Reproduced from 1983 Annual Report of Berkshire Hathaway Inc.

BERKSHIRE HATHAWAY'INC.

Goodwill and its Amortization:

The Rules and The Realities

This appendix

deals only with economic

and accounting

Goodwill

not the goodwill

of everyday

usage, For example, a business may be well liked, even loved, by most of its customers but possess no economic goodwill. (AT&T, before the breakup, was generally well thought of, but possessed not a dime of economic Goodwill.) And, regrettably, a business may be disliked by its customers but possess substantial, and growing, economic Goodwill. So, just for the moment, forget emotions and focus only on economics and accounting, When a busines is purchased, accounting principles require that the purchase price first be assigned to the fair value of the identifiable assets that are acquired, Frequently the sum of the fair values put on the assets (after the deduction of liabilities) is less than the total purchase price of the business. In that case, the difference is assigned to an asset account entitled "excess of cost over equity in net assets acquired". To avoid constant repetition of this mouthful, we will substitute "Goodwill". Accounting Goodwill arising from businesses purchased before November 1970 has a special standing. Except under rare circumstances, it can remain an asset on the balance sheet as long as
the business bought is retained.

That means no amortization charges to gradually extinguish that asset

need be made against earnings. The case is different, however, with purchases made from November 1970 on. When these create it must be amortized over not more than 40 years through charges- of equal amount in every year - to the earnings account. Since 40 years is the maximum period allowed, 40 years is what managements (including us) usually elect. This annual charge to earnings is not allowed as a
Goodwill,

tax deduction and, thus, has an effect on after-tax income that is roughly double that of most other
expenses.

That's how accounting Goodwill works. To see how it differs from economic reality, let's look at an example close at hand. We'll round some figures, and greatly oversimplify, to make the example easier to follow. We'll also mention some implications for investors and managers. Blue Chip Stamps bought See's early in 1972 for $25 million, at which time See's had about $8 million of net tangible assets. (Throughout this discussion, accounts receivable will be classified as tangible assets,a definition proper for business analysis.) This level of tangible assets was adequate to conduct the business without use of debt, except for short periods seasonally. See's was earning about $2 million after tax at the time, and such earnings seemed conservatively representative of future earning power in constant 1972 dollars. can be expected to produce earnings such assets on considerably in The capitalized value of this excessreturn is economic Goodwill.

Thus our first lesson~ businesseslogically are worth far more than net tangible assetswhen they

excess market rates of return. of

tax on net tangible assetsthat was earnedby See's - doing it, furthermore, with conservative accounting and no financial leverage. It was not the fair market value of the inventories, receivables or fixed assets that producedthe premiumratesof return. Rather it was a combination of intangibleassets, particularly a pervasive favorable reputation with consumers based upon countless pleasant experiences
they have had with both product and personnel.

In 1972 (and now) relatively few businesses could be expected to consistently earn the 25% after

Such a reputation createsa consumerfranchisethat allows the value of the product to the purchaser, rather than its production cost, to be the major determinantof selling price. Consumer franchises are a prime source of economic Goodwill Other sources include governmental franchises not subject to profit regulation, such as television stations, and an enduring position as the low cost producer in an industry.
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Let's return to the accounting in the See'sexample. Blue Chip's purchase of See'sat $17 million over net tangible assetsrequired that a Goodwill account of this amount be established as an asse on Blue Chip's books and that $425,000be charged to income annually for 40 years to amortize that asset. By 1983, after 11 years of such charges,the $17 million had been reduced to about $12.5 million. Berkshire, meanwhile, owned 60% of Blue Chip and, therefore, also 60% of See's. This ownership meant that Berkshire'sbalance sheetreflected 60% of See'sGoodwill, or about $7.5 million.

In 1983 Berkshire acquired the rest of Blue Chip in a merger that required purchase accounting as contrasted to the "pooling" treatment allowed for some mergers.Under purchase accounting, the "fair value" of the shares we gave to (or "paid") Blue Chip holders had to be spread over the net assetsacquired from Blue Chip. This "fair value" was measured,as it almost always is when public companies use their sharesto make acquisitions, by the market value of the sharesgiven up.

The assets"purchased" consisted of 40% of everything owned by Blue Chip (as noted, Berkshire already owned the other 60%). What Berkshire "paid" was more than the net identifiable assetswe received by $51.7 million, and was assignedto two pieces of Goodwill: $28.4 million to See'sand $23.3 million to Buffalo Evening News. After the merger, therefore, Berkshire was left with a Goodwill asset for See's that had two components:the $7.5 million remaining from the 1971 purchase,and $28.4 million newly createdby the 40% "purchased" in 1983. Our amortization charge now will be about $1.0 million for the next 28 years, and $.7 million for the following 12 years, 2002 through 2013.

In other words, different purchase dates and prices have given us vastly different asset values and amortization chargesfor two pieces of the same asset.(We repeat our usual disclaimer: we have no better accounting system to suggest.The problems to be dealt with are mind boggling and require arbitrary rules.) But what are the economic realities? One reality is that the amortization chargesthat have been deducted as costsin the earningsstatementeach year since acquisition of See'swere not true economic costs. We know that becauseSee'slast year earned $13 million after taxes on about $20 million of net tangible assets- a performance indicating the existence of economic Goodwill far larger than the total original cost of our accounting Goodwill. In other words, while accounting Goodwill regularly decreased from the moment of purchase,economic Goodwill increasedin irregular but very substantial fashion.

Another reality is that annual amortization chargesin the future will not correspondto economic costs. It is possible, of course, that See'seconomic Goodwill will disappear. But it won't shrink in even decrementsor anything remotely resembling them. What is more likely is that the Goodwill will increase - in current, if not in constant, dollars - becauseof inflation.

That probability existsbecause true economicGoodwill tends to rise in nominal value proportionally with inflation. To illustrate how this works, let's contrast a See'skind of businesswith a more mundane business. When we purchased See'sin 1972, it will be recalled, it was earning about $2 million on $8 million of net tangible assets.Let us assumethat our hypothetical mundane businessthen had $2 million of earnings also, but needed $18 million in net tangible assetsfor normal operations. Earning only 11% on required tangible assets,that mundane business would possesslittle or no economic Goodwill. )

A business like that, therefore, might well have sold for the value of its net tangible assets,or for $18 million. In contrast, we paid $25 million for See's,even though it had no more in earnings and less than half as much in "honest-to-God" assets.Could less really have been more, as our purchase price implied? The answer is "yes" - even if both businesseswere expected to have flat unit volume - as long as you anticipated, as we did in 1972, a world of continuous inflation.

To understand why, imagine the effect that a doubling of lhe price level would subsequently have on the two businesses.Both would need to double their nominal earnings to $4 million to keep themselves even with inflation. This would seem to be no great trick: just sell the same number of units at double earlier prices and, assumingprofit margins remain unchanged,profits also must double. ~

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But, crucially, to bring that about, both businessesprobably would have to double their nominal investment in net tangible assets,since that is the kind of economic requirement that inflation usually imposes on businesses,both good and bad. A doubling of dollar sales means correspondingly more dollars must be employed immediately in receivablesand inventories. Dollars employed in fixed assets will respond more slowly to inflation, but probably just as surely. And all of this inflation-required investment will produce no improvement in rate of return. The motivation for this investment is the survival of the business, not -the prosperity of the owner. Remember,however, that See'shad net tangible assetsof only $8 million. So it would only have had to commit an additional $8 million to finance the capital needsimposed by inflation. The mundane business,meanwhile, had a burden over twice as large - a need for $18 million of additional capital. After the dust had settled, the mundane business, now earning $4 million annually, might still be worth the value of its tangible assets,or $36 million. That means its owners would have gained only a dollar of nominal value for every new dollar invested. (This is the same dollar-for-dollar result they would have achieved if they had added money to a savings account.) See's,however, also earning $4 million, might be worth $50 million if valued (as it logically would be) on the same basis as it was at the time of our purchase. So it would have gained $25 million in nominal value while the owners were putting up only $8 million in additional capital over $3 of nominal value gained for each $1 invested. Remember, even so, that the owners of the See'skind of businesswere forced by inflation to ante up $8 million in additional capital just to stay even in real profits. Any unleveraged business that requires some net tangible assetsto operate (and almost all do) is hurt by inflation. Businesses needing little in the way of tangible assetssimply are hurt the least.

And that fact, of course,has been hard for many people to grasp.For years the traditional wisdom - long on tradition, short on wisdom - held that inflation protection was best provided by businesses laden with natural resources,plants and machinery, or other tangible assets("In Goods We Trust"). It doesn't work that way. Asset-heavybusinessesgenerally earn low rates of return - rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses. In contrast,a disproportionate number of the greatbusinessfortunes built up during the inflationary years arose from ownership of operations that combined intangibles of lasting value with relatively minor requirements for tangible assets.In such cases earnings have bounded upward in nominal dollars, and these dollars have been largely available for the acquisition of additional businesses. This phenomenonhas been particularly evident in the communicationsbusiness.That businesshas required little in the way of tangible investment - yet its franchises have endured. During inflation, Goodwill is the gift that keeps giving. But that statementapplies, naturally, only to true economicGoodwill. Spurious accountingGoodwill - and there is plenty of it around - is another matter. When an overexcited managementpurchases a business at a silly price, the same accounting niceties described earlier are observed. Becauseit can't go anywhere else, the silliness ends up in the Goodwill account. Considering the lack of managerial discipline that created the account, under such circumstances it might better be labeled "No-Will".. Whatever the term, the 40-yearritual typically \ is observedand the adrenalin so capitalized remains on the books as an "asset" just as if the acquisition had been a sensible one.
* * * * *

If you cling to any belief that accounting treatment of Goodwill is the best measureof economic reality, I suggestone final item to ponder. Assume a company with $20 per share of net worth, all tangible assets. Further assume the company has internally developed some magnificent consumer franchise, or that it was fortunate enough to obtain some important television stations by original FCC grant. Therefore, it earns a great deal on tangible assets,say $5 per share, or 25%.

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With such economics,it might sell for $100 per share or more, and it might well also bring that price in a negotiated sale of the entire business. Assume an investor buys the stock at $100 per share, paying in effect $80 per share for Goodwill (just as would a corporate purchaser buying the whole company). Should the investor impute a $2 per share amortization charge annually ($80 divided by 40 years) to calculate "true" earnings per share?And, if so, should the new "true" earnings of $3 per share causehim to rethink his purchase price?
* * * * *

We believe managersand investors alike should view intangible assetsfrom two perspectives: (1) In analysis of operating results - that is, in evaluating underlyingeconomics a business the of unit - amortization chargesshould be ignored. What a business can be expected to earn on unleveraged net tangible assets,excluding any charges against earnings for amortization of Goodwill, is the best guide to the economic attractivenessof the operation. It is also the best guide to the current value of the operation's economic Goodwill. (2) In evaluating the wisdom of business acquisitions, amortization charges should be ignored also. They should be deducted neither from earnings nor from the cost of the business.This meansforeverviewing purchasedGoodwill at its full cost,beforeany amortization. Furthermore, cost should be defined as including the full intrinsic businessvalue - not just the recorded accounting value - of all consideration given, irrespective of market prices of the securities involved at the time of merger and irrespective of whether pooling treatment was allowed. For example, what we truly paid in the Blue Chip merger for 40% of the Goodwill of See's and the News was considerably more than the $51.7 million entered on our books. This disparity exists becausethe market value of the Berkshire sharesgiven up in the merger was less than their intrinsic business value, which is the value that defines the true cost to us.

perspective A goodbusiness not alwaysa goodpurchase althoughit's a goodplaceto look (2). is for one. We will try to acquire businessesthat have excellent operating economics measuredby (1) and

Operations that appear to be winners based upon perspective(1) may pale when viewed from

that provide reasonable returnsmeasured (2). Accountingconsequences be totally ignored. by will

l/

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