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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.

 

 

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*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.) 

HP's Autonomy Debacle: Mistakes were Made -- and Capitalized?

Companies overpay to acquire other companies all the time; but Hewlett Packard Co. just might be the new record holder for getting fleeced. I don't have the exact amount, but let's say that the goodwill HP initially recorded from the E.D.S. and the Autonomy acquisitions combined was on the order of $20 billion. Given the subsequent goodwill impairment charges for most of it, and the revelations that surrounded those charges, it should come as no surprise that investors have expressed dissatisfaction with everyone – management and the board, their outside financial advisors and auditors – associated with the decision making and the accounting for these ill-fated investments.

One very compelling expression of dissatisfaction came recently in a letter from the CtW Investment Group to Rajiv Gupta, HP's lead director and chair of its corporate governance committee. CtW works with pension funds, which in the aggregate are substantial HP shareholders. Supported by a detailed nine-page analysis, CtW has called for nothing less than "…a comprehensive overhaul of the board's oversight of the audit process and the replacement of long-time outside auditor, Ernst & Young."

Highlights of the claims made by CtW against EY are as follows:

• Large amounts of non-audit fees paid to EY in recent years, although not technically prohibited, challenge the presumption of its independence from HP.
• However, HP was a lobbying client of Washington Counsel, which was owned by EY: "We further note that it has been reported that the SEC is investigating Ernst & Young for allowing its … subsidiary to lobby for audit clients."
• The timing of the $8 billion goodwill impairment charge in 2012 relating to the 2008 acquisition of E.D.S. "reveals a significant performance failure on Ernst & Young's part." CtW's analysis of reported results indicate that significant goodwill impairment(s) should have been recognized in earlier years; and the delay in recognition resulted in misleading reported earnings for those years.

One of the motivations of this post was simply to bring to your attention this letter, which if substantiated, has important implications for EY and for financial reporting in general. But, a second motivation is to further discuss the accounting for goodwill, using the Autonomy debacle as a case study. This is the way that CtW teed up the issue I want to explore:

"Ernst & Young, as HP's independent auditor, had a duty to review HP goodwill accounting in its 2011 Form 10-K and for its 2012 financial statements. Ernst & Young did not discover any improper accounting practices [at Autonomy], nor does it appear to have objected to the amount of goodwill HP recorded in association with the Autonomy acquisition." [emphasis added]

Auditing Initial Goodwill is Not Necessarily about Goodwill

I'm sure that most readers already understand that goodwill is nothing more than the difference between the purchase price of the acquisition* and the opening measurements of all the identified assets acquired and liabilities assumed. Setting aside what goodwill on the balance actually means or doesn't mean, the CtW letter does not explicitly acknowledge that an auditor's responsibility for the initial amount of "goodwill" recognized actually begins with examining the non-goodwill amounts. In practice, goodwill itself would rarely be an object of scrutiny by the auditors; but more on that later.

The CtW letter does indicate a concern that EY missed something very important in its examination of Autonomy assets acquired and liabilities assumed. In this regard, it notes that a PwC forensic investigation of Autonomy's accounting uncovered "…a variety of inappropriate and arguably fraudulent accounting practices, including improper timing of revenue recognition…" But, while the PwC investigation doesn't bode well for EY it is not, as CtW seems to imply, because EY may have allowed initial goodwill to be overstated.

To illustrate this point, let's just focus on one particular asset acquired: customer accounts receivable. It has been alleged that Autonomy improperly recognized revenue from agreements to resellers of software licenses, even before a single license had been sold to an end user. Presumably, the improper revenue recognition would have caused customer receivables to be overstated.

But, if EY did not compel HP to back out any premature recognition of receivables, then the arithmetic business combination would not have been reflected in a misstatement of total assets. Even though customer receivables would have been overstated, it would have been offset by understated goodwill. That's why I wish CtW had framed its concerns in terms of the reported amounts for the non-goodwill assets acquired and liabilities assumed, instead of goodwill itself.

But, it is also possible that EY discovered a misstatement in, say again, customer receivables; and it compelled HP to reduce the receivables accordingly. If this had been the case, then EY looks better in one respect and worse in another; because, if EY had permitted HP to offset the downward adjustment in customer receivables with an increase in goodwill, then the issue that CtW raises is manifest: goodwill was artificially inflated, and EY might have noted that fact.

My sense is that if EY missed something it is more likely that they failed to note an overstatement of customer receivables. But, the reason I wanted to discuss this alternative scenario is because the accounting for 'mistakes' in a business combination is frequently problematic.

'Mistake' Capitalization Happens All the Time

I suppose that one could justify initial capitalization in goodwill of some mistakes – like overvaluing future prospects – because they are impossible to detect at the time a transaction takes place. For example, shortly after an acquisition is consummated in good faith by both parties, and before the first financial statements are issued, an acquiror might learn that its forecast of future profitability was too optimistic. But, if customer receivables are found to actually not exist at some point before the financial statements are issued, how should that be handled?

The FASB Accounting Standards Codification is silent on this point, but it turns out that the SEC took a position on a similar matter a number of years ago. I stumbled upon that position in a fascinating interview of Clarence Sampson, SEC Chief Accountant for more than a decade starting in the mid-1970s. Of his many tales of peculiar interactions with special interests, this one impressed me the most:

"In the process of recording ... [a business combination transaction, the acquiror] ... discovered, by golly, that in a $300,000,000 acquisition, $100,000,000 of assets they thought they had didn't exist. And so the company tromped in with their auditors and said, the rules say the difference between what we got and what we paid is goodwill. I simply wasn't able to accept the fact that there should be $100,000,000 goodwill on their books, which didn't exist, and we told them to write it off." [emphasis added]

The amount of shareholder value destruction from the E.D.S. and Autonomy debacles were extreme, but the fact of the matter is that mistakes in major acquisitions happen with great frequency, if not most of the time. There are business school academics who spend virtually their entire careers trying to explain why it is so often the case that an acquiror's stock price goes down (i.e., shareholder value is destroyed) after plans to acquire another company are announced. During my part-time career as litigation consultant, I have been involved in at least four cases where acquirors have claimed that assets they purportedly purchased either didn't exist, or were worth much less than the amounts recorded on the balance sheet of the acquire.

In all of those cases how did a mistake get accounted for? Capitalized as goodwill, of course!

In a nutshell, Sampson stated the obvious: despite what the accounting rules say – or don't say – an asset that doesn't exist can't be goodwill. But, just so everyone should get the message, two things ought to happen:

First, no matter at what point subsequent to the acquisition date that the errors in Autonomy's financial statements were discovered, HP should not have capitalized them in goodwill; therefore, the SEC should require HP to correct its accounting error by restating all periods affect – and perhaps also by amending previously filed financial statements in which the erroneous amount of goodwill was reported.

Second, the FASB ought to use this case to echo that sentiment. It should amend U.S. GAAP to make it clear that when a company thought it bought it asset, but didn't, the asset that never existed is not goodwill.

I am not a supporter of recognizing goodwill as an asset under any circumstance, but if it is to be, then it should be clear that when it is discovered that an asset is overstated or does not exist, that's clearly not goodwill.

Perhaps, then, companies like HP will be more careful about: what they acquire; what they pay; and what the contracts state about what they are entitled to if assets that are purported to exist in fact do not.

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*To you accounting sticklers, I know that my description is technically accurate only if an acquiror purchases 100% of the outstanding shares of the acquiree. For the purposes of this post, that's close enough.