Speech by SEC Staff:
Enforcement Issues, and Is the Cost of Purchased Goodwill an Asset?
Walter P. Schuetze
Chief Accountant, Division of Enforcement,
U.S. Securities and Exchange Commission
Financial Accounting and Reporting Section
American Accounting Association 1998 Annual Meeting
New Orleans, Louisiana
August 17, 1998
The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any publication or statement by its employees. The views expressed herein are those of Mr. Schuetze and do not necessarily reflect the views of the Commission or the other staff of the Commission.
When Bob Swieringa called several months ago and asked me to speak here today, he suggested that I talk about some of the financial accounting and reporting issues that I see on the enforcement side of the Securities and Exchange Commission and about my views about accounting for intangible assets.
First to Enforcement. There is nothing new under the sun on the accounting side at the Division of Enforcement. Over the years, I have heard every Chief Accountant of the Division speak at forums like this one, and they all said the same things. I have been the Chief Accountant of the Enforcement Division since November 1997, and I have seen nothing new except that some of the frauds are now on the Internet. There are only so many ways to cook the books. I too am going to sound like a broken record.
Let me illustrate the kind of problems that we accountants in the Enforcement Division actually work on. In the nine months that I have had to look at the problems since I became Chief Accountant of the Enforcement Division, I see that we do not deal much with esoteric accounting problems such as foreign currency translation or the ins and outs of pension accounting or postpretirement benefits other than pensions. We deal with more pedestrian issues.
Premature revenue recognition appears to be the first choice for cooking the books. Recognizing revenue in advance of the customer's acceptance of the product. Recognizing revenue when right of return exists. Shipping product to company warehouses and employees' homes and recognizing sales revenue. Keeping the sales journal open after the end of the quarter or year but back-dating sales invoices.
Deferral in the balance sheet of costs that should have been reported in income as operating expenses. Assigning inflated, often outrageously inflated, dollar values to exchanges of nonmonetary assets, particularly with related parties. Assigning inflated, often outrageously inflated, dollar values to nonmonetary assets contributed to the corporation in exchange for stock of the corporation. Not disclosing the existence of related parties and transactions with related parties. Recognizing officers' salaries as receivables. Recognizing cash taken from the corporation by officers as cash in bank, or as an investment, or as a direct reduction of stockholders' equity instead of as a charge to expense. Bleeding into income, without disclosure, "reserves" established in business combinations or in so-called restructurings. In some recent cases, the bleeding has turn into hemorrhaging.
I thought that the "reserve" issue had been resolved in 1975 when the Financial Accounting Standards Board issued Statement 5 on "Accounting for Contingencies." But, I have found that reserves are like crab grass. They are everywhere. Tax liability cushions. Deferred tax asset cushions. Inventory reserves. Bad debt reserves. Merger reserves. Restructuring reserves. They are everywhere. The Division of Corporation Finance, in its reviews of filings by issuers, sprays Roundup on issuer's balance sheets, but the crab grass reserves keep re-emerging. (For you apartment dwellers, Roundup is a herbicide that is supposed to kill weeds.) The reserves are being used to manipulate earnings. Need a penny a share to meet Wall Street's expectations? Need two pennies? A nickel? A dime? Two bits? Dip into the chocolate chip cookie jar reserve. The mere existence of reserves is a chocolate chip cookie jar that management cannot resist when the earnings need a sugar high. We need to fix reserve accounting. It's time to make another pass at reserves; we need a Year 2000 version of FASB Statement 5.
How about treasury stock carried as an asset in the balance sheet at market, with "unrealized" gains credited to unearned income and "realized" gains on sale of the treasury stock credited to income. (I'm not making this up.) How about increasing fixed assets and crediting cost of sales. Not booking all of the accounts payable; just put the invoices from suppliers into a desk drawer. Not writing down or writing off uncollectible receivables. Booking barter trade credits as if they represented US dollars. Such is the grist of our accounting mill. Not very esoteric stuff. If I draw an analogy to police work, what we see is stolen automobiles with finger prints on the door handles, not murders where there are no clues except for dogs that did not bark.
On the audit side, I now have seen several nonaudits since I came on board last year. Auditors accepting, with little or no evidential support, values ascribed to both monetary and nonmonetary assets. Art work by unknown artists booked as assets at huge amounts but without any support for the assigned value or no inquiry by the auditor about independent valuation of the artwork. Receivables acquired from collection agencies for pennies but booked at dollars without any documentation and no auditor inquiry as to the basis for the value. Auditors not doing substantive audit work but relying on so-called analytical procedures where the evidence, or lack thereof, cries out for substantive audit work. Auditors not doing cut off work for sales and purchases. And, of course, we see cases where the auditors were lied to or were not given all of the documentation that they should have been given. But, sometimes I wonder whether the auditors asked the right questions.
Now, on to Intangibles, and specifically whether the cost of goodwill is recognizable as an asset. The FASB has on its agenda the broad question of accounting for business combinations and what to do about the cost of purchased goodwill. The Board tentatively has concluded that the cost of purchased goodwill is an assetthat it meets the Board's definition of an asset in its Statement of Financial Accounting Concepts No. 6, "Elements of Financial Statements," which I will refer to as "Concepts Statement 6." The Board presumably also has concluded that the cost of goodwill has all of the necessary characteristics to constitute an asset and that the measurement criterion is met although I am not sure that the Board has had a thorough-going discussion about measurement.
In articles and speeches in 1991 ("Keep It Simple," Accounting Horizons, June 1991, pp. 113117) and 1993 "What is an Asset," Accounting Horizons, September 1993, pp. 6670), I proposed that accountants use as a definition of an asset the following: "Cash, contractual claims to cash, and things that can be sold separately for cash." I proposed that exchangeability be a required feature of anything recognized as an asset in a balance sheet. Under my proposal, the cost of goodwill would not qualify as an asset. The Financial Accounting Standards Board has not adopted those proposals, however. Thus, in addressing the question of whether the cost of goodwill should be recognized as an asset, I will use the FASB's definition in its Concepts Statement 6, namely, "Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events" and the Board's enumerated characteristics of assets. Exchangeability is not a required feature of an asset in the Board's Conceptual Framework.
The basis for the Board's tentative decision is, as I understand it, as follows, in highly summarized form: (1) While the cost of goodwill itself lacks the capacity to generate future net cash inflows, it has the capacity in combination with other assets to contribute indirectly to those cash flows and therefore meets the "future economic benefit" test; (2) control over the cost of goodwill is provided by the acquirer's controlling financial interest in the acquired entity's equity or equity securities; and (3) the cost of goodwill obviously arises from a past transaction which is the third condition in the definition. I do not agree with the Board's analysis. I think that the analysis omits too much.
The Board's articulation, in Concepts Statement 6, of the necessary characteristics of an asset says that (a) it, whatever it is, must have a probable future economic benefit, (b) a cost, by itself, is not an asset, and (c) in order for something to be an asset it must be controlled by the enterprise that calls the something its asset. I think that, ultimately, the Board will not be able to demonstrate convincingly and persuasively that the cost of purchased goodwill satisfies each and every one of those three characteristics. I will explain why, using the Board's own words.
In paragraph 172 of Concepts Statement 6, the Board said, "Future economic benefit is the essence of an asset. An asset has the capacity to serve the entity by being exchanged for something of value to the entity, by being used to produce something of value to the entity, or by being used to settle its liabilities." The cost of purchased goodwill is simply the amount paid by one entity for the net assets of another entity, or for a controlling equity interest in another entity, in excess of the fair value of the individual, identifiable net assets (assets minus liabilities) of that other entity; the amount said to represent the cost of purchased goodwill is just the excess amount left overin a word, the lump. But, the lump cannot be exchanged for anything. The lump cannot be used to produce anything of value. The lump cannot be used to settle a liability. I conclude, therefore, using the Board's own words, that the future economic benefit criterion is not met.
In paragraph 179 of Concepts Statement 6, the Board said, "Although an entity normally incurs costs to acquire or use assets, costs incurred are not themselves assets." The lump is just a cost, nothing more. It is not the cost of something that will, by itself or in combination with anything else, produce any identifiable positive future cash inflow or reduce any identifiable future cash outflowwhich is what a future economic benefit is. As the Board itself said, a cost is not an asset, so the lump fails to be an asset by the Board's own words.
In paragraphs 183 and 184 of Concepts Statement 6, the Board said, "To have an asset, an entity must control future economic benefit to the extent that it can benefit from the asset and generally can deny or regulate access to that benefit by others, for example, by permitting access only at a price... The entity having an asset ... can exchange it, use it to produce goods or services, exact a price for others' use of it, use it to settle liabilities, hold it, or perhaps distribute it to owners." But, the lump cannot be exchanged for anything; it cannot be used to produce goods or services; it cannot be leased or loaned to others for a price; it cannot be used to settle liabilities; it cannot be held the way one holds, for example, land or patents or marketable securities; and it cannot be distributed to owners. I conclude, therefore, using the Board's own words, that the lump cannot be controlled.
Maybe my difference of opinion with the Board represents a different view of what the financial statements of operating companies should show versus what the financial statements of investment companies should show.
There is no doubt, and I agree, that the owner of an investment in net assets, or an interest in net assets, controls that investment. If the financial statements are to show the investment, which investment implicitly includes the lump, and the results of holding that investment, then the balance sheet will show a one-line item representing the investment, perhaps at cost or perhaps at fair value, and the income statement will show dividends flowing from the investment and perhaps changes in the fair value of the investment. That is the way an investment, and the results of holding an investment, are shown in the financial statements of an investment company. In the financial statements of an operating company, however, the investment is not portrayed; instead the individual operating assets such as marketable securities, loans, inventory, land, plant, equipment, mines, and patents, and the results of using or holding those individual operating assets, are portrayed, for it is those individual operating assets that generate cash inflow, and only those operating assets. It is in the balance sheet of an operating company that the lump does not, in my opinion, satisfy the control criterion even though that criterion would be met in the balance sheet of an investment company as to the investment itself.
There is a final question to ask about whether the cost of goodwill should be recognized as an asset by an operating company, namely, whether there is reasonably reliable measurability. Assume, arguendo, that, somehow, one can argue convincingly that the cost of goodwill meets the definition of an asset. The problem does not end there. The next and conclusive step is that the future economic benefit from that asset be measurable, with reasonable reliability. (See paragraphs 4448 of Concepts Statement 6.) Even at the date of acquisition, the cost of goodwill is not a reliable indicator of the value of any possible indirect future economic benefits. At the date of acquisition, the cost of things such as raw materials, land, equipment, computers, mines, and patents is approximately the amount that all market participants have judged to be the appropriate cash price (laying aside the difference between bid and ask prices). That cash price is the market participants' collective judgment about the future economic benefit (cash flows) embodied in the thing that was acquired, and one can look to that market place for a reliable measure of those benefits. Not so for the cost of goodwill, not even at the time of acquisition. No one would pay anything for it alone. And, no business person would sign his or her name to a purported appraisal value of goodwill standing alone. Thus, the measurability criterion is not met.
If the cost of purchased goodwill is not an asset in the financial statements of an operating company, whether because of definitional problems or measurement issues, then what is it? The cost of purchased goodwill is not the distribution of an asset (a dividend) to owners, which would be charged to equity. If the cost of purchased goodwill is not an asset, as I have argued, and as the cost of purchased goodwill is not a distribution of an asset to owners which would be charged to equity, the cost of purchased goodwill then must represent an expense at the time the cost is incurred. The cost of purchased goodwill is like other costs that are not assets under the Board's definition of an asset: advertising new or existing products or services, recruiting employees, training new employees, training or retraining existing employees, scouting new locations, opening new stores, starting a new line of business, restructuring an existing business, writing software code to fix the Year 2000 problem, and researching possible new drugs, to name only a few; all such costs, not being assets under the Board's definition of an asset are charged to expense.