GM's recent filing of its registration statement with the SEC represents the collision of two topics I have written about. First, the fortuitous arrival of $30.2 billion of "goodwill" on GM's balance sheet so soon after the company crammed a bankruptcy organization down the throats of irate creditors and shareholders fits nicely into my collection of goodwill accounting curios. Second, GM's description of how that "goodwill" came to be will allow us to further consider the implications of my concern that the SEC's review of GM's IPO registration could be inadequate.
I became of aware of the goodwill issue from reading Jonathan Weil's article in Bloomberg last week. Out of all of the bad things that happened to GM, at least it became eligible for "fresh-start" accounting (see the Accounting Standards Codification starting at ASC 852-10-45-17). What it meant for GM is that measurement of all recognized assets and liabilities began anew on July 10, 2009, plus a fresh delivery of goodwill from being able to pretend that the reorganized shareholder group purchased the reorganized, "New GM," (which, of course, it didn't), and accounted for it by the rules for a business combination.
As set forth in the fresh-start accounting rules, the imaginary terms of the imaginary acquisition is that shareholders bought New GM for its "reorganization value" and assumed all of New GM's liabilities (of course, the shareholders of New GM don't actually pay anything). Any positive difference between the booked assets and liabilities is recognized as "goodwill"; and an asset shortfall would result in negative shareholders' equity.
Jon makes many interesting observations in his article, and I highly recommend that you read it, but the one point that I am going focus on is that GM's shareholders' equity at December 31, 2009 would have been a negative $6.2 billion if it were not able to book a whole bunch of goodwill. Even though everyone knows that goodwill is merely, as GM itself puts it, "a residual," it can be a pretty important residual. To say that few companies would be able to pull off a successful IPO with a negative number for shareholders' equity on its balance sheet would be an understatement. To say the same after applying fresh-start accounting would be a statement of fact.
Negative shareholders' equity is an accounting anomaly. If a balance sheet purports to portray financial position of the shareholders, then – just like a negative share price – negative shareholders' equity makes no sense. The only possible explanation is that assets and liabilities themselves are out of whack. Who wants to invest in a company, especially after fresh-start accounting is applied, whose assets and liabilities are so obviously out of whack?
Let's Play SEC
So, a couple of posts ago, I asked whether the SEC was capable of functioning as an effective gatekeeper of a GM IPO. GM's application of fresh-start accounting, especially the 'goodwill' part, could well be the acid test.
This could make pretty dry reading, but I'm going to play the role of an SEC staffer who is actually drafting comments to GM. To avoid dry becoming turgid, I'm dispensing with a lot of the formalties to be found in a genuine comment letter, and virtually all of the standard form. Anyway, here goes nothing.
Comment #1 – Overstatement of reorganization value
On page 125 of your registration statement, you state that reorganization value is the sum of four components: (1) a discounted forecast of expected future cash flows; (2) "the fair value of operating liabilities"; (3) the fair value of non-consolidated investments, and (4) excess cash balances as of July 10, 2009. The following comment pertains to the fair value of operating liabilities (the second component), which you indicate on page 127 was $80,832 million.
We do not believe that you have determined reorganization value in accordance with GAAP. ASC 852-10-05-10 states as follows regarding the determination of reorganization value:
"…Reorganization value generally approximates fair value of the entity before considering liabilities…." [italics supplied]
PLEASE RESTATE to exclude the "fair value of operating liabilities" from the determination of reorganization value [and perhaps wipe out all of the goodwill in the process!].
Comment #2 – Definition of "operating liabilities"
The definition of "operating liabilities" is provided on page 127:
"Operating liabilities are our total liabilities excluding the liabilities listed in the reconciliation above …"
Nothwithstanding any effect of Comment #1 on your registration statement, the forgoing definition is deficient; it does not actually describe "operating liabilities," except in terms of an apparently arbitrary calculation. Should it become necessary to provide a substantive definition of "operating liabilities" after you have taken into consideration our Comment #1, you should provide a definition that is independent of total liabilities and its non-operating liability components. If necessary, restate the amount of "operating liabilities" to conform to the revised definition.
Comment #3 – Excess cash included in reorganization value
On page 126, you state that the excess cash component of the reorganization value was $33.8 billion, and that $21.2 of cash and marketable securities were restricted as to their use.
We note that if there were no excess cash balances, then reorganization value would be reduced such that goodwill recognized by fresh start accounting would be completely wiped out. In consideration of its materiality, PLEASE AMEND your registration statement to provide additional details as to how excess cash was determined. Provide an explanation of the cash flow forecasting model used, its key assumptions, how those assumptions adequately reflect the exceptionally high risks that New GM faces, and provide a sensitivity analysis on those assumptions in a tabular format. Also, provide a description of the negotiations with creditors that granted you the ability to retain excess cash; specifically, how it came to be that creditors did not successfully claim these amounts (if they were truly excess) for themselves.
In summary, we are skeptical that, with the possible exception of your restricted cash, that New GM should consider itself to be in possession of excess cash balances.
Comment #4 – Effect of Taxes and Pensions on Goodwill
On page 136, you stated the following:
When applying fresh-start reporting, certain accounts, primarily employee benefit and income tax related, were recorded at amounts determined under specific U.S. GAAP rather than fair value, and the difference between the U.S. GAAP and fair value amounts gives rise to goodwill, which is a residual. … If all identifiable assets and liabilities had been recorded at fair value upon application of fresh-start reporting, no goodwill would have resulted." [italics supplied]
The last sentence, above, is incorrect because goodwill is also a function of reorganization value. Therefore, PLEASE AMEND your registration statement to correctly state the calculation of goodwill, and as follows:
- Provide, preferably in tabular format, the following: the balance sheet categories for which fair value and recorded amounts differed as of July 10, 2009; their recorded amounts and respective estimated fair values; and the difference.
- In separate tables, disaggregate the forgoing differences by the variables that significantly contributed to the differences. State any assumptions that were required for the preparation of this table.
[Note: the deferred tax asset valuation allowance determination is a fertile source of earnings management. At the date of the fresh-start accounting, a "conservatively high" valuation allowance increases goodwill; and in subsequent periods, reductions in the allowance also reduce reported income tax expense. Therefore, it would behoove the SEC reviewer to examine the determination of the initial deferred tax valuation allowance very closely.]
What Will the Real Comment Letter Contain?
In summary, I reviewed only about ten pages of GM's registration statement, and generated the above comments. Among other things, I found three reasons why New GM probably doesn't have any goodwill, and as a consequence, negative shareholders' equity:
- Overstated reorganization value due to inclusion of operating liabilities;
- Overstated reorganization value due to overstated excess cash and marketable securities;
- Potential overstatement of the deferred tax asset valuation allowance, with the added consequence of creating an earnings bank which can be drawn down by reducing the valuation allowance.
Eventually, the SEC's comment letter on GM's registration statement will have to be made public. Here's hoping the Commission's staff is doing its job—even if it means that GM's IPO doesn't go forward.