It's easy to see why we call the financial asset "goodwill." It first appears in the heady days of big mergers when a company has paid big bucks to acquire another in hopes of years of growing cash flows and happy shareholders.
And then, when things don't work out so well and the value of that goodwill disappears in big writedowns? Well, it probably should be called "ill-will," but we'll just have to settle for the term "impairments."
As in nearly $28-billion of goodwill impairments at Canadian companies in the years from 2011 to 2013, according to a recent study by the firms Duff & Phelps and MergerMarket. And while the results aren't in for 2014, sinking commodity prices suggest the losses could be even larger in the next couple of years.
Perhaps it sounds a bit dull, particularly since companies who take these impairment charges often stress they are "non-cash" accounting charges that don't represent actual dollars flowing out of the kitty.
What these impairment charges do represent, however, is real money – either cash or shares of company stock – that were used for acquisitions that can no longer produce the cash flow to justify their price.
"Management did pay for [the acquisition], and now management is saying under their stewardship that it's worthless," says Lynn Turner, a former chief accountant at the U.S. Securities and Exchange Commission who is a frequent critic of companies' financial-reporting choices. "That doesn't say a whole lot for management."
Here is a brief technical explanation of goodwill: When one company purchases another, it buys tangible assets such as buildings and equipment, and takes on liabilities such as debt. When the purchase price for the company exceeds the value of these tangible assets, minus liabilities, the result is goodwill. The idea is that it represents the value of the acquired company's customer relationships, brand name and so forth.
Goodwill does not sit on a balance sheet indefinitely. If the cash-generating power of the acquired businesses cannot support the amount of goodwill, companies are supposed to determine that it's "impaired," write it down, and take that writedown as a charge against earnings. Companies are supposed to test goodwill at least annually, and perhaps more often, if events dictate.
Duff & Phelps found the materials industry to be the top contributor to 2013's Canadian goodwill writedowns, with just under $6-billion of the $8.9-billion recorded by all Canadian companies in the study. Barrick Gold Corp.'s $3.1-billion in impairments were the largest of any company. The only other billion-dollar impairment in 2013 was Lightstream Resources Ltd.'s $1.3-billion writedown.
How is 2014 looking? It's too early to tell. The disproportionate amount of goodwill impairments occur in a company's fourth quarter, as it closes its annual books, and many companies end their fiscal years in December. According to data I requested from Standard & Poor's Compustat database, nearly half of 2013's impairments occurred in the fourth quarter of the calendar year.
Through the first three quarters of 2014, Canadian goodwill writedowns total $2.3-billion, tracking well behind 2013's $4.9-billion. But with Canada's heavy representation from the mining and energy industries, the numbers could easily swell.
Estimating cash flows as part of a goodwill impairment test involves, naturally, using estimates of the price you obtain for your primary product. And gold miners and oil and gas companies are facing prices much lower than when they made any number of their key acquisitions. (To be clear, any companies that have made acquisitions but now face market changes that decrease cash flow are at risk. The media industry is an example.)
In forecasting cash flow and assessing goodwill impairments, companies need not simply plug in the market price on the day of the valuation. Instead, they can use a higher price they feel is more representative of a future, near-term average. At the same time, however, it has to be grounded in some version of reality.
"Management's first year of telling us that [a commodity price drop] is a blip is a believable story," says Tom Mannion, a director at BDO Consulting who specialized in business valuation. "If the preponderance of evidence is that it's four or five years before it goes up to $100 [U.S.] a barrel, but management has it coming back to that next year, we can push back on that."
"My take is this year, we wouldn't see that many impairments at companies just based on the price of oil," Mr. Mannion adds. "I think next year there could be a bunch."
However, this winter's release of financial statements may reveal 2014 to be a year of more impairments for the miners. As gold dropped below $1,200 an ounce in early November, the analysts at TD Securities noted that several gold producers ran their year-end impairment tests at prices of $1,300 per ounce or higher, including Goldcorp, Newmont Mining and B2Gold. (Gold crossed the $1,200 mark several times in December and finally topped $1,250 Thursday on news of the Swiss National Bank's currency moves.)
There's a possibility that companies will find a way to avoid these eye-popping writedowns. Not by making smarter acquisitions, of course, but by changing the accounting rules.
Both the International Accounting Standards Board, which sets the rules Canadian public companies follow, as well as the U.S. Financial Accounting Standards Board have goodwill accounting "at the forefront of [their] agendas," says Carla Nunes, one of the authors of the Duff & Phelps report. One of the options is to simply amortize goodwill over a number of years, recognizing an expense each quarter, rather than performing frequent impairment tests.
"If goodwill is simply amortized, analysts would add back the non-cash charge to estimate metrics such as EBITDA, but would have no sense how well past acquisitions are performing," Ms. Nunes said.
That would be quite a change from today, where it's starkly clear when companies are writing down millions, or billions, of dollars of goodwill.
