In the past, goodwill (in the financial sense) was a concept that only a bean counter could know, love and worry about. However, in our world today, represented by post-Enron financial scrutiny and laws that require business executives to personally certify the accuracy of their companies' financial statements, goodwill has become top of mind for many people. Nearly every week we see company earnings reports that chronicle sometimes massive goodwill impairment charges.
What is going on here? What's all the fuss about goodwill? Why should we care?
When a company buys another firm, it must appraise the fair market value of the target firm. If the purchase price is higher than the fair market value, the premium must be recorded on the acquiring company's books as goodwill. Therefore, goodwill is basically an intangible asset that represents the target firm's ability to generate additional profits or value for the acquiring company which may result from the target's reputation, brand, customer list, distribution capabilities, strategic partners, etc.
In the past, companies were required to amortize goodwill (completely write it off) in equal increments over a period of up to 40 years. The amortization of goodwill was a noncash charge that reduced reported income for the company. Because of the negative effect of goodwill amortization, companies avoided booking of goodwill, choosing another accounting method called pooling of interest for business combinations whenever possible. Pooling of interest accounting did not create goodwill and required no charges to current earnings.
In mid-2001, the Financial Accounting Standards Board (FASB), which governs the use of generally accepted accounting principles (GAAP), released two standards rulings Statement of Financial Accounting Standards (SFAS) Numbers 141 and 142 that affected accounting treatment for acquisitions. SFAS 141 eliminated the use of pooling of interest accounting treatment for acquisitions, and SFAS 142 eliminated the amortization of goodwill, which had the effect of allowing companies to keep premiums paid in acquisitions on their books indefinitely. However, lest you think that SFAS 142 would be too favorable, consider this. A company must now conduct an annual impairment test to determine whether its goodwill has permanently declined in value. If an acquisition is no longer worth what a company paid for it, the goodwill must be written down to reflect the current value. Companies are now trading a ratable goodwill amortization for goodwill impairment.
This change in accounting treatment has resulted in significant problems for companies that overpaid for their acquisitions during the bull market frenzy. As the economy slowed, some companies were not able to make good on the promises that prompted their acquisitions. For example, AOL Time Warner recorded a goodwill impairment of $54 billion in 2002, reflecting its difficulty in realizing the value of the merger of AOL with Time Warner. Many other companies have recorded lesser, though similarly painful, impairment amounts in their quest to comply with the new rulings.
In their ruling change, the FASB concluded that treating goodwill as a wasting asset with predictable deterioration over long periods of time was not realistic. Rather, the FASB recognized that goodwill can quickly decrease in value based on changing economic and market conditions. In addition, the FASB rulings required that all business combinations be accounted for in the same manner by eliminating the pooling of interests method. This puts all companies on a level playing field, albeit one that can result in more earnings volatility.
Why should non-accountants care about this change in accounting for goodwill? Financial viability is an important indicator of company health, and non-accountants are going to be required to understand some accounting basics such as goodwill impairment to assess company health. The bean counters need to know the rulings in depth, but others need at least familiarity with the concept and its implications for their own companies as well as the companies with which they do business.
The Enron scandal has had a ripple effect on the accounting industry. One implication we can't ignore is that we all have to get smarter about accounting rules. The Enron lesson is that we can't just leave accounting to the accountants. All companies using generally accepted accounting principles and conducting acquisitions of other companies will need to comply with SFAS 141 and 142. A large amount of goodwill on a company's balance sheet could be an indication that the company's acquisition premiums, which may have been justified at the time of acquisition, may result in future write-downs based on the annual test for impairment. This puts us all in the position of being goodwill hunters.