Goodwill hunting, the sequel

Does he regret that lunch?

Modern accounting defines goodwill as an intangible asset created when a company purchases another firm for a price higher than its book value.

Back in 1906, when Lawrence Dicksee first published Goodwill and Its Treatment in Accounts, the definition was a little different. He described it as “the probability of old customers going to the new firm which has acquired the business”. In earlier times goodwill was even written as god willa, which had implications of failing to act in good faith. And this older expression seems to have regained its relevance in China’s A-share market, with investors getting pummelled by profit warnings that cite goodwill impairments as a key cause.

In the four trading days before the Chinese New Year up to 260 A-share firms warned shareholders to expect losses or lower profits in the upcoming reporting season. Securities Daily calculated that the companies would be reporting aggregate losses of Rmb280 billion ($41 billion) for the fiscal period. Many of them mentioned goodwill charges as a reason and the trend has continued through February.

The dubious accolade of “lossmaking king” belongs to Zeus Entertainment, which warned that its losses for the year ending last December would reach at least Rmb7.8 billion (almost twice as much as the company’s market value, Securities Daily noted).

Zeus has previously stayed out of the headlines, bar the time that its boss Zhu Ye spent $2.35 million on a charity lunch with Warren Buffett (see WiC297). According to Zhu, the best tip from the Sage of Omaha was not to buy stocks you don’t understand although something must have got lost in translation as Zhu has taken Zeus from wooden floor making into online games (where it competes with the deep-pocketed titans Tencent and NetEase).

National Business Daily reports that Zeus spent more than Rmb12 billion on buying at least 12 companies as part of its transformation. These acquisitions resulted in Rmb6.5 billion of goodwill being assigned (as of last September) with Zeus then announcing last month that it was writing down Rmb4.9 billion of the value.

Zeus is not alone in running up large amounts of goodwill on its books. Citing figures from financial data provider Wind, China Economic Weekly has noted that the aggregate goodwill sitting on A-share firms’ balance sheets was less than Rmb100 billion in 2010. But a busy M&A spree since then – especially after 2015, when it became easier to finance takeovers with borrowed cash – saw the figure jump to nearly Rmb1.5 trillion by September last year.

Companies are now starting to recognise that a lot of this business came at implausibly high prices. But changes in accounting standards are also playing an important role. In an effort to prevent takeovers at inflated values or limit situations in which firms play around with the value as a way of avoiding taxes or boosting earnings, the China Securities Regulatory Commission now requires that they re-evaluate their goodwill at least once a year.

This has pushed some companies to take the charges now rather than keep the goodwill on their books and risk future delisting brought about by several years of losses, China Daily points out.

China Economic Weekly also notes that other firms stand accused of “manipulating” their financial statements by taking hefty, one-off charges to prepare themselves for more upbeat earnings ahead.

This kind of scenario has also got the attention of regulators, especially on the ChiNext board in the Shenzhen Stock Exchange, where some of the biggest charges have been taken.

Goodwill averages 21% of net assets for companies on the ChiNext Index, versus 4.4% for Shanghai’s main board, Bloomberg says.

Zeus is one of the companies regulators have singled out for greater scrutiny over how it manages its balance sheet. According to National Business Daily, stock market watchdogs have already sent requests for a more detailed explanation of its accounting policies.

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