Corporate Goodwill, the Next Big Write-off

By: Hans_Wagner

Corporate earnings are in a tailspin, falling to new lows as we have seen in the latest quarterly reports. As sales falter, companies scramble to shore up their financial statements. Writing off assets is becoming more commonplace. Those companies that have large amounts of goodwill on their books are encountering additional review.

As the risk of losses grows, it pays to look carefully at the goodwill line item on the balance sheet of any company you own or are considering. For example, Flextronics, the large electronics manufacturer, wrote off the entire value of its goodwill, a total of $5.9 billion. “The impairment charge was driven by a significant decrease in the company's valuation” when compared to the September 2008 quarter, management stated. The write of was primarily attributed “declines in the stock market and adverse macroeconomic conditions.”

Investors anticipated the goodwill write off by Flextronics, so the impact on the share price was a non-event. However, such a write off could be a surprise to other firms.

What is Goodwill

Goodwill is an intangible asset on the balance sheet that is used to value a strong brand name, good customer relations, good employee relations, patents, and proprietary technology. Goodwill arrives on the balance sheet when a firm acquires another for more than the book value of assets acquired. When a company pays more than the book value for a company, the difference between the price paid and the book value of the assets is classified as goodwill.

SFAS 142 is the accounting rule from the Financial Accounting Standards Board (FASB) that defines how to treat goodwill. The rules requires that companies are to assess goodwill for impairment at least annually. If goodwill is deemed to be impaired, its carrying amount is reduced and an impairment loss is recognized on the income statement. This means that the amount spent for an acquisition is no longer worth what was paid.

Under the rules, all goodwill is assigned to the company's reporting units that are expected to benefit from the goodwill. The goodwill is tested at least annually to determine if the recorded value of the goodwill is greater than the fair value. If the fair value is less than the carrying value, the goodwill is said to be “impaired” and must be charged off. This reduces the value of the goodwill on the balance sheet to the fair market value. This is a just like a mark-to-market charge for financial assets only it is for goodwill.

If the goodwill impairment charge is sufficiently large, it can cause the company to report a significant earnings loss. As every company will point out, goodwill impairment does not involve a loss of cash. Keep in mind that the company cash or cash like securities like stock to acquire the company that caused the goodwill to be entered as an asset on the balance sheet.

Due to the current recession and bear market, every company will need to pay greater attention to its annual goodwill impairment test. Companies that perform a goodwill impairment analysis will discover that an impairment has occurred. These companies are faced with a new accounting pronouncement designed to eliminate some of the different approaches used in prior goodwill assessments. SFAS 157's fair value accounting defines fair value as an exit price, or how much could be obtained upon a sale of the asset.

Using the detailed rules Goodwill impairment goes through a two-step process:
Step 1: Test for Potential Impairment
Step 2: Measuring the amount of impairment loss.

What this Means to Investors

As mentioned in the Barron's article “Goodwill Hunting: Balance Sheets' Latest Torment,” Chairman of Audit Integrity , James Kaplan states “Over the next two months, we will see a substantial number of goodwill impairments, which will be taken as expenses and hit earnings.” While these write-downs do not involve a change in cash, they cause loss of reported earnings, reduction of equity and assets.

Goodwill write-downs raise several questions for investors. First, the decision to take a goodwill impairment charge is up to management, who can be motivated to delay writing off assets and reporting lower earnings. After all their compensation packages encourage them to grow earnings and share value, not lower them. Moreover, goodwill impairment indicates that the decision to acquire a company might not be as good as originally thought. This tends to apply to the management that was in place when the acquisition was made. If new management has taken over, writing off goodwill might be a way for the new team to help clear the decks and start anew.

In addition, impairment charges reduce a company's equity levels that might trigger technical loan defaults. Most lenders require companies who have borrowed money to promise to maintain certain ratios. If the company does not meet these obligations, known as loan covenants, the company can be declared in default on the loan.

Fortunately, SFAS 142 offers some guidelines to auditors that can be used by investors as signals that a goodwill impairment might be coming. Some actions by a company that might raise the possibility of goodwill impairment include:

• A significant adverse change in legal factors or in the business climate;
• An adverse action or assessment by a regulator;
• Unanticipated competition;
• Loss of market share by an acquired business unit;
• A loss of key personnel;
• A potential sale of a reporting unit or significant portion of a business unit that will be sold or otherwise disposed of; and
• Loss of stock market value by a competing unit indicating that the long-term value is now lower.

For firms that have a significant portion of their assets in the goodwill category, say greater than 15%, investors should look more carefully at the potential that a write-off could be in the future. Ask yourself if any of the conditions mentioned above might apply and you will have a better idea if a goodwill write off is likely. While it does not necessarily mean the share price ill fall, it does signal that there could be a problem if the write off was not anticipated.

On the other hand, if the write off has been anticipated , it could become a positive for the company as they further restructure the company's balance sheet to reflect actual market value. As we saw when Flextronics wrote off all of their goodwill, the market did not react. This can be interrupted that the write off was a positive action by management. Investors need to assess if the write off is a sign of problems in the future or just a sign that the problems have been addressed and the goodwill impairment is an accountants recognition of prior events. If the goodwill write off is forward looking and a sign of future problem, then it is a warning sign. If it comes after the fact then it can be viewed as a positive.

If you wish to learn more regarding analyzing financial statements I suggest reading: Financial Statement Analysis and Security Valuation by Stephan Penman. Focuses on the output of financial statements to understand how to use them to value companies. While expensive, this text book is an excellent reference for any investor and will pay for itself very quickly.

By Hans Wagner
tradingonlinemarkets.com

My Name is Hans Wagner and as a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market at http://www.tradingonlinemarkets.com/

Copyright © 2009 Hans Wagner

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