Here We Go Again

True North and its predecessor, Foote, Cone & Belding, have a history of finding land mines where competitors haven’t even found a minefield; its litigious relationship with France’s Publicis comes to mind. But the company, much like a stalwart centipede, soldiers on despite the occasional loss of a foot.

The latest detonation resulted, reported the company, from a routine inquiry made to the Securities and Exchange Commission concerning an arcane accounting issue. Acquisitions are common in the marketing-services industry, and many of these deals are made using an earn-out formula. The seller gets paid when the deal closes, but may earn more later. How much more depends upon the acquired company’s financial performance over the earn-out period, typically three to five years in the future.

The feds were fine with True North’s accounting for these payments. But once they looked into their financials, they questioned something else: “intangible assets,” something of value that has no physical being. The most familiar of these is “goodwill.”

The concept has economic logic in cases involving basic industries, where one company might buy another and get valuable hard assets, such as factories and inventories. Any price paid above the market value of these hard assets, plus the value of any other intangible asset—like the secret formula that gives the product its special appeal—is goodwill.

Since almost nothing lasts forever, companies’ financial statements reflect the gradual loss in value of most assets. They aren’t required or allowed to show the entire acquisition as an expense in the year it occurred.

The rules also assume goodwill doesn’t last forever. So how to account for this presumed loss of value? Arbitrarily. The rules require that goodwill be shown to lose value—with a corresponding amount indicated as an expense on the company’s profit statement—over a period not to exceed 40 years. Why 40? Why not?

Clearly, some intangible assets can be ascribed a legitimate value and a measurable life span: a magazine’s list of paid subscribers or an ad agency’s below-market lease. The schedule for or amortizing the write off of these items must be derived from the particulars, case by case. But in marketing services, coming up with the valuation details of identifiable intangibles isn’t worth the effort. So most of an acquisition’s purchase gets lumped into goodwill and amortized over a long time span.

That’s what the government accountants seized upon. Some of the goodwill probably included assets that had measurable and finite lives—and probably less than 40 years. So the SEC ruled that 40 years was too long; 20 years would be better.

Even mathophobes can see that X divided by 20 will yield a bigger number than X divided by 40. So the amortization expense using the 20-year standard will be greater. Thus, the profit reported will be less than otherwise because that one expense got bigger. Does it matter? Nope. The “expense” is phantomlike and doesn’t represent an outflow of cash.

Where does that leave us? Struck by True North’s propensity for running into the goofiest of problems.

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