Commentary: Goodwill write-offs: Let's not forget impact on future

During the last year, the list of companies recording huge write- offs of goodwill has continued to grow.

For example, in 2002, AOL Time Warner (AOL) recorded a charge against income of about $54 billion, reflecting a reduction in the carrying value of its goodwill. This write-off reduced AOL's shareholders' equity by one- third.

Gemstar-TV Guide International Inc. recorded a $5 billion write-off that reduced its shareholders' equity by two- thirds.

There has been much discussion about these write-offs because of the staggering amounts. Most of these discussions have centered on how these write-offs impact current performance and future earnings.

For example, a lot has been said about how companies that recorded large amounts of goodwill amortization will suffer a one-time earnings "hit" and then have dramatic increases in their earnings in future years.

Users of these financial statements should not view the increase in earnings as a positive sign of better performance because the increase in earnings could be caused solely by eliminating goodwill amortization.

Recording huge write-offs of goodwill brings to the forefront the long- established business practice of recording a huge negative adjustment in a period where there is a net loss.

In other words, companies believe that if you are required to record a huge loss, record it in one period and move on so that future financial statements, especially the income statement, are not affected by these negative items.

One topic that seems to be forgotten is how recording a huge write-off for goodwill will improve a company's future profitability ratios, even if earnings and/or sales stay the same.

When a company records a huge write-off of goodwill, both total assets and total shareholders' equity are reduced. Profitability ratios, including return on assets, asset turnover and return on equity, will increase in future years, even if earnings and sales are the same because the decrease in total assets and total shareholders' equity will decrease the denominator of these ratios.

In the management discussion and analysis section of the annual report, many companies include a form of Economic Value Added to measure a company's internal creation of value.

EVA is a company's earnings less a capital charge for all investments employed.

As with the other profitability ratios, EVA will increase in future years, even if earnings and sales are the same, because the decrease in total assets reduces a company's capital charge.

There are many discussions centered on recording the huge write-offs of goodwill.

When analyzing the impact of these write-offs, make sure you consider the impact on current performance and future earnings. Also, do not forget about the impact of these write-offs on future profitability ratios, even if earnings remain the same.

Phillip J. Korb is an associate professor of accounting at the University of Baltimore. He is a CPA and holds an M.B.A. and master of science degree in taxation. Thomas E. Vermeer is an assistant professor of accounting at the University of Baltimore. He is a CPA and holds a doctorate in accounting.

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