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Goodwill Valuations – The Good, The Bad and The Ugly

August 8th, 2011

Because of the current recession and related bear market, practically every company will need to pay greater attention to its annual goodwill impairment test required under Financial Accounting Standard 142 (“SFAS 142″). Many companies performing an updated goodwill impairment analysis will find that impairment has occurred.

In addition, earlier goodwill assessments probably need to be altered. Starting this year, SFAS 157’s fair value accounting is now mandatory. This new accounting pronouncement eliminated some of the diversity in practice that had previously existed in goodwill assessments. Even without the recession and changing valuation landscape, previously acceptable goodwill appraisals might not pass the new SFAS 157 rules. Most importantly, SFAS No. 157 defines fair value as an exit price, or how much could be obtained upon sale of the asset. Considerations of entity-specific rationales that are not reflective of what the marketplace would pay are no longer acceptable.

What is Goodwill? What is its Proper Accounting?

When a company buys another firm, the purchase price is allocated among the various components of the acquired business. This allocation is based on the appraised value of the underlying assets. If the purchase price is higher than the fair market value of the acquired business’s identifiable net assets, the excess purchase price is labeled goodwill.

Prior to SFAS 142, goodwill was written off as an expense (called “amortization”) over the estimated life of the goodwill, but in no case more than 40 years. This caused the goodwill value to be reduced gradually. Under the current rules, goodwill is no longer written off slowly. Instead, a company must evaluate the value of goodwill each year, and write down any goodwill in excess of its current value. Accountants call these write-downs “impairment”. When goodwill impairment occurs, it must be presented as a separate line item on the income statement.

Goodwill is identified at the reporting unit level. Generally, companies with different types of operations or businesses will have multiple reporting units. Testing for goodwill impairment requires that each reporting unit with goodwill be valued.

Potential goodwill impairments are identified by comparing the fair value of each reporting unit to that reporting unit’s accounting carrying amount (including goodwill). Goodwill is not impaired as long as the fair value of the entire reporting unit is greater than its carrying value. If the fair market value of the entire reporting unit is less than its book value, then a goodwill impairment loss is recognized to the extent that the goodwill book value exceeds its implied fair market value.

Private company compliance is generally poor

Most large, publicly-traded companies are aware of the rules, and their outside auditors are checking compliance. The financial statements of these companies probably comply with SFAS 142. But the same cannot be said for the financial statements of private companies.

Regardless of whether your (or your client’s) company is public or private, SFAS 142 rules apply. Appropriately determining value requires business appraisal expertise, which most moderate and small companies do not have internally.

For obvious reasons, some private companies might ignore the need for an annual test, but this could lead to violation of contractual obligations and fraud allegations. Without a proper assessment, the potential results include:

  1. Most acquisitions include representations and warranties that the financial statements are prepared in accordance with Generally Accepted Accounting Principles (“GAAP”). Without the required analysis, these representations cannot be made responsibly.
  2. Commercial loan agreements generally require periodic submissions of GAAP financial statements to the lender. To be in compliance with these requirements, an annual goodwill assessment is needed.
  3. Commercial loan agreements often include financial covenants based on GAAP financial statements. Once goodwill write-offs occur, loans may be in default. Proactively addressing this situation with the lender is almost always preferable to having the lender raise the issue.
  4. In the event that proper assessments are not made and losses occur, plaintiffs will claim that the accounting failure was so great as to indicate a purposeful hiding of the truth, or fraud. Executives and professionals involved with such financial statements could become personally exposed.

 

Fulcrum Inquiry performs business appraisals for a wide variety of financial reporting, tax, transaction, intellectual property, and litigation purposes.