dharan-valuation-issues-in-the-coming-wave-of-goodwill-and-asset-impairments

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Timely news, analysis, and resources for defensible valuations Excerpt from Vol. 15, No. 4, April 2009

BUSINESSVALUATIONUPDATEBVRWhat Its Wo

Valuation Issues in the

Coming Wave of Goodwilland Asset Impairments

By Bala G. Dharan, Ph.D., CPA

Widespread stock price declines and reces-sionary conditions will significantly affect corpo-rate valuation and financial reporting of goodwilland long-term assets. The S&P 500 index, which

represents a broad cross-section of the economy,declined by about 38.5 percent in 2008its worstperformance since 1937and the stock market fellanother 15 percent in the first two months of 2009.While the financial sector represented in the S&P500 index declined the most in this period, all tensectors represented registered significant double-digit declines.

Accounting standard FAS 1441 requires compa-nies to periodically assess the fair value of long-term assets and take impairment charges to theextent the fair value decline is considered otherthan temporary. In addition, FAS 1422 requires thataccounting goodwill be periodically assessed forimpairment and written down to fair value. Sincethese standards require a fair value assessment,they are covered by the fair value disclosure stan-dard FAS 157.3 FAS 157 defines fair value as theprice at which an asset can be sold or a liability canbe settled, and requires that the valuation processused by the company reflect market participantsviews. This means that valuation model inputs,such as cash flow projections, cost of capital, anddiscount rates, should incorporate current market

conditions and market participants views.

Similarly, market-related data used for valuationprocedures, such as the guideline public companymethod or guideline transaction method, shouldreflect current market conditions and market par-ticipants views.

Given the widespread stock price declinesand the deepening recession, it is not surprising

Continued to next page..

that several companies have in recent weeks an-nounced large write-downs of goodwill, intangibleassets, and other assets. Recent corporate an-nouncements of multi-billion dollar goodwill andasset write-offs include Time Warner ($25 billion)ConocoPhillips ($35 billion), Regions Financial ($6billion), and Royal Bank of Scotland ($33 billion4)One should expect to see more such announce-ments of asset write-offs in the coming weeks andmonths. Goodwill is particularly vulnerable to largewrite-offs. Because of the wave of mergers and

acquisitions that started in the late 1990s, good-will is now a large percentage of the total assetsof many corporations, so goodwill write-offs, whenthey occur, can be significant. In general, technology, media, energy, and consumer products companies tend to have large goodwill accounts due toindustry consolidations and acquisition activitiesFor some technology companies, such as CiscoSystems, Inc., goodwill is the largest non-currenasset on the balance sheet.

According to a research report cited by TheEconomist, goodwill in corporate balance sheets

totals about $2.6 trillion.5 A large portion of thisgoodwill undoubtedly resulted from mergers andacquisitions completed at the height of the stockmarket valuation in the 2004-2007 period. Thesetransaction valuations have to be reassessed giv-en the stock market decline and the recessions effect on projected cash flows. It is easy to see thatthe resulting goodwill write-off may add up to sev-eral hundreds of billions of dollars, rivaling in mag-nitude the initial wave of 2008 losses recognizedfrom mortgage-related assets.

If history is any guide, we may also see severa

lawsuits against companiesand their advisorsfollowing the asset impairment announcementsrelated to the amount and the timing of these im-pairment charges as well as the alleged damagesbased on stock price declines. A late-2008 impair-ment announcement by CBS Corporation providesan illustration. During 2008, the stock price of CBSdeclined considerably, falling almost 50 percent by

Reprinted with permission from business Valuation Resources, LLC


2/4Business Valuation Update april 20092

NEIL J. BEATON, CPA/ABV,CFA, ASA

Grant Thornton

Seattle, Wash.

JOHN A. BOGDANSKI, Esq.Lewis & Clark Law School

Portland, Ore.

NANCY J. FANNON,ASA, CPA/ABV, MCBA

Fannon Valuation Group

Portland, Me.

JAY E. FISHMAN, FASA, CBAFinancial Research Associates

Bala Cynwyd, Pa.

LYNNE Z. GOLD-BIKIN, Esq.Wolf, Block, Schorr & Solis-Cohen

Norristown, Pa.

LANCE S. HALL, ASAFMV Opinions

Irvine, Calif.

JAMES R. HITCHNER, CPA/ABV, ASAThe Financial Valuation Group

Atlanta, Ga.

JARED KAPLAN, Esq.McDermott, Will & Emery

Chicago, Ill.

GILBERT E. MATTHEWS,CFA

Sutter Securities Incorporated

San Francisco, Calif.

Editorial Advisory Board

Business Valuation Update (ISSN 1088-4882) is published monthly by BusinessValuation Resources, LLC, 1000 SW Broadway, Suite 1200, Portland, OR, 97205-3035. Periodicals Postage Paid at Portland, OR, and at additional mailing offices. Post-master: Send address changes to Business Valuation Update, Business Valuation

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Although the information in this newsletter has been obtained from sources that BVRbelieves to be reliable, we do not guarantee its accuracy, and such information may becondensed or incomplete. This newsletter is intended for information purposes only,and it is not intended as financial, investment, legal, or consulting advice.

Copyright 2009, Business Valuation Resources, LLC, (BVR). All rights reserved. Nopart of this newsletter may be reproduced without express written consent from BVR.

BUSINESSVALUATIONUPDATEExecutive Editor: Lisa Isom

Legal Editor: Sherrye Henry Jr.

Contributing Editors: Paul Heidt & Adam Manson

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September 30, 2008.6 On October 10, 2008, thecompany announced that as a result of adversemarket conditions, it conducted an impairmentanalysis of goodwill and intangible assets that re-sulted in a goodwill write-off of about $9.6 billion andan additional write-off of about $4.6 billion in other

intangible assets. In December 2008, a purportedclass action lawsuit was filed against the companyalleging, among others, the failure to timely write-down impaired intangible and goodwill assets.

Goodwill write-offs and stock price declines.For goodwill and other non-financial assets, thepurpose of periodic fair value evaluation is to de-termine whether impairment in the value of theasset has occurred, i.e., whether the fair value ofthe asset is less than the assets balance sheetcarrying value. If the fair value evaluation sug-gests that an other than temporary impairment

of fair value has occurred, then the company mustwrite-down the carrying value of the asset on thebalance sheet to the estimated fair value and rec-ognize a corresponding impairment charge (loss)in its income statement. Factors considered fortests of impairment vary by the type of asset evalu-ated. In testing the goodwill asset for impairment,the market capitalization of the firm is often con-sidered relevant. This is why the recent stock pricedeclines are likely to lead to an increase in goodwillimpairment tests, although a falling stock price isneither necessary nor sufficient for the recognition

of impairment of goodwill or other assets.To understand why stock price declines could

precipitate a goodwill impairment test, it is useful toreview the accounting basics for goodwill recogni-tion and write-off. The goodwill account on the bal-ance sheet is created when a firm acquires anotherfirm or its assets and liabilities for a price that is inexcess of the estimated fair values of the individualassets and liabilities acquired. FAS 142 requiresthat fair values are first determined at the so-calledreporting unit level for all identifiable assets andliabilities acquired, including acquired intangible

assets such as brands, royalties, and copyrights.Goodwill is then the excess of the price paid overthe fair values of all identifiable assets less liabili-ties acquired.

Goodwill thus essentially represents unidentifi-able intangible benefits from acquisition. For ex-ample, FAS 142 suggests that goodwill may be due

Goodwill and Asset Impairments

Z. CHRISTOPHER MERCER,ASA, CFAMercer Capital

Memphis, Tenn.

JOHN W. PORTERBaker & Botts

Houston, Texas

JAMES S. RIGBY, ASA, CPA/ABV

IN MEMORIAM (1946 2009)

RONALD L. SEIGNEUR,MBA CPA/ABV CVA

Seigneur Gustafson

Lakewood, Colo.

BRUCE SILVERSTEIN, Esq.Young, Conaway, Stargatt & Taylor

Wilmington, Del.

JEFFREY S. TARBELL,ASA, CFA

Houlihan Lokey

San Francisco, Calif.

GARY R. TRUGMAN,ASA, CPA/ABV, MCBA, MVS

Trugman Valuation Associates

Plantation, FL

KEVIN R. YEANOPLOS,CPA/ABV/CFF, ASA

Brueggeman & Johnson Yeanoplos, P.C.

Tucson, AZ

Reprinted with permission fromBusiness Valuation Resources, LLC


3/4april 2009 Business Valuation Update 3


to, among others, the control premium over fairvalues that a buyer would pay to get acquisition-related synergies. FAS 142 states: Substantialvalue may arise from the ability to take advantageof synergies and other benefits that flow from con-trol over another entity...An acquiring entity often is

willing to pay more for equity securities that give it acontrolling interest than an investor would pay for anumber of equity securities representing less thana controlling interest. That control premium maycause the fair value of a reporting unit to exceedits market capitalization. The quoted market priceof an individual equity security, therefore, need notbe the sole measurement basis of the fair value ofa reporting unit.7

Impairment and consideration of stock pric-es. FAS 142, of course, requires that goodwill, oncecreated, should be carried indefinitely at its original

value without amortization unless an impairmentanalysis of the fair value of the reporting unit levelindicates that goodwill has been impaired. Such atest for goodwill impairment must be done at leastannually and also in the interim between annualtests if an event occurs or circumstances changethat would more likely than not reduce the fair valueof a reporting unit below its carrying amount.8

FAS 142 lists several examples of events orchanged circumstances that might require an interimtest for goodwill impairment. Although none of theseexamples specifically refers to a decline in the stock

market value of the company as a trigger for goodwillimpairment analysis, major accounting firms havestated that a significant stock price decline may bea potential event or changed circumstance requiringan impairment analysis for goodwill. For example,an Ernst & Young publication dated October 2008states: A significant decline in a companys stockprice may suggest that the fair value of one ormore reporting units has fallen below their carryingamounts. Similarly, declines in the stock prices ofother companies in a reporting units industry maysuggest that an interim test for goodwill impairment

is required.9 Similar comments on the potential forgoodwill write-offs due to recent stock price declineshave been included in recent publications by othermajor accounting firms.10

The SECs view on stock price decline andgoodwill impairment. The Securities and Ex-change Commission (SEC) has also said that it ex-pects more goodwill impairment than usual due tothe recent declines in stock prices. Robert Fox, III,

a Professional Accounting Fellow at the SEC, saidat a recent accounting conference that the needto test for goodwill impairment required judgmenand that this judgment may be more challenging inthe current environment due to recent market de-clines that indicate that a potential impairment ex-

ists.11 He added that the SEC would expect moregoodwill impairment than in recent years... in theupcoming financial filings.

At the same conference, Steven Jacobs, an Associate Chief Accountant at the SEC, indicatedthat a decline in market capitalization below bookvalue, including the duration and severity of [the]difference,12 would be an impairment testing indi-cator for goodwill, assuming factors such as short-term volatility are ruled out as the causes. Moreinterestingly, Mr. Jacobs noted that even in caseswhere a current impairment charge of goodwil

is not taken, companies may be required to pro-vide early warning disclosures of potential futuregoodwill impairment charges if there is a reason-able possibility of loss. These remarks by SEC stafmembers suggest that the SEC would be lookingfor an explanation from corporations on how theyconsidered current stock price declines when ana-lyzing goodwill impairment.

The SEC staff appears to have already madethese kinds of inquiries during 2008 in some oits comment letters sent to companies request-ing clarifications related to their 10-K and 10-Q fil

ings. For example, in a comment letter to RegionsFinancial Corporation dated June 17, 2008, theSEC staff asked the company to explain, How youdetermined that your goodwill balance is not im-paired. Please specifically address how you tookinto consideration the fact that you have beentrading at a market value that is below your bookvalue.13 The company, in its reply filed on July 12008, responded that, management could noconclude that [lower market value] was a long-term trend, particularly when our stock price wastrading above book value in the fourth quarter of

2007. Further, given the relatively small differencebetween our stock price and our book value pershare, we determined that a potential buyer wouldoffer a control premium for our business franchisethat would adequately cover these differences be-tween trading prices and book values.

As Regions Financial explained, a commonlyclaimed mitigating factor when the market value oa company is below its book value is whether the

Reprinted with permission from Business Valuation Resources, LLC


4/4Business Valuation Update april 20094

goodwill on the balance sheet represents (or maybe justified by) the control premium that a currentbuyer would pay for the company. Clearly, there is

judgment involved in determining the amount ofcontrol premium for a reporting unit. However, theSECs Fox, the speaker at the above-mentioned

AICPA national conference, cautioned that compa-nies should be prepared to justify the assumptionsof control premiums that current buyers would paygiven the significant fall in stock prices last year.Fox said, I would also note that the amount of sup-porting evidence supporting your judgment wouldlikely be expected to increase as any control pre-mium increases.

Valuation and economic effects. Goodwill andasset impairment charges are generally consid-ered non-cash in nature, i.e., they affect earningsbut not cash flows from operations. Nevertheless,

there may be stock price effects from goodwill an-nouncements depending on the extent to which theinformation is a surprise to the market. In addition,stock price effects will also depend on whether theimpairment charges could affect a companys fu-ture operations and cash flows.

The effect on cash flows is hard to predict, andit would depend on how the impairmentsand theresulting earnings declineaffect the companysloan covenants, employment agreements, compen-sation plans, etc. Goodwill and asset impairmentwill also affect several financial ratios used in loan

covenants and used by financial analysts to evalu-ate risk and returns. For example, large goodwill orother asset impairments would increase the debt-equity ratio and could cause violations of someratio-based loan covenants. There could also beanalyst rating changes and credit rating changesthat could increase the cost of borrowing. Earn-out contracts and contingency payments relatedto mergers and acquisitions could be dependenton reported earnings, which could affect the cashflows related to these contracts. Valuation special-ists and accountants need to consider these po-

tential effects in evaluating the possible valuationconsequences of goodwill and asset impairment.

________________

About the author: Bala Dharan is a vice president in the fi-nancial accounting and valuation group at CRA International,Inc., a global business, financial and economic consulting

firm. Dharan is also a visiting professor of accounting atHarvard Law School.

Statement of Financial Reporting Standard No. 144, Ac-1.counting for the Impairment or Disposal of Long-LivedAssets, Financial Accounting Standards Board, August

2001, as amended. The corresponding InternationalFinancial Reporting Standard (IFRS) 5, Non-currentAssets Held for Sale and Discontinued Operations,International Accounting Standards Board, is similarto FAS 144.

Statement of Financial Accounting Standard No. 142,2.Goodwill and Other Intangible Assets, Financial Ac-counting Standards Board, June 2001, as amended.The corresponding international financial reportingstandard is similar. See IAS 36, Impairment of Assets,International Accounting Standards Board.

Statement of Financial Accounting Standard No. 157,3.Fair Value Measurements, Financial AccountingStandards Board, September 2006, as amended. TheInternational Accounting Standards Board (IASB) hasnot yet issued a corresponding standard covering fairvalue definition, but it issued a discussion paper, FairValue Measurements, in November 2006 in which ithas indicated its preliminary view that the FASBs fairvalue definition based on exit value is an improvementon the disparate guidance in IFRS.

See Goodwill Hunting: Balance Sheets Latest Tor-4.ment, Barrons, February 24, 2009, for examples ofother recent goodwill writeoffs.

Corporate Write-downs: The Goodwill, the Bad and the5.Ugly, The Economist, January 29, 2009.

The company only reported after-tax writeoff amounts,6.and before-tax amounts given here are estimates.

FAS 142, para. 23, as amended by FAS 157, para.7.E22 d.

FAS 142, para. 28.8.

Recent Market Events: Accounting and Reporting Con-9.siderations, Ernst & Young, October 7, 2008.

See, for example, Mergers & AcquisitionsA Snap-10.shot, PricewaterhouseCoopers, December 2008.

Remarks by Robert G. Fox III before the 2008 AICPA11.National Conference on Current SEC and PCAOBDevelopments, December 8, 2008. Available at theSEC website.

Remarks in presentation slides of Steven Jacobs before12.the 2008 AICPA National Conference on Current SECand PCAOB Developments, December 9, 2008. Avail-able at the SEC website as part of the presentation byChief Accountant Wayne Carnall.

Regions Financial Corp., Form CORRESP, filed July13.1, 2008.


Reprinted with permission from business Valuation Resources, LLC

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