Accounting Goodwill has to be one of the more boring and esoteric financial topics. There are situations where product managers can benefit from having a basic working knowledge of it. Goodwill could impact their future bonuses and level of funding for their product lines.
“Goodwill is an intangible asset associated with the purchase of one company by another. Specifically, goodwill is recorded in a situation in which the purchase price is higher than the sum of the fair value of all identifiable tangible and intangible assets purchased in the acquisition and the liabilities assumed in the process. The value of a company’s brand name, solid customer base, good customer relations, good employee relations, and any patents or proprietary technology represent some examples of goodwill.”
A case in point is IBM’s recent acquisition of Red Hat. While IBM has not filed their year-end financial statements yet, the acquisition will add approximately $25 billion of goodwill to IBM’s balance sheet. In other words, IBM paid $25 billion more than Red Hat’s net assets at the time of the acquisition. As of the end of September IBM had about $35 billion in goodwill on their balance sheet.
“Goodwill impairment is an earnings charge that companies record on their income statements after they identify that there is persuasive evidence that the asset associated with the goodwill can no longer demonstrate financial results that were expected from it at the time of its purchase. Because many companies acquire other firms and pay a price that exceeds the fair value of identifiable assets and liabilities that the acquired firm possesses, the difference between the purchase price and the fair value of acquired assets is recorded as a goodwill. However, if unforeseen circumstances arise that decrease expected cash flows from acquired assets, their fair value can be lower than what was originally paid for them, and a company must book a goodwill impairment.”
Goodwill impairment results in an increased expense for the period in question and consequently a reduction in net income and earnings per share. The most notorious example of goodwill impairment was AOL/Time Warner. According to an article from Time Magazine:
“Sticking out of AOL Time Warner’s rather humdrum earnings report Wednesday was a very gaudy number: A one-time loss of $54 billion. It’s the largest spill of red ink, dollar for dollar, in U.S. corporate history and nearly two-thirds of the company’s current stock-market value. (It’s also, as a lot of news outlets have noted, more than the annual GDP of Ecuador, but that’s hardly relevant here.) All for something called “goodwill impairment.
Why so many? Call it a bunch of drunken sailors nursing a hangover. When AOL and Time Warner first decided to merge, the dot-com love affair was raging and the stock of the combined companies was worth $290 billion, mostly thanks to the price of AOL. By the time the stock-swap deal closed a year later, the bubble had burst, AOL was back on earth, and even though AOL had technically been the acquirer (thanks to that high stock price), the new AOL Time Warner suddenly had a relative lemon on its hands.”
Product managers should care about goodwill for two reasons – bonuses and product line funding. Bonuses can be impacted by goodwill impairments because of the potential impact to quarterly/annual net income and EPS. Goodwill impairments also pose a threat to long term funding of product lines.
When an acquisition occurs, the accountants will go through a formal exercise known as goodwill valuation. Experts determine what the future cash flows will be from the acquired assets. This model describes how the acquiring company expects the acquired assets to perform from a financial perspective. Product managers do not need to understand the details behind these valuations – just that they exist. On an annual basis, the company will “test” the goodwill for impairment. If the assumptions that the company made about the goodwill have changed in a negative way, they must “impair” the goodwill and take the appropriate charge on their income statement. If you want to learn about the details of goodwill accounting, check out this detailed post from CFI.
This annual day of reckoning for goodwill can significantly impact a product line’s future. If he product line has failed to produce the revenues and profits anticipated in the goodwill valuation model, the accountants may have no choice but to impair it. The company may decide to reduce future funding or investment in the acquired product lines. That could be bad news for the associated product managers.
Product managers do not need to become experts in the nuances of goodwill accounting. They do, however, need to understand how it could impact their compensation and level of funding for their products.