong

not to add back goodwill amortization -- and if you don't, you will underestimate the real earnings of a number of very smart, shareholder-oriented companies that do not play the quarterly earnings number game.

When an Expense Is an Asset

The other issue is: Why is goodwill automatically considered an expense? Let's pretend that in 1950, I bought

Coca-Cola

(KO) - Get Report

in its entirety for $100 million. Say the book value was $60 million at the time, so I have to amortize $40 million over 40 years, or $1 million a year. My company has 1 million shares outstanding, so it "costs" me a dollar a share of reported earnings, which are now $14 per share instead of the $15 per share I would have reported.

Forty years go by and I finally have the goodwill off my books. All else being equal, who wouldn't argue the franchise value or "goodwill" associated with Coca-Cola has gone up a zillionfold in 40 years? Yet, according to the accountants, the franchise went down in value $1 million every year as I amortized the goodwill. There are all sorts of other numbers tricks you can play with the accounting effect of goodwill over the years, and I will send you to

BerkshireHathaway.com to browse the Great One's take on the subject, which is right on the money.

My whole point is that investors should stop asking if this issue matters or not -- it

obviously

matters. What's needed now is to get companies -- and for that matter a number of analysts -- to view goodwill in its proper place and to not twist themselves into knots over how investors will treat goodwill's effect on earnings. It should be a nonissue for investors who are paying attention. My advice: Just lay it out -- and we'll figure it out!

Jeffrey Bronchick is chief investment officer at Reed Conner & Birdwell, a Los Angeles-based money management firm with about $1 billion of assets under management for institutions and taxable individuals. Bronchick also manages the RCB Small Cap Value Fund. At time of publication, RCB was long PepsiCo and Fortune Brands, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Bronchick appreciates your feedback at

jbronchick@rcbinvest.com.