Well, I just can’t seem to get away from this subject. You all keep writing, and in doing so, engender material for follow up columns. Hopefully, this will be the last for a while, but a couple of letters bought up important points that I wanted to address today.

The Goodwill Games

One reader inquired as to why I described goodwill as “funny money” in my last column on the subject. Here’s my explanation:

When company A acquires company B, a premium is usually paid. This premium, often referred to as goodwill, is mathematically calculated as the difference between the price paid for the company and the value of the assets acquired. Some companies reflect this difference against their bottom line and write off the goodwill over a number of years. This is called purchase accounting. Some companies use a pooling of interests method of accounting, which blissfully ignores the premium it pays for companies. With the pooling of interest method of accounting, the earnings statements and balance sheets of the two companies are simply combined, hence the term “pooling of interests.”

The differences between these two accounting methods are described in detail in this Motley Fool article.

Earlier this year, new FASB standards went into effect that eliminate the pooling of interest method of accounting. But at the same time, it put into effect new rules that effectively enable companies to effectively ignore goodwill. All of which means that from this point forward, most companies will exclude goodwill on their financial statements.

I know that some would argue that goodwill is a good way to determine whether one company overpaid for another. I would caution people because such judgments are likely to change over time. Right now, for example, it appears that JDSU grossly overpaid for ETEK and SDLI. Perhaps three years from now, these acquisitions will look like bargains. One never knows. But even if JDSU did overpay, they overpaid with their own inflated stock.

Charge It (and Forget It)

Another reader asked how I felt about excluding one time expenses from earnings per share? Well I’ll tell you how I feel about that.

When I was a young newlywed, I developed a monthly budget. The first few months, we blew the budget due to the occurrence of some significant, unexpected “one time” expense that we could not have predicted and budgeted for. At first, our attitude was, “This won’t happen again. Our budget is realistic.” But as the months and years wore on, we realized that a month without some major unexpected one time expense was the exception, rather than the rule. We couldn’t exclude them from our budget, even if we couldn’t label them in advance. They may have been “one time expenses”, but they sure as hell were dilutive to my earnings.

And that’s how I feel about the exclusion of one time expenses on earnings statements. I think that they should be itemized on the earnings statement so that an investor can make judgments regarding the nature of such expenses, and that they should not be excluded from the consensus / headline statement of earnings per share. These are real expenses people, not funny money. Furthermore, have you ever noticed that once a company begins taking one time expenses for restructuring charges, that these one time expenses have a way of reappearing quarter after quarter? There’s no mystery here. Once a company begins restructuring, it is not at all unusual for a company to have to continue restructuring over a period of time — sometimes until the company restructures itself out of business! But everything sure looks good until they close the doors and turn out the lights!

Most restructuring charges are tantamount to management errors. We screwed up. We have to layoff people. To Ignore them is to ignore mismanagement. In my opinion, the single biggest folly in pro forma accounting is that of ignoring restructuring charges.

But if we are going to continue down this slippery slope of pro forma accounting, I would like to argue that it should be practiced in all businesses. That is why I am pleased to report that, by the magic of pro forma accounting, the Atlanta Braves won the series with the Arizona Diamondbacks. Ignoring the pinch-hit homerun in game 3 against Tom Glavine (a one time event), and the unearned runs scored by the Diamondbacks in games 4 and 5 (errors that obviously should be excluded from earnings), the Braves actually won games 3, 4, and 5, and hence the series.