Back in November 2012, when it released its fourth quarter results, computer giant Hewlett-Packard announced that it would be taking an $8.8 billion charge to write down a botched acquisition of U.K.-based Autonomy Corporation PLC. The write-off, which was described as a non-cash charge for the impairment of the Autonomy purchase, included goodwill and intangible asset charges.

What Is Goodwill?

Goodwill frequently arises when one company buys another; it is defined as the amount paid for the company over book value. Goodwill is an intangible asset, as opposed to tangible assets such as buildings, computer and office equipment, and related physical goods, including inventory and related forms of working capital. In other words, goodwill represents an acquisition amount over and above what the purchased firm's net assets are deemed to be valued at on the balance sheet. (For more, see "Is Goodwill Considered a Form of Capital Asset?")

When Goodwill Goes Bad

In the case of HP's acquisition of Autonomy, given the charge announced in November, it is clear that most of the original $11 billion purchase price was over and above the book value, or net asset value of Autonomy, a fast-growing software company. According to a Bloomberg study, Autonomy listed total assets of $3.5 billion right before it was acquired. At the time of acquisition, HP initially accounted $6.6 billion toward goodwill and $4.6 billion towards other intangibles. These numbers were later changed to $6.9 billion and $4.3 billion, respectively.

HP's mistake, in addition to questions over the amounts it initially decided to write down goodwill by and subsequently booked, demonstrates that the concept of goodwill is uncertain and open to interpretation. To determine goodwill amounts, companies usually rely on their own accountants, but they will also turn to valuation consultants to help estimate.

In reality, other tangible assets, including the depreciated value of land and equipment is also subject to estimates and other interpretations, but these other values can at least can be linked with either a physical good or asset. In contrast, goodwill is more difficult to place a firm value on. A 2009 article in The Economist described it as "an intangible asset that represents the extra value ascribed to a company by virtue of its brand and reputation."

From HP's perspective, there is little question that it had high hopes for Autonomy, which was based off its reported profit levels and the expectation that its rapid growth would continue well into the future.

How Goodwill Is Written Down

Once an acquisition is made, and provided it was a sound purchase, goodwill remains on the acquiring firm's balance sheet indefinitely. Prior to 2002, goodwill was amortized over 40 years, much the way a piece of equipment might be depreciated over a period, depending on estimates of its useful life. But since then, rules have gotten more stringent: Goodwill can be amortized on a straight-line basis over a period not to exceed 10 years. If at any time, the value declines, as happened in rapid fashion with goodwill related to Autonomy, then an impairment charge is required.

HP, and other firms that end up writing down significant amounts of goodwill, are quick to point out that a goodwill impairment charge is non-cash, and so does not affect cash flows. It represents, however, a huge past mistake that drained the corporate coffers. In regard to HP, which funded the Autonomy purchase through cash reserves, it ended up destroying billions in shareholder value, since the company is worth only a fraction of its earlier estimated value.

The Bottom Line

Goodwill impairment charges don't hurt current year cash flows, but they demonstrate mistakes made in the past by management teams. In HP's case, the decision to purchase Autonomy without sufficient due diligence and tire-kicking represented one of many instances where a serious lapse in judgment was made.

For other companies, goodwill impairment charges are generally less significant, but they still require analysts to investigate just what went wrong and if the mistake is likely to be repeated in the future, to the detriment of existing shareholders.

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