Accounting Myths, Goodwill and Mark-To-Market

This was in the Wall Street Journal today. It brought back memories...

I first really ran across "goodwill" back when I was working in Washington, DC, around 1986/1987. I worked with a company - long since gone - that assessed the sale and purchase of radio and TV stations. I did the balance sheet analysis of the companies involved and forecast their profits based on fair value for the company, which, simply defined, was what the company could be sold for based on depreciated tangible assets plus what could be financed by using the 90% of the cash flow to finance the purchase over a 10 year period, based upon both demographic growth and market share. I also put together a database of the sales of such TV and radio stations over time - they're a matter of public record - going back some 20 years, which gave a great idea of what comparable stations had been sold for in comparable markets.

Now, a lot of the radio and TV stations were sold for considerably more than their "fair value". This was the excess value that the buyer perceived the radio or TV station was worth: if the station had depreciated tangible assets worth, say, $10mn and the cash flow was such that the fair value was $30mn, then the fair value was $40mn. If the station was sold for $60mn, that difference was "goodwill", meaning all the intangibles that were associated with the station, such as memorable call signs for the stations (for the European readers: each radio or TV station in the US has a 3 or 4 letter call sign associated with them, such as KDKA in Pittsburgh, one of the first radio stations around, or WNYC in New York: this latter, for instance, is easier to remember (and hence market!) than WAXQ or some other series of letters), long-term contracts with good radio or TV personalities, etc.

But we all knew that it was an accounting myth: there wasn't anything backing it. It was intangible, fleeting at best: employees could - and often did - leave, programming changed, and you could, via the database, track the sale and purchase of a number of radio stations and research why one station varied in value over the years. That is why the fair value concept made sense: it was tanglible, real and even forecasting balance sheets was a heck of a lot better than trying to estimate the goodwill involved.

For banks to be booking goodwill as part of their assets means that the banks were booking ... nothing. An intangible is and remains always that: fleeting, insubstantial, and in comparison to fixed assets, something that can't, really, be considered an asset at all. The two are simply not in the same ballpark.

So now it looks like many banks, mostly European, are actually vastly more heavily leveraged than one would otherwise think: the "goodwill" of a company isn't, however, an asset. It is an accounting myth, a nicety used to avoid telling clients that they actually spent considerably more than their newly purchased asset is actually worth (or, more exactly, a tool for sellers to pump up their selling price: in most cases, goodwill represented their actual profit of the sale). Overleveraged banks are the banks that fail, the ones that go bang with a boom and collapse, since they cannot cover their losses.

Readers here will have noticed that I am not a fan of Mark-To-Market. I understand why the bookkeepers love it: it puts a value on something that is otherwise hard to value. But it is, I am afraid, as much an accounting myth as goodwill is, and one that is as dangerous. Mark-to-Market gives the bookkeeper the ability to destroy and create capital that has nothing to do with the real values involved: the value of an asset must be valued as a book value until the point where the asset is disposed of. Anything else is folly.

Banking and bookeeping must become the rather tedious and dreary support businesses that they really are. The only real excitement in banking is investment banking of the old school, of working out deals and financing seriously large projects with qualified investors. An entire generation of financial services people have, through their accounting myths, led us to the perilous place we are now.

Thanks, guys and gals. A reversion to classic accounting - depreciating tangible assets and calculating the book value of investments, and ignoring the rest - would go a long, long way to solving most of the problems we are facing. Of course, it means abandoning the "value" created by accounting myths that have brought us here: there is no real, tangible value in intangibles. There never was, there never will be, and it is part of the problem.

Not part of the solution.