Blue Sky and Goodwill

Christmas is almost here, and it is that time of year where we hear a lot about goodwill and giving. You may have come across goodwill as an asset on a balance sheet before, and often wondered what it meant. Has the CU or business done something good for someone that it can count as an asset? That all depends on how you look at it.

In the world of finance, goodwill is an accounting term. We need to remember that Assets = Liabilities + Net Worth. Goodwill results when more money is exchanged than the total assets being purchased. In other words, say a company has $3 million in assets, but somebody buys that company for $4 million. The company will then report $1 million of its assets as goodwill. Sometimes, that $1 million is also referred to as “blue sky” above the book value. But, what was technically purchased for $1 million, or why would someone want to pay more than what actually exists?

We know that a company is not simply a balance sheet alone. A company has the ability to generate income. That income stream may be more desirable than the actual book value of assets. A company may also have recognized brand or a strategic market position. Or, a company may own a patent, a client list or rights to services or products. These are challenging items to put a price on, and often, their value isn’t readily reflected on a balance sheet. They could all be reasons why someone may want to pay more for a company than its actual book value.

But, we need to be careful about how much value is assigned to goodwill. Just because someone is willing to pay above book value for a business may not mean another person is willing to do the same. A frequent criticism is the current owner is usually the added value behind the business, and when that owner sells, often that added value is lost. Does that mean if a business starts to perform poorly after it is purchased with goodwill, that the goodwill should be charged down? Well, that depends.

It used to be the case that goodwill was expensed through amortization, just like how capital assets are expensed through depreciation. However, accounting rules have more recently changed so that goodwill can only be expensed if there is a measurable impairment in the value of that business. For financial institutions and regularly audited companies, it is best practice to have this impairment test done annually. Various accounting firms can be charged with this task.

The NCUA has weighed in on the matter, noting that goodwill cannot be considered as an acceptable form of collateral. Goodwill does not necessarily mean the business itself is marketable collateral, and so no matter the perceived value of the business, credit unions must demonstrate there is other tangible collateral securing any business loan request.

So does goodwill mean that something good was done?  Perhaps. The seller certainly benefits from the transaction, but they have to consider whether what was sold was worth cashing out from. But, whether someone can capitalize charitable giving, contributions, or acts of kindness; sorry, those are expenses that must run through your P&L!