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.
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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