Autodesk’s John Walker Explained HP and IBM in 1991

When you purchase another company, the difference between its market value (if publicly traded) and the acquisition price is booked as an asset called "goodwill."

If it's clear you've overpaid for the asset, you have to "write down" the goodwill (take the lost value as a loss). One example: http://www.businessinsider.com/hps-8-billion-write-off-is-re...

If it weren't for goodwill, no one would acquire anyone else b/c they would take an immediate earnings hit.

One way to view this is companies have 2 buckets to allocate costs to:

1 - Ongoing operations

2 - Investments

Investors care about margins (% of sales) on ongoing operations, but tend to view investments with a "Return on Capital" (% of assets). Note that margins are on flow, where as ROC is on a fixed asset. The idea is that if you know the margin and growth of a business, you can come up with a long term value estimate. (If you're interested, I can write more about how this calculation works) It's also worth noting that this isn't the "optimal" way to make spending decisions. Good companies know that it's worth treating all expenses as a "Return on Capital" basis rather than purely optimizing on margins. (This can be called EVA or Economic Value Added)

What the article captures is the essence of good leadership and management. You can't be 100% long term - investors would never know if the money is being well spent. You can't be 100% short term - you'll never invest for the future, and will get crushed when the future arrives.

There is one caveat... If a company decides that it can no longer innovate, then the "Stop spending money, and return money to sharedholders via buybacks so that they can invest it elsewhere" actually does make sense. (Move capital from IBM to companies who need it to grow)

It is actually a cost and Walker is wrong. What changes is how the cost is spread. If you buy a building and you spend 1M you will have -1M cash and +1M in property. But since the building will age you will have to amortize it, let's say over 10 year. So you will account 100K as an operating expense and you will reduce the value of that building on your capital, so at the end of the year the build value is only 900K. And you do the same for the remaining 9 year. But this make sense, if I buy a building, I'm not going to use it for just one year. If you buy a company it is a little bit different. Usually the physical assets goes on the balance sheet as explained above. The difference between the buying cost and the assets is called Goodwill and it is the only part that doesn't need to be amortized. Goodwill are many things, the brand value, the internal know how etc etc and doesn't need to be amortized. But you are required to re-evaluate it every year and if it has lost value you have to write it down, so it is a cost.

If you look at it carefully, the accounting rules make perfect sense. Otherwise buying a building (or server) for my company will impact the margin of just one year and it would be difficult. The problem is that Goodwill is difficult to evaluate, so managers could decide to re-evaluate it as they want in order to boost their bottom line. But it is bad management, not bad accounting.

Regarding is point on sales, it is not even accounting, but the dumb use of financial ratios. Usually the company could use the earnings call and the notes on the balance sheet to explain this shifts. But again, it is a call on the management side to explain it and sometimes they prefer not to explain to hide from competitors. They need to find the right balance between hiding their moves from competitor and informing the investors...

Probably Slate Rock and Gravel Company from The Flintstones.