By Lisa Marquis Jackson. While making acquisitions has become second nature for a number of national builders, the treatment of these deals is hardly getting easier. That's due largely to the impact of the Financial Accounting Standards Board's (FASB) implementation of new standards on the treatment of goodwill in a company's financial statements. FASB Statements 141 and 142 include a variety of new guidelines, most significantly the requirement to include more intangibles on balance sheets and the elimination of goodwill amortization, which are to be replaced with annual, and in some cases quarterly, impairment tests.
Although these new rulings have been in effect for a little more than a year, their impact goes beyond mere accounting work. It also impacts the operational part of business "on an on-going basis," according to Phil Whitcomb, vice president of acquisitions for Dallas-based Centex Homes.
"Under the old rules, we could amortize the goodwill -- and Centex did that aggressively -- to keep that number low," says Whitcomb. "Now we can't. And, we are in the same position as all of our brethren: That is, we are going to have to be careful about the quality of assets we buy and the goodwill impact on our balance sheet. We have to get comfortable about the fact we can get high enough returns to go ahead and carry that non-performing asset. Historically, the company has been allergic to non-performing assets."
What the new rules also have done is heighten the focus on intangibles. "During an acquisition, we have to spend more time and focus on the quality of the asset pool -- not just what does the land bank and work-in-process look like -- but what do the intangibles look like," says Whitcomb.
Companies value these intangibles differently. One example is with trade names. A builder like D.R. Horton, in Arlington, Texas, who uses trade names for a long period of time for the companies it buys, could allocate a lot of value to a trade name and reduce its goodwill significantly. Long-term supplier relationships can also be leveraged. A builder going into a new market, where they have not established long-term trade or purchasing relationships, may be able to lay off some of the purchase premium as a result.
Regardless of the details, accountants are making certain that processes are consistent -- even on the little deals. "Whether we are buying a $100 million company or a $500 million company, we are using the same processes," says Whitcomb. "If you've got a special rule for the little guys, and on the big guys you're going to do it differently -- that's what's really unacceptable."
A Different Spin
For Hovnanian Enterprises, using a differentiated accounting treatment helps lower its goodwill. Since 2001, the Red Bank, N.J., company has made seven acquisitions. Those acquisitions resulted in $32.3 million of goodwill being carried on the books at the beginning of the year, which represented 5.3 percent of the company's equity.
In April, the company acquired Summit Homes, in Canton, Ohio. "Consistent with our approach on previous acquisitions, we were as conservative as possible with respect to the creation of goodwill, since it can no longer be amortized -- a policy which we don't like or agree with," says Larry Sorsby, executive vice president and CFO at Hovnanian Enterprises.
Instead of booking goodwill, subject to final appraisals, Hovnanian plans on assigning the majority, if not all, of the entire purchase premium to the "step-up of assets" and definite-life intangibles, which can be amortized rapidly.
This same treatment was used during the January acquisition of Brighton Homes, in Houston, Texas. "We allocated $41.7 million, the full amount of the premium from this acquisition, to stepping up the basis of housing inventory or to definite life assets that can be amortized over a period of time," says Sorsby.
Of the $41.7 million premium, $14.9 million was allocated to step up the value of inventories which will be expensed during the next several years. The remaining $26.8 million of the premium was allocated to definite life intangibles which will be amortized during the next two to five years. "Had we allocated 100 percent of the premium to goodwill, our projected pre-tax income would have been roughly $8.7 million higher in 2003, equal to approximately $0.16 per share," says Sorsby.
How Much Is Too Much
Historically, builders have been valued on a price-to-book basis. Astute analysts are now making the adjustment to exclude goodwill as a part of the valuation by examining the price-to-tangible-book -- believing that, at some point, the goodwill may have to be written down. The risk remains that it may not be a viable part of the equity portion of the business in the future.
Although analysts and accountants agree there is no magic threshold to indicate when a builder carries too much goodwill, "any number can be too much if it relates to a distressed business," says Greg Schulte, partner at the real estate accounting firm KPMG, in San Diego, Calif. On the flipside, Schulte says he thinks circumstances are being considered. "I've seen 20 [percent] to 30 percent [of assets in goodwill] being acceptable because a company is accessing the capital market."
Several analysts use 10 percent as a benchmark. "At 10 percent, you start to pay attention," says Rick Murray, associate analyst with Raymond James and Associates. Others agree. "That's quite a chunk," says Michael Coyne, investment analyst at Columbia Management. "Any time you have a decent amount of goodwill on your books, it raises a red flag."
How does the scrutiny affect the future of acquisitions? "If it was a good deal under the old rules, it's a good deal under the new ones," says Stacey Dwyer, D.R. Horton's executive vice president of investor relations. "Savvy buyers and savvy sellers will figure out ways to bridge the gap and come up with solutions," says Whitcomb. "I think that's what you'll see."