"Blue skies smiling at me"
Like the sentiment in the song “Blue Skies,” the accounting term “blue sky” — or “goodwill” — is a thing to be welcomed. And with mergers and acquisitions on the rise this year, it’s a good time to familiarize yourself with the terms.
What is “blue sky” or “goodwill”?
You should think of goodwill as the unobservable value of your dealership, or what differentiates it from other dealerships. This is the value that comes from years of cultivating relationships with repeat customers, having a reputation for offering fair prices and reliable, friendly customer service. You can’t touch goodwill, but it’s potentially valuable, particularly when you’re ready to sell your business.
Accountants have a more formal definition, of course. The Financial Accounting Standards Board (FASB) defines goodwill as “an asset representing the future economic benefits arising from other assets acquired in a business combination [. . .] that are not individually identified and separately recognized.”
Goodwill typically appears on a balance sheet, as an asset, after a merger or acquisition when one business acquires another business, or the assets and liabilities of another business, for a price higher than the fair value of the identifiable assets acquired and liabilities assumed.
What does GAAP require?
Generally Accepted Accounting Principles (GAAP) requires business buyers to allocate the purchase price of assets acquired and liabilities assumed based on their fair values.
In an auto dealership, this typically represents vehicle and parts inventories, fixed assets, and floorplan debt, as well as other assets — such as customer lists and naming rights. Keep in mind that outside appraisals may be needed to accurately determine fair value of some assets.
The amount of the purchase price that exceeds the fair value of identifiable assets and liabilities acquired is recorded as goodwill. GAAP then requires goodwill to be tested for impairment at least annually (or more frequently if certain conditions exist).
Goodwill impairment happens when the fair value of the company or reporting unit falls below its carrying value. If goodwill is determined to be impaired, its carrying value is reduced on the balance sheet and an impairment loss is reported on the income statement. This could, theoretically, raise a red flag with investors and lenders.
Are there other options?
The FASB’s Accounting Standards Update (ASU) No. 2014-02, Intangibles — Goodwill and Other (Topic 350): Accounting for Goodwill, offers privately held companies an alternative goodwill measurement method. That’s because — after soliciting feedback from private company lenders, owners and accountants — the FASB learned that many stakeholders disregard goodwill and impairment losses when assessing operating performance.
Private dealers now have the option to amortize existing and newly acquired goodwill on a straight-line basis over a 10-year period (or less, if a shorter useful life can be justified). By electing to use the alternative method, you’ll lower the carrying value of the goodwill. This, in turn, reduces the likelihood of needing to record an impairment loss in the future. Also, you’ll no longer be required to perform impairment testing annually unless certain conditions exist.
When might impairment take place?
Goodwill impairment is more likely to happen under certain conditions. The guidance requires private dealerships to test for impairment when “triggering events” occur. Examples include 1) unanticipated competition, 2) the loss of a key person and 3) the issuance of a new regulation that has a significant adverse effect on auto dealerships.
Goodwill impairment equals the excess of the carrying amount of the reporting unit over its fair value. This measurement standard is simpler for private entities, since they aren’t required to hypothetically reallocate fair value to all of the entity’s identifiable assets and liabilities.
In addition, private entities can measure impairment at the entity level. So, if you have multiple franchises that are doing well overall, but an acquired franchise is under-performing, the modified rules give you extra time to turn things around before reporting an impairment loss.
Why does it matter?
Even though most stakeholders disregard goodwill, determining a company’s fair value can be an expensive undertaking, possibly requiring the use of an outside appraisal. While this might not be needed annually, it would be necessary when impairment is determined to have occurred, and those additional costs will likely be an unwelcomed surprise added on to the circumstances that caused the impairment.
Get a handle on it
If you’re thinking about entering into a merger or acquisition, it’s never too early to get a handle on goodwill. Your CPA can help you learn how this intangible might factor into a transaction.