My class on fundamental analysis is wrapping up our semester at Columbia Business School. We rarely encounter exciting concurrent accounting developments when the semester is in session. But this year has been an exception on account of the election and the flurry of enforcement actions coming out in the last months of the Biden SEC.
The latest action relates to the SEC’s sanction against UPS for not writing down goodwill, despite knowing that the fair value of the business unit is smaller than the book value of the unit. In particular, the SEC’s action reads:
“According to the SEC’s order, UPS determined in 2019 that UPS Freight, a business unit that transported less-than-truckload shipments, was likely to sell for no more than about $650 million. GAAP required UPS to use the price it would receive to sell Freight in calculating whether it needed to write-down the value of the goodwill it had assigned to the business unit on its balance sheet. UPS’s own analysis indicated that nearly $500 million of goodwill it had associated with Freight was impaired. Rather than use that analysis, however, UPS relied on an outside consultant’s valuation of Freight without giving the consultant information necessary to conduct a fair valuation of the business. Using assumptions approved by UPS, which were clearly not ones a prospective buyer of Freight would make, the consultant estimated Freight was worth about $2 billion – three times as much as UPS had determined. On that basis, UPS did not record a goodwill impairment in 2019. Had UPS properly valued Freight, its earnings and other reported items would have been materially lower.”
I have long argued that companies don’t take timely goodwill write-downs. The system has defaulted to the following arrangement. The CEO knows before anyone else that the acquisition is not going well, and the so-called synergies are not getting realized. But taking the write down is usually an ego blow and a public mea culpa that the acquisition was perhaps not the greatest use of capital. Hence, the CEO resists taking a timely write-down. The auditor is supposed to enforce the goodwill write-down, assuming the auditor has reason to believe that the acquisition is not working as intended. However, in practice, the auditor rarely has the political power or sometimes the economic incentives to get the CEO to take a write-down.
Considering this, the SEC official’s articulation of how the system is intended to work is heartening:
“Goodwill balances provide investors with valuable insight into whether companies are successfully operating the businesses they own,” said Melissa Hodgman, Associate Director. “Therefore, it is essential for companies to prepare reliable fair value estimates and impair goodwill when required. UPS fell short of these obligations, repeatedly ignoring its own well-founded sale price estimates for Freight in favor of unreliable third-party valuations.”
The statement almost begs the question of how many more UPS-like cases lurk in the shadows. Quantifying that is not trivial. But I ran a simple filter to identify potential cases where goodwill needs to be written down. The filter, inspired by an older paper by Ramanna and Watts (2008), is as follows:
- Firms that hold more than $1 billion in goodwill and intangibles on their balance sheets as per their latest annual report; AND
- Firms whose market to book ratio is less than one. I relaxed that assumption to less than 0.5 to avoid claims that stock prices are volatile and the market to book ratios will eventually recover to greater than one.
The thinking behind this filter is straightforward. A market to book ratio of less than one suggests that the stock market assesses the book value of net assets to be less than its fair value. Note that net assets refer to assets minus liabilities, otherwise known as the book value of equity, or the denominator in the market to book ratio. In effect, the stock market is publicly asking the CEO to take a write down!
The real list of firms, that need to take goodwill and intangible write downs, is likely many times longer. Why? Information about the lack of success of an acquisition stays private with the CEO and management team for quite a while before the investing public finds out. And, UPS, to be clear, is an otherwise thriving business with a market capitalization of $113 billion at the time of writing and a market to book ratio of 6.95. My filter was deliberately designed to avoid the likes of UPS to try and identify cases that are likely to be truly tardy in taking write-downs.
The filter, run on S&P’s CAP IQ database, produces 507 global firms with goodwill and intangible assets more than $1 billion and market to book ratios less than one. If you are interested in getting the list, please write to me.
Of course, there may be mitigating circumstances. The firm may have implemented a restructuring plan that the stock market has not given the CEO credit for. Stock prices are volatile, and I may have picked up transitory under-valuation. To address the latter comment, I re-ran the filter with a market to book ratio of less than 0.5. The list shrinks somewhat to 142 firms.
It is worth looking at the top 10 firms in the list, sorted on the largest dollar value of intangibles:
Volkswagen is the 100-pound gorilla on this list. The firm holds $98 billion of intangibles as of December 31, 2023. Ironically, the last time, Volkswagen’s price to book to ratio was above one was way back in January 2022. Has Volkswagen delayed taking substantial write downs on its intangible assets for years? Why have investors, auditors and regulators failed to raised questions or red flags?
In essence, many of these are accounting/reporting disasters are hiding in plain sight. I am surprised that the governance ecosystem does not highlight and discuss such cases more. Should we blame the general disengagement with accounting propriety on the usual suspects: near zero interest rates, passive investing and machine learning based quant investing?
Part of the blame falls on us educators for our failure to excite non-accounting majors about the immense body of valuable signals about management and the business that stay undiscovered in the hidden recesses of financial statements.
This article was originally published on Forbes.com.
