If you are like many companies these days, odds are the answer to that question is “yes.” In the current weakened economic environment, companies are learning that the goodwill that they carry on the balance sheet is impaired due to the diluted value of the entire enterprise.
The process of evaluating goodwill for impairment really is based in a very simple mathematic equation under current accounting guidance outlined in Statement of Financial Accounting Standards No. 157, Fair Value Measurements (“SFAS 157”) and Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (“SFAS 142”). Is the Company’s book value of equity greater than the fair value of its equity? If so, then impairment exists, resulting in a laborious process in which most accounts on the entity’s balance sheet must be revalued. While measuring the book value of equity is a rather simple task, measuring the fair value of the equity can be complex. It involves consideration of common methods to business valuation, such as the income and market approaches.
Under the income approach, a Company’s value is derived from the level of earnings or cash flows (these could be historical or projected, depending on the nature of the business being valued) it can generate for its shareholders. These earnings or cash flows are then capitalized or discounted using an expected rate of return, but that is a discussion for another time. In a weakened economic environment, both historical and projected earnings can take a significant hit. Overall, spending is down in many industries, resulting in an adverse effect on company earnings and cash flows.
Alternatively, a company may measure its value under the market approach. The underlying assumption when using this method of valuation is that an entity’s value is best measured by the price it could command on the open market. There are two major issues facing companies that use this methodology. First, as is the case with the income approach, value is derived using earnings (or a derivative thereof such as EBITDA, EBIT, or revenues). This earnings “base” is then multiplied by a market multiple as observed either in the public markets or through private transactions. As with the income approach, a diluted earnings base has a downward impact on value. Further, it is clear that market observed multiples are declining as well (as indicated by falling stock prices). Secondly, the market method is based on the presumption of consummating a transaction for the purchase/sale of the entity. While it is difficult to measure the additional cost associated with obtaining credit in the current financial environment, it is very clear that there are increased costs associated with executing such a transaction. This concept also has a dilutive effect on value.
You are probably asking, “what does this really mean for my company?” It’s an interesting question that can vary depending on the company itself. The current economic environment is of course having significant adverse impacts on companies and their profits. The kicker, however, is that many companies will have to recognize an additional impairment charge associated with overvalued goodwill balances. But is this simply a technical issue for your accountant to deal with and not an economic issue? As always in the valuation world, that depends.
On one hand, the goodwill impairment charge appears “below the line” and thus does not have a negative impact on key profitability metrics such as EBITDA (which are often used for bank covenants). Additionally, there is no impact on cash flow (which is what most equity holders really care about anyway). In these ways, the impairment charge is just a one-time “paper loss.” On the other hand, this is a day of reckoning for acquisition-happy companies (and those advising them) that may have overpaid in the past. No one wants to hear that they may have made a bad investment, but the accounting treatment for goodwill is giving a lot of visibility to these deals.
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