Why is he critical of the accounting treatment of goodwill?

Warren Buffett's Critical View on the Accounting Treatment of "Goodwill"

Buffett has repeatedly criticized traditional accounting standards for handling goodwill in Berkshire Hathaway's shareholder letters, primarily for the following reasons:

1. Distinction Between Accounting Goodwill and Economic Goodwill

• Accounting Goodwill: Refers to the excess of the purchase price over the fair value of a company’s net assets during an acquisition. Under traditional U.S. accounting standards (e.g., APB Opinion No. 17), this goodwill must be amortized periodically (typically over 40 years), reducing reported profits annually.
• Economic Goodwill: Buffett emphasizes that this represents a business’s true economic value—such as brand strength, customer loyalty, and competitive advantages—which often appreciates over time (e.g., the brand value of Coca-Cola or Gillette razors).
• Critique: Accounting amortization ignores economic reality, distorting financial reports. Amortization artificially suppresses profit figures, even when a business’s actual profitability improves, making it harder for investors to assess intrinsic value.

2. Profit Underestimation Due to Amortization

• Buffett argues that goodwill, unlike tangible assets (e.g., machinery), does not physically depreciate or become obsolete. If an acquisition is sound, goodwill’s value manifests through higher returns.
• Example: In his 1983 letter, Buffett noted that when a company acquires an exceptional business at a premium, the resulting goodwill should not be amortized, as this would "penalize" successful acquisitions by reporting lower earnings per share than economic reality justifies.
• He criticized this approach for incentivizing managers to avoid acquisitions (to prevent profit drag) or use workarounds like "pooling-of-interests accounting," thereby distorting accounting fairness.

3. Impact on Financial Reporting

• Amortizing goodwill detaches financial statements from economic substance, misleading investors. Buffett advocates evaluating businesses using "economic earnings" rather than "accounting earnings."
• He supported subsequent accounting reforms (e.g., FASB’s SFAS 142 in 2001), which eliminated periodic amortization and replaced it with annual impairment tests. Losses are only recognized when goodwill’s value is genuinely impaired, aligning closer with economic reality.
• However, Buffett warns that even under the new rules, impairment tests may delay problem recognition if management overpays for acquisitions, creating an "accounting illusion."

4. Buffett’s Recommendations

• Investors should ignore accounting amortization and focus on "owner earnings"—calculated as net income plus depreciation and amortization minus capital expenditures.
• In multiple letters (e.g., 1983, 1990), he used Berkshire’s acquisitions (e.g., See’s Candy) to demonstrate that economic goodwill far exceeds its accounting value and should not be "obliterated" by amortization.

In summary, Buffett’s criticism stems from accounting standards failing to reflect goodwill’s enduring economic value, which distorts financial reporting and investment decisions. He stresses that true valuation must be based on economic substance, not accounting formalism.