Goodwill Valuations - The Good, The Bad And The Ugly

Updated February 2006

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Rules involving accounting for goodwill are being ignored by many privately-held companies. Those involved will be in violation of contractual obligations and potentially face allegations of fraud.

Based on current market conditions and the huge write-offs that have already been reported by public companies, the possibility of a material goodwill write-down at your client or company is very real. Without a proper assessment, the potential results include:

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 can not be responsibly made.
Commercial loan agreements generally require periodic submissions of GAAP financial statements to the lender. To be in compliance with these requirements, an annual assessment of goodwill is needed.
Commercial loan agreements often include financial covenants based on GAAP financial statements. Once goodwill write-offs occur, loans may be in default.

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.

What is Goodwill, and 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 value of specifically identified assets, the excess is recorded as goodwill. This premium is paid because the acquirer believes the acquired firm will generate substantial profits. The value of those future profits is recorded immediately as an asset.

The current accounting rule is Statement of Financial Accounting Standard 142 ("SFAS 142"). Prior to this statement, 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 now evaluate the value of the goodwill each year, and write down any goodwill in excess of its current value. The write-downs are called an "impairment charge".

Prior to SFAS 142, the initial recording of goodwill was sometimes avoided completely by an accounting method called a "pooling of interests". Now, pooling of interests is no longer allowed. This means that goodwill will be recorded more frequently.

The Good

When followed, the new rules provide lenders, investors and others important information. They require elimination of bloated assets from the balance sheet. The impairment charge also provides a way to evaluate management's decision-making, rather than having the impact of bad decisions bled slowly into the income statement as annual goodwill amortization.

Because not all purchases qualified as a pooling of interests under the old rules, acquisitions were treated much differently depending upon which rules were applicable. SFAS 142 eliminated the use of pooling of interests method, making accounting for acquisitions more consistent.

The Bad

SFAS 142 allows a great deal of discretion and judgment in valuing goodwill. Appropriately determining value requires business appraisal expertise, which most moderate and small companies do not have internally. Some executives will no doubt avoid reality with the hope that favorable events will boost their company's value, thus avoiding the write-down.

The rationale behind SFAS 142's no amortization of goodwill was previously discredited. Because the useful life of goodwill is uncertain, the argument is that one should do nothing and trust that the impairment test will take care of everything. These same arguments were used generations ago to support not depreciating any long-lived assets. Properly maintained, such assets were claimed to last forever. Besides, why should there be any expense charge if the assets were not declining in value? Because the well-established principle of decreasing asset values over time is no longer applicable to goodwill, asset overstatements will occur if the annual goodwill assessment is not made.

Goodwill write-downs under SFAS 142 are usually whitewashed. At the time of a goodwill write-down, the company typically stresses the "one-time" and "non-cash" nature of the expense. Users of the financial statements are thereby encouraged to ignore the impairment charge. Too many analysts happily oblige. However, the reality is that goodwill represents the purchased ability to generate future earnings. Without amortizing goodwill, the cost of acquiring these earnings is not recognized. Under SFAS 142's impairment approach, a write-down is taken in the wrong period, when the acquired company or product is no longer sufficiently profitable. The company's explanation never discloses the painful truth that this "one time" charge is really the delayed correction of overstated profits for prior periods. Similarly, they do not disclose that the "non-cash" charge was once paid for with either (i) real money, (ii) real debt, and/or (iii) real issuances of stock that diluted existing shareholder interests.

The Ugly - Material Accounting Overstatements Are Likely Right Under Your Nose

Most large, publicly traded companies are aware of the new 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. Private company compliance is generally poor.

Regardless of whether your (or your client's) company is public or private, SFAS 142 rules apply. If your company has any goodwill or other intangible assets on its financial statements, take the following test:

Did your company make an acquisition in the second half of the 1990's?
Is your company in an industry where stock prices of the public companies have declined?
Are your earnings less robust as they were a few years ago?

The majority of companies with acquired goodwill will answer "yes" to at least one of these questions. Even a single "yes" means that a serious review is needed.

These detailed accounting and valuation rules are quite specialized. Our firm's expertise in both accounting and valuation allows us to provide comprehensive advice. When disputes arise regarding these issues, our litigation experience separates us from other financial experts.