More on Goodwill, Internal Controls

Today I want to circle back to that lawsuit the SEC filed last week against Sequential Brands for failing to impair its goodwill assets in a timely manner. It’s a glimpse of poor internal control that raises an intriguing question: How many other companies might be in a similarly precarious position? 

After all, goodwill has been piling onto the corporate balance sheet for years. Valuing goodwill is just as much qualitative art as it is quantitative science, and the internal controls to govern goodwill assessment — the evidence gathering, the management reviews, the documentation — can be pretty squirrelly at some firms. 

So what factors would make a company vulnerable to the sort of shenanigans outlined in the SEC’s complaint against Sequential? And what should a company consider as it designs internal controls for such a crucial line item?

Let’s begin with the circumstances that could leave a company vulnerable to goodwill impairment abuses. As one reads the SEC complaint against Sequential, three things stand out. 

First, goodwill assets were a significant portion of total assets: 21.4 percent in 2016, the year mentioned in the SEC complaint. So goodwill was a material line item for investors, and a tempting target for earnings manipulation. 

Second, Sequential used a straightforward benchmark to determine the fair market value of its goodwill assets: the company’s market capitalization. So even if executives were tempted to inflate the value of goodwill, the company had a clear, empirical benchmark that could disprove any inflated values. That’s not always the case; other firms might calculate fair market value according to the performance of operating divisions or other metrics, where fudging the value of goodwill is easier to accomplish. 

Third, Sequential had weak internal controls over how and when executives assessed the value of goodwill assets. So even if fudging the value of goodwill was a bad idea (see empirical benchmark, above; able to disprove inflated values), weak internal controls could let an unscrupulous executive try anyway.  

Who Has Lots of Goodwill?

I was curious to know how many firms have a significant portion of their total assets reported as goodwill. So I went to Calcbench.com, a financial data warehouse, to answer that question for the S&P 500. (Disclosure: Calcbench.com pays me to do editorial work for its blog. The folks there were not involved in my post here.)

Figure 1, below, shows how goodwill has grown as a percentage of total assets over the last seven years. The blue line notes quarter-to-quarter changes, and you can see a sharp drop at the start of this year when the pandemic prompted lots of companies to impair goodwill. The red line, however, notes the overall trend — and the trend is upward, from 7.09 percent at the start of 2014 to 8.78 percent today.

 

 

Still, this picture represents the S&P 500 altogether, and 8.78 percent isn’t a huge amount. So I also looked at S&P 500 firms individually. Figure 2, below, shows the 10 firms with the largest percentage of total assets tied up in goodwill as of Q3 2020. 

 

 

Overall, 59 companies in the S&P 500 reported at least 40 percent of total assets as goodwill; nearly 200 had at least 20 percent of total assets reported as goodwill. 

That’s a lot of companies with a material amount of goodwill on the balance sheet — like, really material. Which makes the internal controls to govern goodwill testing and impairment that much more important.

Which brings us back to the SEC’s allegations of poor internal control at Sequential Brands. What were the details there? 

Goodwill & Internal Control Design

As we noted in our previous post, Sequential had only one internal control to govern goodwill impairment testing. It’s short enough to reprint in its entirety from the SEC complaint:

On an annual basis, or as triggering events occur during the year, the DAER [Director of Accounting and External Reporting] completes an impairment assessment of Goodwill and Intangible Asset accounts to determine if an impairment of the intangible asset has occurred. In addition, a memo detailing the review is provided to the CFO and VP Finance review. The CFO/VP Finance review includes discussion with the DAER of any noted triggering events, and the calculation of the respective impairment charge, as noted within the impairment memo. All intangible asset impairments are recorded in the [General Ledger] during the period in which the asset’s carrying value is considered to have exceeded its fair value.

In its complaint, the SEC flagged several flaws in an internal control like that:

• No process to identify events that would trigger a test of goodwill impairment. Instead, the control only requires a test “as triggering events occur,” but lets management decide for itself when and what those events might be. 
• No requirement to document management’s conclusion that no triggers were identified.
• No documentation to show that any Sequential employee was monitoring indicators of impairment — like, say, a prolonged and sharp decline in share price, which the accounting standard for goodwill specifically mentions as a triggering event. And which Sequential experienced in 2016. 

Put simply, an internal control like what Sequential outlined above is all subjective judgment, no objective fact. That’s way too loosey goosey for a line item that might account for the majority of your company’s total assets. 

Effective internal control over goodwill assessment depends as much as possible on objective, data-driven evidence. Sure, the CFO and other financial executives still make the final decision on whether an impairment is necessary, but your internal control should be designed to force their hand — that is, the review and testing generate so much evidence that it’s nearly impossible for management to put the results aside and rely on their own subjective judgment.

Why Am I Harping on This?

I’m harping on this because many businesses only assess goodwill once a year (as required by the accounting standard) in the fourth quarter. For most companies, that’s now — after a year of pandemic, recession, stock market collapse in the spring, and stock market rebound in the fall. This year has been a blizzard of external events pressuring goodwill. 

Moreover, the stock market has surged to new highs lately, and the prospects of mass covid vaccinations and the departure of President Trump portend for an even rosier market in 2021. Those forces could tempt some people to keep quiet about goodwill impairment issues, hoping that perhaps better times in 2021 will let you get away with papering over impairment trouble you have right now.

You could only do that if you have internal controls weak enough to let you do that. 

Now the SEC has filed this complaint against Sequential, accusing the company of trying exactly that stunt four years ago. Perhaps the agency is sending the rest of us a signal that we should not try something similar today.