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Bad News for Goodwill Writedowns

By Tammy Whitehouse — June 3, 2008

t won’t be long before the next wave of corporate writedowns begins—this time gutting the balance sheet of “goodwill” that has accumulated from old mergers or acquisitions.

RELATED RESOURCES FAS 142: Goodwill and Other Intangible Assets (2008) White Paper: Ill-Advised Acquisitions and Goodwill Impairment (May 2008) Related Coverage FASB Resolves Intangible Assets Issue (May 6, 2008) Negative Goodwill: An Accounting Conundrum (Oct. 16, 2007)

Valuation experts believe writedowns in goodwill are inevitable, given the downward spirals the market has already witnessed in stock values and earnings. “We had five or six years of positive stock market returns, but now the last 12 months the market has been down,” says Rick Donnalley, a valuation specialist at KPMG. “That should cause CFOs to reflect on the value of that acquisition they made a year or two ago.”

Goodwill is a number that frequently appears on the balance sheet as an asset following a merger or acquisition, says Gerald Mehm, managing principal at American Appraisal Associates. When one company buys another, it allocates the purchase price of all the acquired company’s assets, both tangible and intangible—and the buyer usually finds itself with some leftover amount, too. “What’s left is goodwill,” he says.

Donnalley believes a goodwill correction is on the horizon. In the bull market that preceded this year’s market collapse, companies were all too willing to pay premium prices to make acquisitions. But the declines in stock market prices over the last six months are signals that investors aren’t willing to pay the same premiums that management did.

Donnalley

“Companies may have overpaid,” Donnalley says. “The value of the target company might have eroded, or the value of the legacy, original business might have eroded. The value of the combined company has decreased.”

Financial Accounting Standard No. 142, Goodwill and Other Intangible Assets, requires companies to check the value of goodwill at least annually to see if it has eroded and should be written down. “If the value rises, nothing happens from an accounting perspective,” Donnalley says. “But if it loses value, goodwill is impaired. That’s a direct expense that hits earnings.”

“Goodwill impairment writeoff is not a benign event. It represents the public acknowledgment of the failed nature of an acquisition.” — Feng Gu, Assistant Accounting Professor, State University of New York

Given the widespread decline in stock values in the past year, Donnalley believes companies won’t be able to claim that goodwill value has held up and should still be reported as historically presented on balance sheets. Stuart Moss, a partner with Deloitte & Touche, concurs. “I wouldn’t disagree that the overall stock market decline might lead to goodwill impairments,” he says.

Gu

According to Feng Gu, an assistant accounting professor at the State University of New York, as much as 12 percent of the value held on corporate balance sheets can be found in goodwill entries. In a recent study, Gu and his fellow researcher, Baruch Lev at New York University, sought to analyze the economic consequences of goodwill carried on balance sheets. Their conclusion: Most companies consider goodwill writedowns “a non-event,” Gu says, but the research revealed that writedowns are usually quite significant.

Gu says his research suggests companies that write down goodwill typically end up closing business units, selling assets, and laying off employees. “If you look at the entire trip from acquisition to writeoff, the shareholders of the acquiring firm are worse off,” he says. “Goodwill impairment writeoff is not a benign event. It represents the public acknowledgment of the failed nature of an acquisition.”

History strongly supports Gu’s arguments. In the last bear market of 2001 and 2002, legions of companies wrote off goodwill for overpriced acquisitions in the 1990s. Most famous was the $99 billion loss Time-Warner recorded in 2002 for its merger with America Online in 2001; almost all of that loss was a writedown of goodwill stemming from the collapse of AOL’s value.

GOOD RIDDANCE? Below is an excerpt from FAS 142, Accounting for Goodwill and Other Intangible Assets. 18. Goodwill shall not be amortized. Goodwill shall be tested for impairment at a level of reporting referred to as a reporting unit. (Paragraphs 30–36 provide guidance on determining reporting units.) Impairment is the condition that exists when the carrying amount of goodwill exceeds its implied fair value. The two-step impairment test discussed in paragraphs 19–22 shall be used to identify potential goodwill impairment and measure the amount of a goodwill impairment loss to be recognized (if any). Recognition and Measurement of an Impairment Loss 19. The first step of the goodwill impairment test, used to identify potential impairment, compares the fair value of a reporting unit with its carrying amount, including goodwill. The guidance in paragraphs 23 and 25 shall be considered in determining the fair value of a reporting unit. If the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not impaired, thus the second step of the impairment test is unnecessary. If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill impairment test shall be performed to measure the amount of impairment loss, if any. 20. The second step of the goodwill impairment test, used to measure the amount of impairment loss, compares the implied fair value of reporting unit goodwill with the carrying amount of that goodwill. The guidance in paragraph 21 shall be used to estimate the implied fair value of goodwill. If the carrying amount of reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss shall be recognized in an amount equal to that excess. The loss recognized cannot exceed the carrying amount of goodwill. After a goodwill impairment loss is recognized, the adjusted carrying amount of goodwill shall be its new accounting basis. Subsequent reversal of a previously recognized goodwill impairment loss is prohibited once the measurement of that loss is completed. 21. The implied fair value of goodwill shall be determined in the same manner as the amount of goodwill recognized in a business combination is determined. That is, an entity shall allocate the fair value of a reporting unit to all of the assets and liabilities of that unit (including any unrecognized intangible assets) as if the reporting unit had been acquired in a business combination and the fair value of the reporting unit was the price paid to acquire the reporting unit. The excess of the fair value of a reporting unit over the amounts assigned to its assets and liabilities is the implied fair value of goodwill. That allocation process shall be performed only for purposes of testing goodwill for impairment; an entity shall not write up or write down a recognized asset or liability, nor should it recognize a previously unrecognized intangible asset as a result of that allocation process. 22. If the second step of the goodwill impairment test is not complete before the financial statements are issued and a goodwill impairment loss is probable and can be reasonably estimated, the best estimate of that loss shall be recognized in those financial statements. Paragraph 47(c) requires disclosure of the fact that the measurement of the impairment loss is an estimate. Any adjustment to that estimated loss based on the completion of the measurement of the impairment loss shall be recognized in the subsequent reporting period. Source FAS 142: Goodwill and Other Intangible Assets (2008).

Still, goodwill writedowns rarely presage a collapse in stock price—because the stock price is usually in the tank by then. “The investment community has been following a stock and they know the company is struggling,” Donnalley says. “By the time a goodwill announcement is made, you very seldom see the stock price move significantly.”

Readying the Red Pen

Travers

Mary Ann Travers of the auditing firm Crowe Chizek says the tumble likely will begin in the banking sector, where earnings writedowns are most pronounced and consolidation has been heavy in recent years. “There’s been a lot of deal activity and more competition for transactions, which leads to overpayment,” she says. “In banking we’ll see definitive writedowns in goodwill.”

Purchase prices, Travers notes, often are largely based on expected future cash flows. As liquidity has evaporated in the credit markets, cash flows have dried up. Companies are likely to acknowledge they overpaid anyway, but the current market environment will contribute to the expected writedowns. “Those things are going to drive the majority of goodwill impairment,” she says.

Given the increased scrutiny that the credit crisis has brought to financial statements and valuations in general, companies also are likely to look more carefully at the value of goodwill, Travers adds. Historically, the analysis of goodwill has been conducted by management using cash flow projections, but now companies increasingly hand off the analysis to third-party valuation specialists.

“We’ve seen less-than-stellar documentation, historically speaking, when management has prepared the analysis,” Travers says. “That’s not to say the assumptions or conclusions have been wrong. But with the turn in the market, we’re going to see more external folks getting involved, heightened scrutiny by auditors, and the need for additional documentation.” Travers expects that to include not just cash flow projections, but market data as well.

Market data figure prominently in the calculation of fair value these days thanks to Financial Accounting Standard No. 157, Fair Value Measurement. FAS 157 took effect for financial assets and financial liabilities earlier this year for most entities. Measurement of goodwill, however, is not yet subject to FAS 157; that portion of the standard was deferred for one year while the market and standard setters sort out a number of unanswered questions.

Palacky

Goodwill is a “soft asset” that investors read with some skepticism, says Georgene Palacky, a director at the Chartered Financial Analyst Institute. In a recent membership poll, the CFA Institute found 59 percent of analysts make some adjustments to goodwill figures to alter or remove its effect from net income. That makes it the most commonly adjusted figure in financials statements, she says—which suggests it’s the least trusted.

Palacky doesn’t doubt there will soon be a wave of writedowns in goodwill and wonders whether companies overpaid for acquisitions in recent years because interest rates were low and debt was cheap. “Maybe people paid too much because they wanted the deal to happen,” she says.

Mard

Michael Mard, managing director of the Financial Valuation Group, says movement toward International Financial Reporting Standards is likely to lead to less goodwill on balance sheets in the future. While IFRS may still be several years into the future for U.S. companies, its adoption will lead to a different testing process likely to give goodwill a shorter life span on balance sheets, he says.

Until then, it seems plausible that companies testing values will find erosion in goodwill in the near future. “Because of the way the math works, goodwill ends up taking it in the shorts,” he says. “But when you think about it, it’s only proper. Goodwill is the only intangible asset that really cannot be identified.”

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