Goodwill Impairments May Return Yet Again

A wave of goodwill writedowns in late 2008 and early 2009 may be followed by more in the latter part of this year as companies continue to wrestle with the accounting difference between fair value and book value amid economic uncertainty.

Goodwill is an intangible asset on corporate balance sheets that generally arises from acquisitions, and is the amount paid for a target company that exceeds the fair value of its collective assets. For several years companies have been required to test the value of goodwill at least annually, to determine whether it has become “impaired”—that is, whether the current market value has fallen below the value carried on the books. The grand-daddy of all examples is the $98 billion loss Time Warner reported several years ago, almost entirely driven by a goodwill impairment charge for its acquisition of AOL Inc. in 2001 at the height of the tech bubble.

New rules for measuring fair value and accounting for business combinations, however, coupled with the sudden downturn in the economy, have forced companies to look at goodwill in a different light. Accounting Standards Codification Topic 820 (formerly Financial Accounting Standard No. 157, Fair Value Measurement) and ASC 805 (formerly FAS 141R, Business Combinations) ushered in an entirely new approach.

Under the new package, the allocation of value to the various assets acquired in a business combination (including goodwill) is handled differently, and fair value is measured based on what a hypothetical third party would pay for it. Those requirements, accompanied by the economic crisis, led to a rash of writedowns.

According to a recent study from advisory firm Duff & Phelps, publicly held companies recorded $260.4 billon worth of goodwill impairments in 2008, with sectors such as consumer items, energy, finance, IT and heavy industry hit the hardest. The overall impairment averaged 2.54 percent of all assets and 15.81 percent of all goodwill, the study said.

Likewise, PricewaterhouseCoopers has said Fortune 500 companies recorded $230 billion of goodwill impairment from the third quarter of 2008 through March 2009. That’s more than double the impairment recorded for the three years leading up to third-quarter of 2008.

Barnes

Taking a goodwill impairment is difficult for management to swallow for several reasons, says Paul Barnes, managing director for Duff & Phelps. Most obvious is the hit to earnings the impairment brings, of course. But investors often also interpret goodwill impairments as an admission that the company paid too much when it acquired a business in the first place.

“Does it mean the company couldn’t integrate and assimilate from the acquisition?” Barnes says. “That may be the case, or it may not. [Executives] are concerned about what investors may think that reflects.”

2008 IMPAIRMENTS BY INDUSTRY

Total 2008 impairments in this population amounted to $260.4 billion. The greatest goodwill impairment losses were recorded in the following industry sectors:

Industry

Impairment Loss

Consumer Discretionaries:

$84.4 billion

Energy:

$38.8 billion

Financials:

$37.5 billion

Information Technology:

$37.1 billion

Industrials:

$29.0 billion

Source

Duff & Phelps Study on Goodwill Impairments.

Second, while accounting rules require a company to write down the value of goodwill when it falls below carrying value, companies are not allowed to write it back up in the future. “The elevator only goes down,” Barnes says. “You only write it down. There’s never a chance to redeem that value.”

Barnes says companies are always concerned about whether a decline in stock price, for example, is a temporary blip or a deeper sign that value has declined and must be reflected in an impairment charge. “Companies are concerned when a market cap is significantly depressed that it’s not indicative of intrinsic value of the business,” he says.

Barnes says the Securities and Exchange Commission is studying goodwill impairments and their relationship to a company’s market capitalization, expecting to find some correlation. “The SEC is saying you can't ignore your market cap,” he said.

Testing, Testing

The test to determine if goodwill is impaired is a two-step test spelled out in ASC 350 (formerly FAS 142, Goodwill and Other Intangible Assets), Brian Marshall, a partner with McGladrey & Pullen, said in a recent Webcast on impairments. The first step is a screen to determine if an impairment might be warranted; the second test measures the impairment.

Marshall

Step 2 is where the real work behind a goodwill impairment begins, he said. “You have to do hypothetical business combination accounting,” he said. “Take the fair value from Step 1, assume the reporting unit was acquired for that amount, and assign a fair value of the reporting unit to all of the assets and liabilities. The residual amount is the implied fair value of goodwill.”

2008 LOWER IMPAIRMENTS BY INDUSTRY

Lower goodwill impairment losses were recorded in:

Industry

Impairment Loss

Materials:

$14.5 billion

Consumer Staples:

$8.3 billion

Healthcare:

$7.3 billion

Telecommunications:

$1.9 billion

Utilities:

$1.6 billion

Source

Duff & Phelps Study on Goodwill Impairments.

Barnes and others, like Alberto Dent and Dimitri Drone, both partners with PwC’s Transaction Services practice, say they believe the writedowns seen so far are the worst of it. Drone says the market has recovered significantly since March, so business values are better than they were.

“Maybe it’s also stating the obvious, but companies don’t have the goodwill on their balance sheets that they had a year ago,” he says. “There haven’t been that many new deals this year, and if they had goodwill last year, they probably wrote it off last year.”

Dent

Dent says another significant wave of impairments could emerge if the economy tanks again, as some economy pessimists predict. “That would be horrible, but if it happened you might see another cycle of impairments,” he says.

Kaipo Doorley, a senior manager at regional firm Amper, Politziner & Mattia, says companies may face writedowns this year if they’ve tussled with their auditors over whether declines in value are temporary, which enables them to avoid the impairment charge, or permanent.

GOODWILL INTENSITY

The following table explains how goodwill intensity (goodwill as a percentage of total assets) changed in each sector during 2008. Percentages are from year-end 2007 and year-end 2008, and the change in each industry.

Industry

2007

2008

Increase; (Decrease)

Information Technology:

22.4%

19.7%

(2.7%)

Healthcare:

21.8%

20.6%

(1.2%)

Consumer Staples:

20.3%

18.7%

(1.6%)

Industrials:

19.2%

17.7%

(1.5%)

Telecommunication Services:

18.9%

17.4%

(1.5%)

Consumer Discretionary:

16.4%

13.9%

(2.5%)

Materials:

14.5%

12.9%

(1.6%)

Energy:

9.3%

8.1%

(1.2%)

Utilities:

7.5%

6.6%

(0.9%)

Financials:

3.4%

3.5%

0.1%

Average:

15.4%

14.1%

(1.3%)

Note that average goodwill intensity decreased from 15.4% in 2007 to 14.1% in 2008. Goodwill intensity

decreased for all sectors in 2008 except for Financials. If Financials recorded other asset write-downs during this period, then the relative percentage of goodwill on their balance sheets could be expected to increase.

Duff & Phelps Study on Goodwill Impairments.

“The argument that companies make is that the decrease in value is temporary, which is risky from an auditor’s perspective if management suddenly reports an impairment the next period and there was no warning to investors,” Doorley says. If the company’s circumstances haven’t changed significantly from 2008 to 2009, an impairment charge will be much harder to avoid.

Andrew Burczyk, regional attest leader with Mayer Hoffman McCann, says public companies are further ahead in recognizing impairments than private companies, who in many cases are still learning the new accounting rules. “Public companies aren’t being tripped up by it, but they aren’t happy about it,” he says. “It’s somewhat counterintuitive to think you’re presented with the same facts year over year, but running those facts through new accounting rules gives you a very different answer.”

As with most touchy accounting issues these days, the key to getting the auditor’s acceptance is early communication and plenty of documentation, Burczyk says. “This is not an issue you want to resolve in March or April,” he warns. “This is an issue you want to look at today.”