Goodwill hunting – what is goodwill and why does it matter?

It is rare that accounting policies become front page news – but at the heart of some coverage of recent corporate failures, the issue of goodwill has been a recurring theme.

But what is it and why should trustees care?

What is goodwill?

Goodwill is the price paid to purchase a business less the fair market value of identifiable assets and liabilities obtained. Normally, businesses are bought at a premium to their accounting book value.

The accountants will often use this as an opportunity to identify new intangible assets representing the underlying value of the business acquired (for example trademarks or customer lists). Even then there often remains an unexplained gap between the net assets acquired and the price paid.

This difference is called goodwill and standard accounting treatment is to recognise it on the balance sheet as an asset. Thereafter, its value should be reviewed regularly, often by reference to the expected future cash flows of the business acquired to see if its value is still justified. If not, it is written down, creating an accounting loss.

Why is it a problem?

You might think that’s a bit odd, after all this allows companies to recognise an asset which is actually money already paid to the seller and can’t be reclaimed. Looked at another way, a company is effectively recognising its expected profits on its balance sheet today – which is a big accounting no-no.

And, as was seen when Carillion went bust, the anticipated cashflows are far from certain and goodwill can very quickly be shown to be worthless which can result in substantial write-offs.

In isolation, this wouldn’t be a problem. But treating it as an asset provides companies with book equity which can be used as a basis to return value to shareholders. In some recent failures it could, with the benefit of hindsight, be challenged whether some dividends should have been allowed.

If it wasn’t for goodwill, these dividends wouldn’t have been possible in the first place due to a lack of available equity and the companies may not have failed.

None of this is to say that goodwill shouldn’t be permitted – after all, an alternative which saw goodwill being written off immediately would have a chilling effect on M&A activity. It does however need to be treated with a large degree of caution.

How should trustees assess goodwill when reviewing the covenant?

Trustees could pretend that goodwill is not there when considering balance sheet strength (particularly in terms of the realisable value of assets in distressed situations i.e. insolvency).

Furthermore, when scrutinising returns made to shareholders, trustees would be advised to consider whether the company would still have book equity if the value of goodwill were to be disregarded.

If not, and when coupled with a true reflection of the size of the pension deficit, this would suggest an increased risk that the company is being left undercapitalised, and that the trustees should consider how to act.