IF YOU HAVE SPOKEN TO AN INVESTMENT banker or business broker about selling your home building company, the topic of goodwill and its impact on the valuation of your company has surely arisen as a key topic of conversation.

Acquirers, you will hear more often than not, tend to limit the price they will pay if buying you generates significant goodwill on their balance sheet. As a seller, anything that limits the value of your company is a four-letter word.

What is goodwill? More importantly, why does it impact what buyers are willing to pay for your company? With acquisition activity increasing in 2005, are concerns about goodwill impacting valuations?

Illustration by Paul Levinson When speaking about goodwill, many people commonly use the term to refer to the amount paid above the book equity of the assets acquired. Book equity is the amount of equity found on your financial statements and is calculated in accordance with generally accepted accounting principles (GAAP). For accounting purposes, assets are recorded as the lower of either historical cost or current market value. Therefore, any market appreciation of assets, such as the difference between the current market value of land owned and its historical cost, is not reflected on your financial statements as book equity.

The problem with this definition of goodwill, though, is that it's not quite correct. Fact is, goodwill is actually the difference between the amount paid to acquire an asset and the current fair market value of the asset acquired. Purchase accounting requires the acquired assets to be reflected on the balance sheet of the acquirer at the net fair market value. The term “step-up” is often used as the historical cost of an asset is “stepped up” to fair market value. Once all assets are recorded at fair market value, the difference between the total price paid and the stepped up asset value is goodwill.

IMPAIRED JUDGMENT So what happens to goodwill? Today, our accounting rules require goodwill to remain on the balance sheet until either its value is “impaired” or the assets associated with the goodwill are sold or retired. If the assets generating the goodwill are sold or retired, the goodwill is written off as part of the sale or retirement. If it's is impaired, this implies the amount of goodwill recorded on the balance sheet no longer has its full value to the acquirer. In this case, the amount that is impaired must be written off as an expense reducing current earnings.

Beazer Homes announced in late March of this year that it expected to record an impairment charge of about $130 million in the second quarter of 2005 for the goodwill associated with its Crossman Homes acquisition—writing off a significant portion of the intangible value of the acquisition on its balance sheet going forward. The Wall Street Journal wrote in its March 31, 2005, edition, “The Atlanta home builder said substantially all of the goodwill recorded when it acquired Crossman Communities in 2002 is likely to be impaired.”

Tax accounting treats goodwill differently. Goodwill is written off against current earnings over 15 years without regard to the requirements of GAAP.

Many attribute the expanding emphasis on goodwill to the published work of Credit Suisse First Boston's senior home building equity analyst Ivy Zelman. Zelman is a highly regarded analyst who covers our industry. For a number of years now, she has challenged building companies on the benefit to acquirers and their shareholders if they incur significant goodwill on acquisitions.

Why would anyone be willing to pay someone more than the fair market value of the assets acquired? Zelman shares this concern. She writes in her April 3, 2003, report, “When a builder acquires a private or public company above book value and at a premium to where their stock is trading, they add non-performing assets to their balance sheet via goodwill.