New accounting rules affect valuations for contractors

By Randy Bonnecaze

Like many businesses, construction companies have done their fair share of consolidating in recent years. And doing so has caused concern as to whether construction companies' accounting methods accurately reflect their true core earnings.

In response, the Financial Accounting Standards Board (FASB) has issued Statement 142, "Goodwill and Other Intangible Assets." It tries to more specifically define the value of goodwill - the excess cost a buyer pays for a business beyond that company's individual assets' fair market value.

A short history of goodwill. Let's say, to expand your dominance in your local building market, you buy another contractor's business. When recording the amount you paid for the company, you can usually value what was given up. But you must place the offsetting assets you received on your books at fair market value. Any excess of what you paid beyond fair market value is goodwill.

Buyers commonly pay more than market value for construction-company assets because buyers tend to base prices on the future profits they expect the acquisition to generate. Such confidence may arise from a business' strong word-of-mouth reputation or from an anticipated synergy between a buyer's and a seller's respective merging companies.

Under previous rules, you could amortize goodwill over a period of no more than 40 years. But this is a rather arbitrary number the FASB chose to make sure companies recognized value decreases each year so that a permanent asset did not stay on their financial statements.

If you paid less than fair market value for the assets, you could address the "negative" goodwill by writing down long-term assets (such as property and equipment) to zero. You could set up any excess after this as a deferral and then amortize it over no more than 40 years as "other income."

Two steps replace amortization. These rules have changed. You may no longer amortize goodwill - even negative goodwill. Under the new rules, the value of the "reporting unit" will be subject to an annual impairment test and potentially written down to fair value. The FASB defines a reporting unit in statement 142 as the level at which management reviews and measures a segment of its operations.

The FASB prescribes a two-step approach:

1. Assess fair value. When preparing your financial statement, you (or probably your CPA) will assess the reporting unit's fair value and compare this to its carrying amount on the financial statements. Although you needn't measure fair value at your fiscal year end, you must perform the initial step within six months after your fiscal year starts. If fair value is greater than its carrying amount, then you needn't make any adjustments. If the fair value is less than its carrying amount, an impairment has occurred and you must proceed to step two.

2. Reduce goodwill. At this point, you must reduce the goodwill value on your financial statement to the fair value. Then you need to recognize the loss as an extraordinary item in the year you made this determination. Report any excess negative goodwill as "other income" below "income from operations" and fully recognize it in that year.

Many methods to consider. Let's consider an example. You're a general contractor and you buy an electrical contractor company. You'd most likely have goodwill reflected in the financial statements of the electrical division and you would need to assess goodwill by reviewing the segment's operations.

If you integrate the purchased operations into your existing company, you must measure and value its financial aspects. Of course, this is easier said than done. Determining whether the excess amount you paid for the electrical contracting company was worth the investment is rarely a simple task.

Many financial experts recommend using discounted cash-flow models as the reporting unit, because improved cash flow is what many owners seek during acquisitions. Other experts suggest looking to how business brokers in the construction business measure the value they determine for buyers.

Ultimately, whatever model you used in the decision to buy another construction company may be the best one to monitor and track that segment's return on investments.

Get the goods on goodwill. The FASB has finally addressed the issue of goodwill, asserting that it is not a declining asset like equipment that gradually wears out. In fact, goodwill's value may increase over time.

Thus, you can now at the very least try to keep the original value and avoid an illogical expense.

Editor's Note: Randy J. Bonnecaze is a Certified Public Accountant (CPA) with Hannis T. Bourgeois LLP, Baton Rouge.