Under the accounting standards published by the Financial Accounting Standards Board (FASB) two deal with the way business goodwill is handled: SFAS 141 and SFAS 142.
Business goodwill is put on the company’s books if management acquires another firm. Under the SFAS 141 and 142 goodwill is tested each year for impairment. This impairment occurs when the fair value of the business overall is less than the sum of the fair values of all its assets.
Let’s say that a company carries a book value of $1,000,000 in assets. This includes $100,000 in business goodwill from an earlier acquisition. The goodwill is unchanged until there is an impairment.
If the company’s value this year is $1,500,000; it is clearly above the total asset value and there is no goodwill impairment.
But if the market conditions change, the value of the business may drop down to, say, $900,000. This just covers the asset value. To bring the value of the company in line with its assets it needs to take a write down of business goodwill of $100,000. It is charged to the business earnings in the year and could easily wipe out the entire profit.
This is the case even though this goodwill impairment is a non-cash charge that has nothing to do with how well the company operations did in the year. Because the profits may not look good, the company’s perceived value may go down even more!
When discussing the company’s valuation with potential investors it would be wise to point out that business goodwill impairment may be responsible for a slide in profits. A closer look at business operations may reveal that the company’s earning power is unaffected.More on Valuation