2020 was a pretty wild ride for all kinds of businesses.<\/p>\n\n\n\n
While we\u2019re all glad to see it in the rearview mirror, there are some after-effects regarding valuations that you might want to consider.<\/p>\n\n\n\n
Many businesses report \u201cgoodwill\u201d on their balance sheets. Goodwill is an intangible asset on a company\u2019s books that reflects the amount of the purchase price paid for a company\u2019s net assets above the fair value of acquired tangible and other intangible assets in a sale transaction. Unlike some other assets, goodwill does not necessarily amortize over time, but it can be worth less than its original value. (More on that in a minute.)<\/p>\n\n\n\n\n\n\n\n
An example of goodwill would be this:<\/p>\n\n\n\n
Bank A buys another bank (Bank B) whose tangible and other intangible assets have a fair value of $80 million. However, Bank A pays $100 million to buy Bank B. The $20 million paid above what the actual assets are worth is considered Bank B\u2019s \u201cgoodwill\u201d and is recorded as an asset on the balance sheet of Bank A.<\/p>\n\n\n\n
To illustrate \u201cgoodwill impairment,\u201d let\u2019s consider another example:<\/p>\n\n\n\n
Bank A had a book value of $500 million last year, including goodwill of $20 million. However, this year Southard Financial is hired to do an impairment test in which we discover that the fair value of Bank A\u2019s equity is only $490 million now. They are $10 million below carrying value, so their goodwill is not worth its carrying value. Therefore, Bank A\u2019s balance sheet would be adjusted to now show a goodwill asset of only $10 million instead of last year\u2019s $20 million, and the goodwill is said to be \u201cimpaired\u201d.<\/p>\n\n\n\n
You have to have it tested. GAAP (Generally Accepted Accounting Principles) requires every company to \u201ctest\u201d for goodwill impairment every year.<\/p>\n\n\n\n
Under the current guidance from the AICPA, management teams can choose to assess impairment using qualitative factors, or what is known as a \u201cStep Zero Test.\u201d A simple way to determine the value of a business is to ask, \u201cwhat could I sell it for today?\u201d If you can sell it for carrying value or above, then the goodwill is not impaired.<\/p>\n\n\n\n
For example, let\u2019s say a bank\u2019s CFO knows that banks similar to his are being acquired for X times book value. If the CFO applies that multiple to the Bank\u2019s book value it might be safe to assess that goodwill is not impaired.<\/p>\n\n\n\n
However, if the internal valuation is close to carrying value (book value), it creates a question of possible goodwill impairment. That\u2019s when Bank A would hire someone like Southard Financial to do an actual independent valuation that management would use in Step 1 of its two-step quantitative assessment of impairment. Goodwill impairment sends a message to the market that the acquired net assets of a company have fallen below what the company paid for them.<\/p>\n\n\n\n