Under the accounting rule known as SFAS 142, companies are required to perform an annual goodwill impairment test regardless of whether there is a triggering event. However, if an event somehow depresses the value of goodwill assets, companies are required to reexamine the asset value before their annual test. The current liquidity crisis, and the related tumbling of stock prices, is sure to be a triggering event, forcing companies to test earlier and more frequently.
Originally, the FASB intended for the fair value of goodwill to be measured in a business combination and amortized over its remaining life. However, respondent’s comments indicated that they were concerned about the difficulty of measuring the fair value of goodwill and determining a remaining life. Financial analysts also indicated that they did not regard goodwill amortization expense as being useful information in analyzing investments. As a result, the FASB introduced a compromise. The requirement for amortization of goodwill was eliminated in the final version of SFAS 141. Instead, any goodwill recorded in a business combination will have to be tested for impairment at least annually, or more frequently, if necessary.
The FASB explained that the reason for issuing SFAS No. 142 was that analysts and other users of financial statements, as well as company managements, recognized that intangible assets are an increasingly important economic resource for many entities and are an increasing proportion of the value of assets acquired in many transactions. As a result, better information about intangible assets was needed in financial reporting for business combinations.
SFAS No. 142 improves financial reporting by recognizing the fair values of goodwill and other intangibles arising from the transaction and by reflecting the underlying economics of the acquisition more completely and accurately. As a result, the users of the financial information are better able to understand the investments made in those assets and the subsequent performance of those investments. Subsequent disclosures provide users with a better understanding about any changes in expectations for goodwill and intangibles over time, thereby improving their ability to assess future profitability and cash flows.
The Economic Attributes Of Goodwill
In order to understand why the FASB requires that goodwill be tested for impairment, it is important to understand the economic attributes of goodwill. The International Glossary of Business Valuation Terms describes goodwill as:
Intangible asset arising as a result of name, reputation, customer loyalty, location, products, and similar factors not separately identified.
Goodwill is a slightly different concept in financial accounting. Goodwill is defined in the ASC Master Glossary as:
the excess of the cost of an acquired entity over the net of the amounts assigned to assets acquired and liabilities assumed.
Goodwill is often viewed as a group of assets that contribute value to a business enterprise currently but are non identifiable or separable as of the measurement date. These assets may include perceived value from assets that may exist sometime in the future such as future customers. The amount recognized as goodwill includes acquired intangible assets that do not meet the criteria in ASC 805, Business Combinations (SFAS No. 141(R)), for recognition as an asset apart from goodwill.
In early exposure drafts for business combinations, the FASB listed six components of goodwill that had been commonly recognized in accounting practices under existing authoritative guidance.
The six FASB goodwill components are:
- The excess of the fair values over the book values of the acquiree’s net assets at the date of acquisition.
- The fair value of other net assets that the acquiree had not previously recognized. They may not have been recognized because they failed to meet the recognition criteria (perhaps because of measurement difficulties), because of a requirement that prohibited their recognition, or because the acquiree concluded that the costs of recognizing them separately were not justified by the benefits.
- The fair value of the “going-concern” element of the acquiree’s existing business. The going-concern element represents the ability of the established business to earn a higher rate of return on an assembled collection of net assets that would be expected if those net assets had to be acquired separately. That value stems from the synergies of the net assets of the business, as well as from other benefits (such as factors related to market imperfections, including the ability to earn monopoly profits and barriers to market entry—either legal or because of transaction costs—by potential competitors).
- The fair value of the expected synergies and other benefits from combining the acquirer’s and the acquiree’s net assets and businesses.
- Overvaluation of the consideration paid by the acquirer stemming from errors in valuing the consideration tendered.
- Overpayment or underpayment by the acquirer.
Note: The IASB’s Business Combinations also recognizes similar, but not identical components of goodwill.
The recognition of goodwill on the balance sheet of an entity acquired in a business combination can result from any or all of the six components previously mentioned. The FASB and IASB provide insight about the nature of goodwill from a conceptual standpoint and agree that the third and forth components are conceptually part of goodwill. The third component relates to the excess value of the acquiree’s assembled assets and represents preexisting goodwill at the time of the business combination. The fourth component relates to the excess value created by the synergies of the business combination. The Boards refer to the third and fourth components of goodwill as “core goodwill.”
The Boards indicate that the intent of Statement 141(R) is to reduce the amount of goodwill recognized in the financial statements to the amount of core goodwill. Specifically, component 1 would be reduced or eliminated by recognizing identifiable acquired assets at their fair values rather than their carrying amounts. Component 2 would be reduced or eliminated by identifying and recognizing all acquired intangible assets. And component 5 would be reduced or eliminated by measuring consideration accurately.
Guidance For Impairment Testing
The guidelines for testing impairments of intangible assets are found in two pronouncements: ASC 350, Goodwill and Other Intangibles (SFAS No. 142), and General Intangibles Other than Goodwill (SFAS No. 144). Both describe impairment testing for long-lived assets, including both intangible assets and tangible assets subject to depreciated or amortized.
When there is indication that an intangible asset or goodwill is impaired, testing should be immediate. When no impairment is indicated, then such assets are to be tested annually at a minimum.
Under the SFAS No. 144, a long-lived asset that is currently being depreciated or amortized should be tested for impaired if there is a “triggering event” such as:
- A significant decrease in the market value of the asset
- A significant change in the extent or manner in which the asset is used or significant physical change to the asset
- A significant adverse change in legal factors or in the business climate that could affect the value of an asset, or an adverse action or assessment by a regulator
- An accumulation of costs significantly in excess of the amount originally expected to acquire or construct an asset
- A current period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with an asset used for the purpose of producing revenue
A long-lived asset that is not being amortized because its remaining life is unknown is also tested for impairment but under the “triggering events” described in SFAS No. 142. The triggering events under FASB ASC 350 are similar to those listed earlier; however, there are some differences to note in the following list:
- A significant adverse change in legal factors or in the business climate
- Adverse action or assessment by a regulator
- Unanticipated competition
- Loss of key personnel
- Expectation of sale or disposal of a reporting unit or a significant portion of the reporting unit
- Testing under FASB ASC 350 (SFAS No. 144) of a significant asset group in a reporting unit
- Recognition of a goodwill impairment loss in the financial statements of a subsidiary that is a component of a reporting unit
Level Of Value To Be Tested
According to SFAS No. 142, if goodwill and another asset, or goodwill and a group of assets in a reporting unit (defined as an operating unit per ASC 280, Segment Reporting (SFAS No. 131), are tested for impairment at the same time, the other asset, or asset group, is to be tested for impairment before goodwill. In other words, the long-lived assets that are being amortized or depreciated as of the test date under SFAS 144 are tested first, then indefinite-lived assets other than goodwill are tested under SFAS 142. After all other assets have been tested (assuming triggering events) then goodwill is tested for impairment under the two-step test described in SFAS 142.
Testing for Impairment
Under SFAS 142, Intangibles—Goodwill and Other, goodwill is no longer amortized for financial statement reporting purposes, but rather is tested at least annually to determine if its carrying value has been impaired. Previous standards provided little guidance about how to determine and measure goodwill impairment. As a result, the accounting for goodwill impairment was not consistent or comparable, and users of financial statements questioned the usefulness of those standards.
SFAS No. 142 provides specific guidance for testing goodwill for impairment using a two-step process that begins with defining the reporting unit and measuring its fair value. The first step is a test for potential impairment. If the reporting unit fails the first step, the second step is performed to determine whether an impairment has occurred and to measure the amount of the impairment.
First Step – Under the first step, the fair value of the reporting unit is measured through a discounted cash flow analysis, or other appropriate method. The fair value is compared to the reporting unit’s carrying amount, or book value. If the reporting unit’s fair value is greater than its carrying amount, the reporting unit’s goodwill is not considered to be impaired. If the unit’s fair value is less than its carrying amount, then goodwill impairment is a possibility, and the second step is required.
Second Step – Under the second step, goodwill’s implied value is calculated by subtracting the sum of the fair values of all of the tangible and other intangible assets less liabilities existing on the measurement date from the fair value of the reporting unit. The calculation of implied goodwill includes all assets and liabilities existing on the test date, whether or not they were previously recorded. If the implied, fair value of goodwill exceeds the carrying amount of goodwill, there is no impairment. If goodwill’s carrying amount exceeds its implied value, goodwill is impaired and the difference must be written-off.
In addition to testing goodwill for impairment, SFAS 142 provides guidance on testing intangible assets that are not being amortized (indefinite-lived assets) for impairment. Intangible assets that are not currently being amortized, because their reaming useful life is not known, are tested for impairment at least annually. The test for impairment is rather simple. If the fair value as of the test date is less than their carrying value, the difference is the amount of impairment. If the fair value is greater than the carrying value, the asset is not considered impaired. The carrying value remains on the financial statements.
Issues in Measuring Fair Value When Testing for Impairment
Testing for impairment under SFAS No. 142, is complex and the statement is silent on several issues relevant to its implementation. These implementation issues presented within this section often require judgment on the part of the preparer. The preparer must evaluate the reasonableness of calculations and conclusion when performing impairment testing and focus on the goal of fairly presenting financial information.
Comparing Fair Value Of A Reporting Unit To Its Carrying Value
As discussed previously, SFAS No. 142, Intangibles—Goodwill and Other, describes the test of goodwill for impairment using a two-step method. The first step compares the fair value of a reporting unit with its carrying amount. Identification of the appropriate reporting unit is an important element in impairment testing. Any misidentification has the potential to change the outcome of the impairment test and the dollar amount of the impairment adjustment.
In business combinations, acquired goodwill is assigned to a reporting unit. The reporting unit can be the entire acquired entity, a subset of the acquired entity, or the acquired entity can be combined with one of the acquirer’s existing reporting units. Any new reporting units created in the business combination are consolidated and become part of the acquirer’s operations.
ASC 350 describes a reporting unit as an operating segment, or a unit one level below an operating segment. A component of an operating segment is considered a reporting unit if there is discrete financial information about the component and if its operating results are regularly reviewed by segment management.
Determining the composition of a company’s reporting units is not as straightforward as this description implies. However, it is a critical procedure because a reporting unit’s level within a company’s organizational structure has a tremendous impact on the outcome of goodwill impairment testing.
When reporting units are more broadly defined, cash flows from other internally generated intangible assets and goodwill may be more than sufficient to counterbalance any negative cash flow impact from impaired goodwill. Under a narrow definition of the reporting unit, negative cash flow from the impaired goodwill would stand alone and require recognition in the financial statements.
Acquired assets and assumed liabilities are assigned to a reporting unit as of the business combination date. The carrying amount of a reporting unit equals the reporting unit’s net assets after depreciation and amortization from the date of the business combination. ASC 350-20-35 provides guidance for the assignment of acquired assets and assumed liabilities to reporting units.
For the purpose of goodwill impairment testing, acquired assets and assumed liabilities are initially assigned to a reporting unit when both of the following two criteria are met:
- The asset will be employed in or the liability relates to the operations of a reporting unit.
- The asset or liability will be considered in determining the fair value of the reporting unit.
Certain assets or liabilities are considered part of the corporate function rather than operating unit functions. However, even if an asset is considered a corporate asset, it should be assigned to a reporting unit if both of the above criteria are met. Examples of corporate items that might be assigned to a reporting unit are warranty liabilities and obligations related to non-competition/employment agreements.
Warranty liabilities and non-compete agreement obligations both relate to products produced at operating facilities, and would be included in the determination of the fair value of the operating unit. If corporate assets do not meet both of the above criteria, then they are not assigned to an individual reporting unit. An example would be the corporate headquarters facility. The assignment of acquired assets and assumed liabilities to reporting units applies to those viewed individually and to those viewed as part of a group of assets.
Deferred Tax Considerations
When recognizing and measuring the impairment of goodwill, questions have arisen about how an entity should account for the difference between the book and tax bases of assets and liabilities in determining the fair value of a reporting unit, the reporting unit’s carrying value and the resulting implied fair value of goodwill under FASB ASC 350, Intangibles?Goodwill and Other (SFAS No. 142). In 2002, the FASB issued EITF Issue No. 02-13, Deferred Income Tax Considerations in Applying the Goodwill Impairment Test in FASB Statement No. 142, to clarify some of the goodwill impairment issues relating to deferred tax assets and liabilities.
When performing a test for impairment of goodwill FASB ASC 350, Intangibles?Goodwill and Other, management should make a determination whether the economic value would be higher in a nontaxable versus a taxable transaction under the facts and circumstances as of the test date.
Carrying Foreward An Impairment Test Valuation
ASC 350-20-35, Intangibles—Goodwill and Other (paragraph 27 of SFAS No. 142), provides guidance for carrying forward an impairment test valuation from a prior year, eliminating the need to do another valuation analysis. A detailed determination of the fair value of a reporting unit may be carried forward from one year to the next if all three of the following criteria have been met:
- The assets and liabilities that make up the reporting unit have not changed significantly since the most recent fair value determination. A recent significant acquisition or a reorganization of an entity’s segment reporting structure is an example of an event that might significantly change the composition of a reporting unit.
- The most recent fair value determination resulted in an amount that exceeded the carrying amount of the reporting unit by a substantial margin.
- Based on an analysis of events that have occurred and circumstances that have changed since the most recent fair value determination, the likelihood that a current fair value determination would be less than the current carrying amount of the reporting unit is remote.
Impairment testing for goodwill and other intangible assets is covered in either SFAS No. 142, Goodwill and Other Intangibles, or in SFAS No. 144, Property, Plant and Equipment. Goodwill and intangible assets with indefinite lives fall under SFAS No. 142 and are subject to impairment testing, annually, or sooner if indicated by a triggering event. Such events generally occur when there has been an adverse change in the business climate or a significant reorganization.
Goodwill impairment testing is a two-step process that identifies the existence of a potential impairment and then measures the amount of the impairment. Impairment testing for intangibles is a more straightforward comparison of fair value to carrying value. Impairment testing under SFAS 142 has nuances that include proper identification of the reporting unit, determining the order of testing, assessing any control premium, objective evaluation of valuation assumptions, and determining whether it is appropriate to carry forward an impairment test valuation from year to year.