A measurement known as "goodwill" is supposed to offer a sense of what a company is worth beyond the tangible _ the added value that comes from the potential for future success, based on past acquisitions.
But in this weak economy, a lot of that goodwill is vanishing, and that's adding to the pain for many struggling companies. On that list: financial services company Marshall & Ilsley Corp., restaurant chain Wendy's/Arby's Group Inc. and clothing manufacturer Jones Apparel Group Inc.
Here are some questions and answers about what goodwill is and why it is presenting a challenge in today's tough financial climate.
Q: The term "goodwill" keeps popping up in corporate earnings reports. What exactly does it mean?
A: When one company buys another, it tends to pay more than just the fair value of the acquired company's assets. The premium it pays is known as goodwill, and it becomes an asset on the purchaser's balance sheet.
It's considered an intangible asset because it is intended to reflect the added value, by way of cash flows or profits, that will come from the combination of the two companies, said J. Edward Ketz, a professor of accounting at Penn State University.
For instance, let's say that in 2006, when the economy was chugging along and the stock market was reaching new records, Company ABC purchased Company XYZ for $100 million. If $30 million of that price reflected the value of the tangible assets, like buildings, inventory or cash holdings, the other $70 million was for goodwill tied to future growth expected from the deal.
Q: What would then cause the value of goodwill to change?
A: When Company ABC purchased Company XYZ, there was hope that their synergies would enhance business. Maybe Company XYZ had a terrific management team or was in markets that weren't reached by the acquiring company. That's why the goodwill was priced at $70 million _ more than two-thirds of the value of the overall deal.
But that was back in 2006, and now times are very different due to the recession and challenging financial market conditions. Under accounting rules, Company ABC is required to "test," at least annually, to see whether its past assumptions regarding the value of the deal still hold up in this tough climate.
If the company discovers that the value of the goodwill should be less than what is on its balance sheet, it then has to write down or write off the asset. That "impairment charge" will then come out of earnings.
In the case of Company ABC, let's say it discovers that the markets it reached through the acquisition aren't performing as well as expected. Therefore, the goodwill should be valued at, say, $40 million instead of $70 million. That means earnings will take a $30 million hit.
"These companies have to face an economic reality that an acquisition wasn't what it thought it would be," said George Victor, a partner at the New York accounting firm Holtz Rubinstein Reminick LLP "They can't keep something on their books at one value when under further study it is determined that it is worth much less."
Q: If goodwill can be written down in tough times, can its value be increased in good times?
A: No. Once a goodwill impairment charge is taken, the goodwill can never be adjusted higher again under the accounting rules, Ketz said.
Q: Are there any particular industries where this is showing up more than others?
A: Goodwill impairment charges appear to be widespread, reaching sectors around corporate America.
Many financial companies that made acquisitions earlier this decade to broaden their roster of services are now having to lower the value of their goodwill at the worst of times. That's because the goodwill impairments coincide with other large write-downs they have had to take on their mortgage-related and other risky assets.
But the financial sector is hardly the only spot where this is happening. On Monday, Wendy's/Arby's Group announced it was taking a $460 million goodwill impairment charge related to weak performance at company-owned Arby's locations. That represented all of the goodwill related to that unit of the fast-food chain, the Atlanta-based company said in a conference call with analysts.
That charge wiped out all of the company's quarterly profits, and then some, leaving it with a $393.2 million loss for the three months that ended Dec. 28.
Wendy's/Arby's Group was formed last year when Triarc Cos. Inc., the owner of Arby's, bought Wendy's and changed the name of the company.
Q: Besides the hit to earnings, what are the other risks to the reduction in goodwill?
A: Companies taking large goodwill charges could also breach "net worth" provisions in their lending agreements with creditors, said accounting and tax expert Robert Willens, who runs his own consulting firm. That could then put them into default.
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