THE ACCOUNTING ONION HAS MOVED!
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After having just written a post on HP’s massive write-off of goodwill, I am reluctant to keep on banging the drum of how bad goodwill accounting can be. But, I can’t resist following up on Bloomberg columnist Jonathan Weil’s coverage of yet another recent acquisition by a big-time company that went sour practically out of the box.
Mr. Weil’s main motivation was to express annoyance at companies that are wont to characterize asset impairment charges as being “non-cash” in nature -- as if it could mute the impact of the largest single accounting entry by the company in recent memory. ‘If mistakes were made, they’re history. So just fuggedaboutit.’
But, in Caterpillar's case, I think it goes deeper than merely choosing the words for best (or least bad) effect: it's misleading.
The sad story began last June, when Caterpillar Inc. acquired ERA Mining Machinery Limited (ERA), including its wholly owned Chinese subsidiary Zhengzhou Siwei Mechanical & Electrical Manufacturing Co., Ltd., commonly known as “Siwei.” According to Caterpillar’s 10-Q for its second quarter, tangible assets acquired and recorded at fair value totaled $671 million, customer relationships and trade names were valued at $105 million, liabilities assumed were $592 million and goodwill in the amount of $461 million was recognized.
"Goodwill … represents the estimated future economic benefits arising from other assets acquired that could not be individually identified and separately recognized. … Factors that contributed to a purchase price resulting in the recognition of goodwill include expected cost savings primarily from increased purchasing power for raw materials and a reduction in other manufacturing input costs, expanded underground mining equipment sales opportunities in China and internationally, along with the acquired assembled workforce [many of whom were later fired because it was believed that they conspired to inflate the purchase price]."
One would have hoped that Caterpillar’s audit committee and due diligence team would have seen the large amount of goodwill for a manufacturing company to be a red flag – plus: key intangible assets were separately accounted for; ERA had recently obtained a backdoor listing on the Hong Kong stock exchange; and combined with all the other news we have heard about audits in China, there should have been a legitimate concern that the audit report should not be relied upon.
As it turns out, such was the case. From the 8-K announcing the impending goodwill impairment charge:
"Caterpillar first became concerned about an issue when discrepancies were identified in November 2012 between the inventory recorded in Siwei’s accounting records and the company’s actual physical inventory. This was determined by a physical inventory count conducted at Siwei as part of Caterpillar’s integration process. [whatever that is, and why ever it took so long] Caterpillar promptly launched a comprehensive review and investigation into the nature and source of this discrepancy. This extensive review has identified inappropriate accounting practices involving improper cost allocation that resulted in overstated profit. The review further identified improper revenue recognition practices involving early and, at times unsupported, revenue recognition."
For a company that strongly desires to project an image of adherence to high ethical standards, the above is not very forthcoming. Caterpillar has not even deigned to tell us whether the inventory count was higher or lower than what was on the books. And, what does inventory count have to do with “cost allocation”?
We also know that, even though the investigation is not complete, Caterpillar is going to record a $580 million charge to goodwill, which as Jonathan Weil has observed is even more than the goodwill originally recognized and is almost as much as the original purchase price. I can think of some scenarios under which the goodwill write-off is actually more than the goodwill originally recognized, but I shouldn’t have to speculate.*
Although other account balances are clearly implicated, the company has not even deigned to tell us whether other assets (like the aforementioned inventory and customer receivables, or the finite-lived intangibles) will be adjusted. In this regard, another factor to consider is that US GAAP allows for a period of time to adjust so-called “provisional” valuations of assets acquired and liabilities assumed as new information that the company is seeking becomes available.
But, surely Caterpillar’s valuations were not provisional until it could ascertain whether or not it was the victim of fraud. Moreover, public companies have to be pretty careful when they adjust provisional amounts, especially if those amounts were previously filed in an annual or quarterly report; that’s because retrospective adjustments to amounts previous filed (and any impact on earnings) are required along with disclosures of the amounts of the adjustments. If anything like that is going to happen, and I don’t think it will, Caterpillar is not talking about it.
In summary, there is enough evidence to strongly suspect that the accounting entry to record the Siwei acquisition was incorrect. It also seems to be the case that Caterpillar had adequate opportunity to become aware of its errors (and that it was the victim of an apparent fraudulent scheme) before it filed its 10-Q for the second quarter of 2012. From Caterpillar’s recent disclosures, we can be confident that inventories were misstated (over or under, we don’t know), customer receivables were recorded that did not exist, and goodwill was recorded that did not exist. It could very well also be that other assets, including the values assigned to customer relationships and trade names were misstated as well.
US GAAP is quite clear as to the remedy for an accounting error: go back and restate all the prior periods presented. So among other things, even if previous quarterly financial statements are not re-filed, when Caterpillar files its Form 10-K for 2012, it should have to report a loss of a few hundred million dollars from having been defrauded. That’s not anything that can be waved away as a non-cash impairment charge.
Another interesting question to contemplate is whether Caterpillar has violated the securities laws. Filing materially incorrect information to the SEC is, in and of itself, a violation, but that’s not what I’m thinking about:
- All companies have an obligation to keep adequate books and records, and the possibility exists that Caterpillar’s due diligence procedures did not adequately respond to the consequences of misstating the assets acquired and liabilities assumed from ERA.
- On the filing of the Form 8-K itself onJanuary 18th, since Caterpillar admitted to having discovered material irregularities already in November, surely they must have come to the conclusion that a goodwill impairment charge in some amount would be necessary much sooner than mid-January. Wasn’t the requirement to file an 8-K triggered long before Caterpillar’s actual filing date?
* * * * *
The moral of the story is that fraud is not an asset. Whatever you think about goodwill accounting, I hope you don’t think that the appropriate way for a company like Caterpillar to report that it has been the victim of a fraud is simply by a "non-cash" charge to goodwill.
*One possibility has to do with the “unit of account” when testing for goodwill impairment. As soon as a company is acquired, it is assigned to a “reporting unit” (roughly speaking, one level below a reportable business segment), and the goodwill assigned by some magical formula to that reporting unit (perhaps from other Caterpillar acquisitions in China) is what is tested for impairment – not the goodwill solely from purchasing ERA. In fact, it is entirely possible that a portion of the goodwill from the ERA acquisition wasn’t tested, because it could have been assigned to another reporting unit. (Yes, the rules are that loosey goosey.)