Companies in the valuation bubble

Does history repeat itself? During the financial crisis, lax accounting rules at the banks had acted like accelerators. The same could happen again in the corona crisis – but now with the companies. Two weeks ago, the German analyst Association DVFA warned: “companies accounting in accordance with IFRS will increasingly have to carry out Goodwill write - downs on goodwill in 2020, which will have additional negative consequences for their income statement and therefore also their equity capital,” the report states.

Goodwill is a type of positive goodwill that arises when the purchase price exceeds the net assets of the takeover candidate. Specifically, this means that the purchasing company receives not only the buildings, land or machines of the competitor, but also intangible assets such as a better market position, a higher innovative power or better access to Know-how. This is then referred to as company or business value (engl. Goodwill).

Here is an example: in 2018, the chemical and pharmaceutical group Bayer paid 60 billion euros for the acquisition of the US agricultural group Monsanto. Bayer estimated the Goodwill from this Deal at almost 24 billion euros. This value was based on" expected revenue synergies through combined product offering “and"expected synergies in administrative processes and infrastructures, including cost savings in sales, research and development and general administration functions”.

No more regular depreciation

Similar to machinery, buildings and other assets, Goodwill is subject to depreciation, which means that it must be written off. And this is where it gets exciting. Since 2005, listed companies have been required to report in accordance with the international Financing Reporting Standards (IFRS). However, a devaluation of Goodwill no longer takes place regularly here, but only if there is an indication of an impairment. So companies have more room for manoeuvre here. Since then, the result has hardly been a write-down on Goodwill. And this is also logical. Because managers have little interest in making write-downs. These pressure on profit, equity and share price-and thus also on bonuses. In addition, high goodwill write-downs would amount to an admission that companies have bought too expensive.

The bottom line is that a bubble has built up in many company balance sheets over the years, which now threatens to burst. The 30 Dax companies alone have currently reported a total of 317 billion euros of Goodwill in their balance sheets, ten years ago it was just under 180 billion euros. In comparison, depreciation is meagre. In 2019, it was only five billion euros. In absolute terms, the Bayer Group leads the field in terms of Goodwill with EUR 39.1 billion, or about 83 percent of equity on the balance sheet. In the case of the health care group Fresenius and Deutsche Post, a complete write-down of Goodwill would eat up almost all equity.

Risks in the balance sheets

The industry itself has already pointed out the risks that lie dormant in the balance sheets. The Institute of auditors (IDW), for example, called for the “rules to be reviewed promptly and urgently in order to prevent pro-cyclical effects of assessments”. The Analysts ' Association DVFA joined this demand two weeks ago: “the DVFA is committed to a planned write-down of Goodwill. This is the only way to prevent that loss situations are not intensified in times of crisis.“Basically, the DVFA only demands that we return to the practice that was common practice until 2004. Until then, listed companies had to write off on schedule, usually over ten to 20 years.

The International Accounting Standards Board (IASB) is responsible for maintaining and maintaining IFRS international accounting rules. Its Standards have now been adopted by all EU member states and more than 90 other countries. The IASB last deliberated on how to deal with Goodwill in June 2019 and then voted eight to six against an open discussion on the return to scheduled depreciation.

No democratic control

However, the problem is that the IASB is not a democratically legitimised Organisation at all. Rather, it is owned by the International Accounting Standards Committee Foundation, a foundation that resides in the US tax haven of Delaware. The members of the IASB are primarily former employees of National Financial Supervisory Authorities, but also of private management consultancies. The IASB is financed by the four major accounting firms PricewaterhouseCoopers, KPMG, Deloitte Touche Tohmatsu and Ernst & Young.

The founding editor of the political magazine “Die Gazette”, Fritz Glunk, has recently written a book about organizations such as the IASB. Glunk refers to such constructs as “Shadow Powers”. These are informal groups or entities in which business representatives and state authorities sit together and establish global rules. “None of these groups is elected or electable or subject to Democratic control; some of the globally agreed norms become, as they are, de facto or de jure World Economic Law,” says Glunk.

“Momentous Shift”

Regarding the IASB, Glunk believes that its work would have resulted in a” momentous shift”. In Germany, for example, essential provisions of the German commercial code (HGB) are no longer valid; instead, the requirements of IFRS apply. In essence, the two Standards differ in which information of the annual financial statements of a company they place in the foreground. While the traditional HGB model is characterized by a cautious determination of profit and has the interests of all parties involved in the company in mind, the Anglo-Saxon IFRS focuses above all on the interest of investors.

How this has a concrete effect can be seen in the Bayer-Monsanto deal mentioned above. Experts assume that this would not have taken place on the basis of scheduled depreciation according to HGB. With a Goodwill of just under 24 billion euros, Bayer would have had to write down billions of euros over the years. Management might have shied away from that.

Incidentally, two weeks ago, the Austrian brick manufacturer Wienerberger provided a foretaste of what could happen in the near future. In presenting the quarterly figures, the company stated that due to the Coronakrise Goodwill write-downs: “the Covid-19 crisis is a starter case where a company has to examine all its Assets,” said Wienerberger CEO Heimo Scheuch. Of the total write-downs of approximately 116 million euros in the first quarter, 94 million euros were accounted for by the full goodwill adjustment in the facade bricks segment in North America. “Since 1999, we have been carrying the ‘Goodwill’ with us, and I said that we will now do it once and for all instead of 10 million again and again – that means there will be no ‘Goodwill’,” Scheuch explained.