Companies account for goodwill in accordance with Statement of Financial Accounting Standards (FAS) No. 142, Goodwill and Other Intangible Assets.  As required by FAS 142, the business enterprise must test for impairment of goodwill annually or whenever events occur or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount.  The current credit crisis certainly qualifies as such an event.

Impairment testing is done at a reporting unit level.  An impairment loss generally is recognized when the carrying amount of the reporting unit’s net assets exceeds the estimated fair value of the reporting unit.

Evidence that income statements might look ugly this season appears in several preliminary reports by a few corporations.  Consider the comments by Escalon, Sun Microsystems, Providence Service Corporation, and Leadis Technology.

On Sept. 29, Escalon Medical Corporation announced its earnings for fiscal 2008, ending June 30, of a loss of $15 million, despite a 7.5 percent increase in its revenues.  A major component of its net loss is a non-cash goodwill impairment charge of almost $10 million.  This impairment was due to the goodwill recorded at its Drew business unit.  Management tried to smooth over this write-down by stating that the Drew business unit increased its revenues by 15 percent.

Sun Microsystems issued a preliminary report on its first quarter fiscal 2009 results on Oct. 20.  While it expects quarterly revenues in the neighborhood of $3 billion, it foresees a quarterly loss.  Management writes, “Based on a combination of factors, including the current economic environment … the Company has concluded that it is likely that the fair value of one or more of its reporting units has been reduced below its carrying value.”  Total goodwill is $3.2 billion, but $1.8 billion relates to reporting units in which the goodwill may be impaired.  It then tries to put a positive spin on things by disclosing its non-gaap earnings that includes everything but the bad stuff.

On Oct. 22, the Providence Service Corporation, which provides various social services to homes and communities and nonemergency transportation services to various governmental agencies, revealed that it expects to report a substantial loss on its third quarter results.  A major reason for this expectation rests with the anticipation of a non-cash charge of $90-$120 million because of goodwill impairment on its LogistiCare unit.

Leadis Technology is a semiconductor developer of color display drivers, LED drivers, and integrated circuits for mobile consumer electronics devices.  On Oct. 23, Leadis Technology issued a press release about its third quarter results.  The entity’s results showed a decline in revenues of only $4.7 million and a net loss of $7.7 million.  The loss included an impairment loss on goodwill of $9.4 million.  Non-cash, of course. 

As typical of technology firms in California, Leadis Technology then goes on to report its preferred non-GAAP earnings that excludes share-based compensation expense, acquisition-related expenses, and impairment charges.  Why do managers believe that these measures somehow reflect better the economics of the business?  They either live in some accounting fantasy-land or they actually know the truth and are just trying to convince others that it ain’t so.

I find it funny that all four of these companies insist that goodwill impairment charges are non-cash.  As if that makes the charge somehow not real.  While technically true, the claim misses a very important point.  Resources were distributed when the acquisition was made, and these resources were accounted for as an asset.  When the utility of the asset is reduced or depleted, then the accountant transfers the amount from assets to expenses.  What is done with goodwill is no different from (say) prepaid rent.

This earnings season will be filled with billions of dollars of goodwill write-downs.  Investors need to be ready for them.

The banking sector may be the hardest hit industry for impairment charges.  But, managers in this industry might resist telling the truth.  I hypothesize this possibility because these same managers have been unwilling to face the music conducted by fair value accounting.  If they don’t wish to tell the truth about their toxic investments, they might try to conceal these truths as well.  I hope the auditing industry is prepared to hold their collective feet to the fire that the banking industry started.

This essay reflects the opinion of the author and not necessarily the opinion of The Pennsylvania State University.

Return to The Accounting Cycle

J. EDWARD KETZ is accounting professor at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of Hidden Financial Risk, which explores the causes of recent accounting scandals. He also has edited Accounting Ethics, a four-volume set that explores ethical thought in accounting since the Great Depression and across several countries. He is the co-author of a monograph, Fair Value Measurements: Valuation Principles and Auditing Techniques (with Mark Zyla, Managing Director, Acuitas, Inc.) to be published by BNA.