When a company is sold for more than net book value, this results in an accounting concept known as goodwill. If you are relying on reviewed or audited financial statements from borrowers, you should be aware of their obligation to test for goodwill impairment.
Once a year, these companies are required to screen for potential impairment, measure the amount of impairment (if any exists), and adjust the value of intangible assets (like goodwill) to reflect current economic realities. If testing reveals that the value of goodwill on the borrower’s books has been impaired (or, in other words, has declined), the company is required to write off this amount to its current fair market value. Note that the value of goodwill can only be written down, not up.
As a lender, you should be sensitive to things that are occurring in borrowers’ businesses which might result in an annual test for impairment. Also, be proactive in recognizing when an adverse test is imminent, and the effect it may have on the company’s future earnings and net worth.
Keep in mind, however, that while impairment will result in a charge to earnings and have an adverse effect on net worth, it will have no cash impact. Therefore, its practical impact on a borrower’s ability to service debt will be negligible. It can be, however, an indication of potential future cash flow problems if the acquired company is not going to perform as well as originally anticipated.
Another rule change impacting accounting for goodwill requires that acquisition-related costs like finder’s fees, professional or consulting fees, and general administrative costs be expensed rather than capitalized. These costs are then added to the fair value of the asset acquired. The result is a lower amount of goodwill that can be booked in the acquisition, thus potentially lowering the acquirer’s bottom line.