The coronavirus has shocked and stress tested institutions all over the world. The emergence of the pandemic, and the global panic it has caused, is a true black swan event.
A gray swan event, on the other hand, is a failure in accounting or management that damages the integrity of a company and reduces its value. At their core, these events result from a failure in transparency. These events may be infrequent, but the risk can often be anticipated and even quantified with proper due diligence.
The coronavirus has caused substantial disruption, as cash shortages cause default and bankruptcy, and it is inevitable that many companies will need to file legitimate impairments. But we suspect some companies will try to use this crisis and see an opportunity to dump billions in worthless goodwill and other assets without it creating the usual bad press.
Kraft Heinz’s Swan Song
Companies like to ascribe their failures to black swan events because it absolves them of responsibility for their failures. We have seen this before in our look at Kraft Heinz (KHC). They issued a surprise $15 billion impairment, which shocked the markets and sent the company into a tailspin. KHC claimed that this impairment was due multiple factors in one bad quarter (as if it were their own personal black swan), but a closer look shows that it was more like they ran out of fingers to stick in a leaky dam. Collapse was inevitable and probably a long time coming.
The $15 billion that set off KHC’s awful year was not enough, and 2019 saw a steady drip of bad news. When we wrote our original piece on KHC (linked above), they had already filed over $1.2 billion in new impairments for 2019, and we predicted more. Indeed, shortly after our prediction, they issued another $676 million impairment for the final quarter.
Could KHC be in danger of further impairments, even if the economy had remained strong? Consider that intangible assets and goodwill still forms over $84 billion of the KHC’s $101 billion in assets. And, the company continues to carry over $28 billion in long-term debt. Today, the net assets of the company stand at $51 billion, but the market cap is $30 billion, that implies an overvaluation of $20 billion.
So, if KHC writes off another huge chunk in assets and blame it on the coronavirus, will you believe them?
We expect many companies will blame the “black swan” for accounting issues this quarter, but how can you be sure it was coronavirus and not due to problems in their accounting? How do you tell a black swan disclosure from a gray swan one? Do the hard homework or leave it to the experts (like us!).
Here is how we think of sniffing-out a company’s own gray swan event from disclosures amid a black swan event. We’ll use potential impairments to goodwill and other intangible assets as a case in point.
M&As and Balance Sheets Bloated with Goodwill
A surge in M&As over the past decade has resulted in fewer registered companies and more goodwill on balance sheets. Whenever companies have a merger or acquisition, the tangible and intangible assets are accounted for, and amounts paid over the value of those assets is recorded as “goodwill” on the balance sheet. We see trouble here. Mergers have been relatively high, but fewer companies have been recording impairments to their goodwill recorded during the merger. Either everyone is a genius when they close their M&A deal, or they are trying to avoid owning up to overstating assets. We might see impairments happen aggressively during the coronavirus black swan event, but those simply might mask bad M&A deals.
However, another factor possibly inflating the amount of goodwill is FASB’s new guidance for (ASU 17-04) which took effect for every public company this year—although some companies had already implemented it. This accounting standard is simpler that the previous one, but it also allows companies to keep a balance sheet bloated with unknown liabilities. Take PayPal, which wrote off virtually all the assets it acquired from its acquisition of TIO Networks because of a data breach that made TIO’s assets worthless. PayPal suspended operations at TIO and impaired the assets it gained in the acquisition—except for the $170 million in goodwill—that money is still lingering around on the books. How is it appropriate to buy a company, find out it’s essentially worthless and write down all its real assets, but then retain the goodwill anyways?
The most logical reason that so much goodwill is being held on company books is because the market was on the longest bull run in history. A healthy market increased the market value of companies, which prevented their book values from looking inflated, even when loaded up with goodwill or other intangible assets. Now there is a pandemic. The market at one point lost a third of its value.
The FASB accounting standards require that companies test goodwill annually, but they also require a special test if an event triggers a concern that the market value of the company is lower than the book value. Well … it seems like every company is going to need a special test because of the pandemic. We can expect many companies will write down goodwill and other assets after those tests.
Newest Data on CAMs Indicate Goodwill Accounting is Particularly Squishy
One reason we are focusing on goodwill is because management’s accounting for it is inherently squishy. We know this because that is what the auditors tell us. Auditors are now required to report on Critical Audit Matters (CAMs), accounting areas that are particularly difficult to verify because they rely on subjective judgement of the management team. Even though the CAMs research is brand new, it has revealed that accounting for goodwill (and other intangible assets) raises more consternation than any other area.
Each of our company Watchdog Research reports includes a CAM section, with links from viewing our report on our website to the SEC filing showing that CAM.
Damage Control is Often a Practice in Deception
The subjective nature of evaluating goodwill means that the area is ripe for obfuscation and potential abuse. Companies in decline may delay writing off goodwill and other intangible assets for as long as possible, to look strong.
We already filled you in on KHC, but a disingenuous impairment by KHC might be easy to spot especially since panicked buying at grocery stores and the closure of dine-in restaurants should boost their sales. Other companies may try equally disingenuous impairments, but they might not be so easy to spot.
Take Under Armour (UA) for example. They declined to report any impairments to goodwill in their latest annual report, even though their Latin American segment has been struggling. According to UA:
The fair value of each reporting unit substantially exceeded its carrying value, with the exception of our Latin America reporting unit. The fair value of the Latin America reporting unit exceeded its carrying value by 19%. Holding all other assumptions used in the fair value measurement of the Latin America reporting unit constant, a reduction in the growth rate of revenue by 2.25 percentage points or a reduction in the growth rate of net income by 3.5 percentage points would eliminate the headroom. No events occurred during the period ended December 31, 2019 that indicated it was more likely than not that goodwill was impaired.
Here UA seems like they are trying to impress us with the precision of their measurements and soundness of their methods, but our experience tells us that these numbers are more showmanship than science.
If you aren’t persuaded by our opinion, then perhaps you should look at PWC’s critical audit matters in their independent report on UA:
The principal considerations for our determination that performing procedures relating to the goodwill impairment assessment of the Latin America reporting unit is a critical audit matter are there was significant judgment by management when developing the fair value measurement of the reporting unit, which in turn led to a high degree of auditor judgment, effort, and subjectivity in performing procedures and evaluating significant assumptions, including the Company’s long-term rate of growth and profitability.
So, if UA writes down the goodwill associated with its Latin American unit, will it be due to coronavirus or because they should have done it already?
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