Financial Accounting Standard (FAS) 142 is the accounting rule that changed how companies treat goodwill. To avoid making bad investment decisions, investors must be aware of this rule's impact on reported earnings.
Before FAS 142, which came into effect in 2001, companies were required to amortize goodwill over a long time (40 years) and this non-cash expense reduced reported EPS. FAS 142 eliminated amortization and instituted an annual impairment test. This article will briefly review the impact of these changes on reported earnings.
EPS Impact: A Potential False Positive
Uninformed investors may get a wrong signal because the rule impacts earnings in the following two ways:
- It generated a one-time boost to earnings per share (EPS) that could fool the market into thinking it represents a change in the fundamentals.
- It provided an incentive to write off goodwill over the quarters following the annoucement of this rule.
A company's fundamentals, real earnings potential and cash flows remained unchanged, regardless of the new rules. But because companies were not required to restate historical results, the change resulted in some EPS growth in the first quarter after adoption of the rule. The following three quarters after FAS 142's implementation, EPS growth is exaggerated when compared to the same quarter of the previous year. However, sequential EPS growth falls back to lower ("normal") levels.
The one-time charge offs that may be forthcoming during the next two quarters will further depress already weak earnings. FAS 142 requires companies have annual impairment tests to evaluate goodwill in light of expected value.
It also requires companies to charge off goodwill if it is impaired. In other words the appraised value is less than the value recorded on the books.
Companies have a year after adoption of FAS 142 to perform the impairment test and charge off impaired goodwill. Incentives are provided during the first fiscal quarter after adoption if the company has the following attributes:
- The charge is made in the company's first fiscal quarter, no restatement is required and the charge is treated as an extraordinary item. Net income isn't affected because it is recorded below the net income line.
- Charge-offs made after the first quarter of the fiscal year will require restatement of preceding financial statements.
- Charges made after the first year will be treated as operating expenses and will reduce net income.
In an attempt to avoid a hit to earnings and the cost of restatements its beneficial for a company to take the charge in their first quarter.
Another factor that may accelerate impairment charge-offs is that the market valuations are significantly below the prices paid for the acquisitions. The opportunity to "clean house", as well as complying with the new rules, might result in very large charge-offs.
Enron is an example of this impairment risk. According to the November 21, 2001 Wall Street Journal Enron's 10Q filing disclosed it "might be forced to take a $700 million pre-tax charge to earnings…due to a drop in the value of some of its assets." FAS 142 is not cited as the sole reason for the write-off, but this seems like an impairment event.
The Bottom Line
Artificially inflated earnings growth and large asset charge-offs could negate each other as well as cause stock volatility. Investors need to dig deeper into financial statements to fully understand a stock's long-term earning potential. Investors should also guard themselves from being fooled by an inefficient market and companies that do whatever it takes to generate spin for their shares.