You may have heard in the news recently about some of the huge write-offs taken by companies like Nortel. You may wonder how it’s possible that a company can just extinguish billions in assets with a stroke of a pen. The majority of those assets are intangible, that is, they cannot be seen or touched. Sometimes it might be a trademark or a patent, but usually those intangibles consist of something called goodwill.
What the heck is goodwill? If Company A buys Company B, they usually have to pay more than just the value of Company B’s assets. That extra amount they pay is called goodwill. So if Company B has $10 million in assets on their books and Company A pays $25 million for Company B, they are getting $10 million in assets and $15 million in goodwill.
You might say “So what?”. Well the IRS now gets into the picture. They tell company A that they can’t take an income tax deduction for that $15 million right away. Instead they have to depreciate it over a period of years. That $15 million is carried on their balance sheet as goodwill and slowly written off. But if it becomes apparent that the goodwill they purchased is basically worthless, then the IRS allows them to write it off all at once. That is where those big write-offs come from, it’s writing down goodwill that turned out to be bad news.
A very important point about this whole intangible asset thing. If a Company X buys a patent from Company Y, it becomes an intangible assets on Company X’s balance sheet. But if Company X develops it’s own product and patents it, it doesn’t show up on the balance sheet anywhere. Only purchased intangibles appear on the balance sheet. What this means is, if you are comparing companies, to compare apples to apples, generally you should subtract all intangibles from both companies. Otherwise you may get a distorted view of their total asset picture.