Table of Contents | Published in March 1995

Goodwill: What Is It Really Worth?

Companies are looking at what goodwill is really worth

By PS | March 1995

Companies are looking at what goodwill is really worth

» Inside Goodwill

The reverse leveraged buyout phenomenon of the past several years has turned the recoverability of amounts recorded as goodwill on corporate balance sheets into a major accounting issue. It can be summarized in one question: What are goodwill assets really worth, and is their carrying value recoverable?

The Accounting Principles Board's Opinion No. 17, issued in 1970, requires preparers to assess the value and future benefits of all intangibles, including goodwill, and to write down goodwill if it is too high. But it supplies no guidance to aid in determining when, and by how much, goodwill's economic value might have been diminished.

Now, however, the Financial Accounting Standards Board is contemplating a new standard that addresses the issue of asset impairments. It focuses on long-lived assets, whether tangible or intangible, and includes goodwill in its scope. While the board has yet to give its final approval, in its current form the proposed standard will be effective for fiscal years beginning after June 15, 1995. Under its provisions, long-lived assets must be reviewed for impairment once events or changes in circumstances show that the carrying value of the assets may not be recoverable.

If properly enforced by auditors and regulators, this statement should produce asset values that are more reflective of a company's underlying economics. In that regard, investors should welcome the new FASB impairment standard-even if it causes a rash of asset writedowns-because their primary concern is that balance sheets show asset amounts that are realizable. Given the puffiness of some balance sheets due to goodwill, investors ought to be glad that this standard compels managements to perform some kind of quantified analysis of their goodwill's worth.


Inside goodwill

Goodwill represents the excess earnings capacity of an acquired entity's net assets. Excess earnings capacity means the ability of an enterprise to generate superior earnings compared to its competition. It can result from business attributes such as a stellar management team, a natural monopoly on low cost production inputs, or an extremely satisfied customer base, among others.

When a rational acquirer buys an entire company possessing superior earnings ability to its peers, the total price reflects that ability. It will not be captured simply in the fair value of the tangible assets, which represents only what those items are worth separately-not how much they are worth when combined with all other business attributes to create a "superior earnings vehicle." Therefore, some part of what an acquirer pays for a superior company should logically include a premium for this excess earnings capacity. In economic terms, this is called goodwill.

So much for the theoretical world of economics, where ephemeral goodwill represents something worth purchasing with hard dollars. In the real world, what winds up in goodwill accounts may-or may not-represent a payment for excess earnings capacity.

Often, it represents a payment for excess ego capacity during a bidding contest. The current spate of "blowout bids," designed to shut out bidding competitors for a company, can create more goodwill than may be justified under the traditional economic view. For many leveraged buyouts, goodwill may have been created under similar circumstances. Warren Buffett once pointed out waggishly that given the lack of managerial discipline that creates goodwill accounts, perhaps a better label might be "no-will."

Some companies have already begun looking hard at the recoverability of their goodwill balances. In early 1993, for example, Supermarkets General contemplated a return to the public markets-the company had been absent since its 1987 LBO. In its filings with the Securities and Exchange Commission, the company revealed a writeoff of $600 million in LBO-related goodwill. Numerous other companies have made large goodwill writeoffs using a variety of methodologies.

In each case, the purpose was to determine whether or not goodwill had been impaired. Some used projected undiscounted cash flows; others, projected net income; and some used future operating earnings. But until FASB took up the issue, there was no standard methodology for determining goodwill impairment spelled out in the accounting literature.

Under the proposed FASB standard, projections of continuing losses from a particular asset would indicate an impairment; so would a change in the legal or business environment that affects an asset's utilization. If a possible impairment exists, a company would first be required to estimate the future cash flows of the asset-including those from its ultimate disposition. If the sum of those cash flows is less than the carrying value of the asset, then the asset would be considered impaired.

An impaired asset would have to be written down to its fair value. If an active market exists-unlikely in the case of most long-lived assets-this would be represented by market value. If fair value cannot be determined in this way, it would be presumed to be represented by the cash flow projections discounted at a rate commensurate with the risk involved. The difference between the discounted cash flows and the carrying value is the amount of the impairment loss to recognize in the company's operations.

How does goodwill figure into this? If goodwill was present in the purchase price, it is part of the asset base being tested. If the cash flow to be generated from the assets will not recover their total costs-including goodwill-then the goodwill carrying value is unjustifed. The impairment charge is applied first to goodwill. The assets alone could not be impaired-so the goodwill gets written down. If the impairment charge is greater than the goodwill, then the remaining asset base will be written down.

So the standard is most likely to cause writedowns to multiply among acquisition-happy companies and reverse LBOs. That is because if goodwill gets written down, as a result of this standard and assets reflect "what really is," these companies are the most likely to be affected.

Investors should note that goodwill writeoffs are a good news, bad news kind of affair. The good news: earnings will be unimpeded in the future by fixed, non-cash charges related to assets that will not ever be realized in full. Stated earnings will be closer to the entity's underlying cash flows. Balance sheets' asset values will reflect expected cash flows, and return on equity may actually mean something going forward.

The bad news: a goodwill writedown is an implicit admission that an adverse price was paid for a past acquisition-an acknowledgspment that an acquirer did not really know what it was getting into at the time. If return on equity means anything in the future, remember that it is only because a management has first confessed how much of shareholders' capital has already been squandered.

That probably explains managements' past reluctance to write down goodwill when it first appears impaired-if they are the same ones who engineered the associated acquisition, they will not want to call their own judgment into question. When management takes a goodwill writedown on its previous acquisition foray, then prepares to make a new purchase, investors might do well to listen skeptically to their implied message: "This time we know what we're doing."

- Jack T Ciesielski