Many purchase business combinations involve the recognition of goodwill. Except to those who follow every bit of accounting standard update, talking about accounting for goodwill today is most likely uneasy (if not confusing,) even to an accounting veteran. Through this post, I am going to overview the accounting for goodwill, in purchase business combinations based on the most current rules.
Under the purchase method, when the legal form of combination is a merger or consolidation, the acquirer records all the acquired assets and assumed liabilities at their fair values. If the actual cost exceeds the fair values of the tangible and identifiable intangible net assets acquired, this excess is recorded as goodwill.
In most current accounting standard, as you might have very well known, goodwill is no longer subject to periodic amortization, but rather, is subject to periodic evaluation for impairment. But that is only a small part of what I call goodwill in the jungle. In this post, I am going to exclusively highlight goodwill in the business combination environment. Included in this post are: Identifiable and unidentifiable intangible assets, useful economic life of intangible assets and goodwill, residual value of goodwill, allocation to goodwill, goodwill impairment, measurement procedures for impairment, initial assessment of goodwill’s fair value, annual impairment testing, other impairment testing considerations, presentation of goodwill and of goodwill impairment.
Determining Identifiable and Unidentifiable Intangible Assets
Requirements for goodwill accounting now differ significantly as mandated under the prior rules. In the United States, they also differ from what appeared to be the goal of the FASB’s original proposal—under which pooling method was to have been eliminated and goodwill arising from purchases was to have been amortized over twenty years or less.
FASB, firstly, prepared to demand accelerating amortization of goodwill over a period shorter than the previously permitted forty years while precluding impairment testing, but then changed its mind and decided to prohibit any form of amortization in favor of the formerly rejected intermittent testing for impairment—and thus an entirely new methodology was introduced.
The asset commonly known as goodwill is a subset of the broader subject, intangible asset accounting. The most recent U.S. accounting standard codification, especially ASC 350, addresses the accounting for all intangibles and raises the bar for delineating among different types of intangibles.
The accounting framework codenamed “CON 5”—with “Recognition and Measurement in Financial Statements of Business Enterprises,” states that an asset is recognized if it meets the definition of an asset, has a relevant attribute measurable with sufficient reliability, and the information about it is representationally faithful, verifiable, neutral (i.e., it is reliable), and capable of making a difference in user decisions (i.e., it is relevant).
In a business acquisition, any acquired identifiable intangible asset must be recognized separately from goodwill when it meets these CON 5 asset recognition criteria, and additionally meets either of the following two criteria:
1. Legal (or contractual) – Control over the future economic benefits of the asset results from contractual or other legal rights (regardless of whether those rights are transferable or separable from other rights and obligations), or
2. Separability – The asset is capable of being separated or divided and sold, transferred, licensed, rented, or exchanged (regardless of whether there is an intent to do so or whether a market currently exists for that asset)—or, if it cannot be individually sold, etc., it is capable of being sold, transferred, licensed, rented or exchanged along with a related contract, asset, or liability.
All intangible assets acquired from other enterprises or individuals, whether singly, in groups, or as part of a business combination, are recognized initially and are measured based on their respective fair values. Under the provisions of ASC 350, however, serious effort must be directed to identifying the various intangibles acquired.
Useful economic life of Intangible Assets and Goodwill
Reliably measurable identifiable intangible assets, with the exception of those meeting the criteria for non-amortization, must be amortized over their respective useful economic lives. Useful economic life is the period over which the asset is expected to contribute to cash flows of the entity, directly-or-indirectly.
Number of important factors to be considered in estimating the useful economic life of an intangible asset to a company, include:
- Legal, regulatory, or contractual provisions that may enable renewal or extension of the asset’s legal or contractual life;
- Legal, regulatory, or contractual provisions that may limit the maximum useful life;
- The effects of obsolescence, demand, competition, and other economic factors—such as the stability of the industry, the rate of technological change, expected changes in distribution channels, and so forth;
- The level of maintenance expenditure required to obtain the expected future economic benefits from the asset.
- The expected use of the intangible asset by the company;
- The expected useful life of assets or groups of assets of the enterprise to which the useful life of the asset may parallel (such as mineral rights to depleting assets)
Note: In some cases where an intangible asset is determined to have an indefinite useful economic life, it will not be amortized until its life is determined to be finite at a later date.
Residual Value of Goodwill
The entire fair value assigned to an intangible asset, typically, will be subject to amortization, although in some instances a residual value may be determined, which reduces the amortizable basis.
The residual value of an amortizable intangible is assumed to be zero unless the useful life to the acquiring enterprise is shorter than the intangible asset’s useful economic life, and either:
- The acquiring enterprise has a commitment from a third party to purchase the asset at the end of its useful life; or
- The residual value can be determined by reference to an observable market for that asset and that market is expected to exist at the end of the asset’s useful life.
The method of amortization is to reflect the pattern in which the economic benefits of the intangible asset are to be consumed. Absent the ability to ascertain this, straight-line amortization is applied.
But that is in the situation where amortization of goodwill is allowed. However, if impairment—which is determined by application of the current accounting standard codification (the ASC 360) criterion—the carrying amount will be written down to the impaired amount.
Allocation to Goodwill
The next step after completing the purchase price allocation, under the previous rule, is to allocate any residual of cost over fair value of the net identifiable assets and liabilities to the unidentifiable asset, goodwill. Formerly subject to mandatory amortization, this now IS NOT permitted to be amortized at all, by any allocation ways and over any useful life.
Impairment testing, using a methodology set forth in the accounting standard codification, must be applied periodically, and any computed impairment will be presented as a separate line item in that period’s income statement, as a component of income from continuing operations.
If all other acquired assets have been identified (including, at the moment the transactions occurs, in-process research and development, which is then immediately expensed) and properly valued, by process of elimination. The remaining excess purchase price can be assigned to no asset other than goodwill.
The decision to eliminate the requirement for amortization was based on the recognition that any assigned useful life would be entirely arbitrary. The FASB recognized that not all goodwill declines in value and that any decline in value would rarely occur on a straight-line basis.
Impairment of Goodwill
In the past, goodwill could only achieve financial statement recognition in the limited situation of being purchased (i.e., internally generated goodwill was not recognizable for financial reporting purposes).
After the decision to end the practice of amortized goodwill, it became necessary to develop a mechanism for ensuring that the amount presented in the financial statements would not exceed the goodwill’s estimated fair value at any point in time. This goal is generally consistent with the rules underlying those governing the balance sheet presentation of other fixed assets.
However, any strategy for testing for impairment will inevitably be confounded by the existence, along with the purchased goodwill, of internally generated goodwill created subsequent to the date of the business combination.
FASB concluded that it would be impossible to track “acquisition-specific” goodwill for impairment testing purposes and accordingly endorsed a major departure from the traditional prohibition against recognition of internally generated intangibles. This approach still results in an inconsistency, however, since only entities that have purchased goodwill in the past will be permitted to recognize the internally generated replacement goodwill to avoid impairment write-downs.
Entities that internally generate goodwill but that have not entered into prior purchase business combinations are still prohibited from capitalizing that new goodwill and from presenting it as an asset on their balance sheets.
It concluded, as long as the total goodwill identifiable with the “reporting unit” to which acquisition-based goodwill was assigned can be shown to have a fair value exceeding the book value of the goodwill arising from the acquisition (which means apples are to be compared with oranges), no impairment will be found. This represents a major departure from prior accounting practice.
A reporting unit is defined in current codification as an operating segment or a component of an operating segment that is one level below the operating segment as a whole. In order for a component to be considered a reporting unit it must:
- Constitute a business (as defined in EITF 98); and
- Have available discrete financial information regarding its operating results that is regularly reviewed by segment management.
Measurement Procedures For Impairment
The FASB recognized that goodwill impairment testing could not be effected by the same mechanical approach as the codification sets forth for other long-lived assets. The reason is that the potentially very long-enduring cash flows emanating from goodwill would obviate the usefulness of the rule’s undiscounted cash flows threshold test for impairment.
In other words, it is computationally impossible to forecast undiscounted cash flows from the use and eventual disposition of an asset that has an indefinite life. In essence, the cash flows would continue into perpetuity and, so, GOODWILL WOULD NEVER be deemed to be impaired.
FASB has devised a unique impairment testing protocol for goodwill.
Since direct measurement of the fair value of goodwill is clearly impossible, the U.S. accounting body concluded that a method similar to the method of allocating the purchase price to the net assets acquired in a business combination would be used to indirectly measure the value of goodwill subsequent to its acquisition date. So, it decided that the fair value of the net assets of a reporting unit be subtracted from the fair value of that reporting unit to determine the implied fair value of goodwill.
The fair value of the net assets of the reporting unit can be measured in a variety of ways:
- Direct market observation is certainly the most objective method, but in the absence of that information, other techniques can be substituted.
- CON 7 sets forth an “expected present value technique” which uses the sum of probability-weighted present values in a range of estimated cash flows adjusted for risk, all discounted using the same interest rate convention.
FASB has indicated that such a technique is a more effective measurement tool than was the traditional present value approach, especially in situations in which the timing or the amount of estimated cash flows is uncertain, as is the case in measuring non-financial assets and liabilities.
In order to make an approach—that incorporates the values of the recognized assets and liabilities—work, the FASB concluded that all of the assets and liabilities of an acquired entity—including goodwill—that will be used in the operations of a reporting unit would be allocated to that reporting unit as of the acquisition date.
For many business entities, the required changes to internal management accounting. To the extent these liabilities relate to one or more reporting unit or units, they are now included in the determination of the fair value of the recognized net assets of that unit or units.
The impairment testing process could not proceed if a similar approach were adhered to, and accordingly under ASC 350 goodwill and all other related assets and liabilities are assigned to reporting units for purposes of testing goodwill for impairment. The amount of goodwill allocated to each segment is required to be disclosed in the notes to the financial statements of publicly held enterprises.
Goodwill impairment testing is a two-step process:
- First-step: The possibility of impairment is assessed by comparing the fair value of the ‘reporting-unit’ taken as a whole to its carrying (book) value. If the fair value of the reporting unit exceeds its book value, there is no need for further analysis, since no impairment will be found to have occurred. If, however, the carrying value exceeds fair value, a second step must be performed to indicate whether goodwill is impaired and, it if is impaired, by how much.
- Second-step: The recorded goodwill is compared to its implied fair value, computed in the same manner as when completing a business combination’s “purchase price allocation.” Thus, the fair value of the reporting unit is allocated to all the unit’s assets and liabilities, including, as a residual, goodwill. If the amount thus assigned to goodwill is less than its carrying value, the excess book value must be written off as an impairment expense. No other adjustments are to be made to the carrying values of any of the reporting unit’s other assets or liabilities.
Unlike ASC 360’s impairment measurement requirements, which use net present values, to actually measure the magnitude of any indicated impairment, the goodwill impairment approach uses a purchase price allocation methodology.
Initial assessment of goodwill’s fair value
In order to facilitate periodic assessments of possible impairment, it is necessary that a ‘benchmark-assessment’ be made. This benchmark assessment is performed in conjunction with most significant acquisitions, regardless of how much goodwill arises from that acquisition.
The benchmark assessment involves identifying the valuation model to be used, documenting key assumptions, and measuring the fair value of the reporting unit. In determining how goodwill is to be assigned to ‘reporting-units,’ a reasonable and supportable approach must be adopted.
Goodwill, in general, is assigned consistent with previous recognition of goodwill and with the reporting units to which the acquired assets and liabilities had been assigned. Goodwill assigned to a reporting unit is measured by the difference between the fair value of the entire reporting unit and the collective sum of the fair values of the reporting unit’s assets, net of its liabilities.
While it may be costly to accomplish, this benchmark assessment is necessary to ensure that the entity has identified and documented all key assumptions and tested the outputs of the selected valuation model for reasonableness prior to actually testing goodwill for impairment.
Again, under the ASC 350, a two-step testing protocol is prescribed:
The first step is to compare the reporting unit’s carrying amount (book value) to the unit’s fair value. If fair value exceeds carrying value, there is no impairment and no need for further analysis. On the other hand, if carrying value exceeds estimated fair value, it becomes necessary to formally test for impairment; that is, to apply the second step as described in the following section.
Goodwill is also required to be tested for impairment on an interim basis when it is deemed “more likely than not” that a reporting unit or a significant portion of a reporting unit will be sold or otherwise disposed of, and furthermore, when a significant asset group within a reporting unit is required to be reviewed for recoverability. Annual testing, however, is not triggered by such circumstances, but rather, is required in all cases.
Assuming the step-one analysis reveals the possibility of impairment, the step-two exercise, impairment testing, must be performed. Because of the nature of goodwill, FASB rejected the use of the impairment testing technique of FAS 121 and instead crafted a unique methodology.
The two-step testing rule requires as the first step that a threshold test be applied: is the fair value of the reporting unit greater than-OR-less than its carrying value? If the fair value is lower than the carrying value, impairment is suggested. The impairment, however, is not validly measured by the shortfall computed in step one, because to do so would effectively be to adjust the carrying value of the entire reporting unit to the lower of cost or market.
The second step of the process is as follows:
- It is necessary to allocate the fair value of the reporting unit to all assets and liabilities, and to any unrecognized intangibles (including in-process R&D), as if the unit had been acquired at the measurement date. Any excess of fair value over amounts assigned to net assets (including the unrecognized assets such as in-process research and development) is the implied fair value of goodwill.
- The implied fair value of goodwill is compared to its carrying amount (book value). If the carrying amount of the goodwill is greater than its implied fair value, a write-down of the carrying amount is required. Once written down, goodwill cannot later be written back up—even if later tests show that the fair value has recovered and exceeds carrying value.
Timing Of Annual Testing
The annual impairment tests need not be performed at fiscal year-ends. Instead, the fair value measurement for each reporting unit could be performed any time during the fiscal year, as long as that measurement date is used consistently from year to year. Different measurement dates can be used for different reporting units. Once elected, however, a reporting unit’s annual impairment measurement date is not permitted to be changed.
Other Impairment Testing Considerations
Impairment of identifiable long-lived assets – Testing for impairment of goodwill in accordance with ASC 350 may intersect with evaluating long-lived assets for impairment, as prescribed by ASC 360.
GAAP requires that assets other than goodwill be evaluated for impairment first, and any adjustments necessitated by this evaluation made before testing for goodwill impairment.
In some cases, possible impairment of long-lived assets may only be discovered as the goodwill impairment testing is progressing; in such instances, the goodwill impairment testing is ceased and other impairment issues fully addressed before returning to the goodwill impairment testing procedures.
Presentation Of Goodwill And Of Goodwill Impairment
The aggregate amount of goodwill is to be presented as a separate line item in the statement of financial position (balance sheet). Traditionally, in classified balance sheets, goodwill is another non-current asset, distinguished from property, plant, and equipment.
The aggregate amount of goodwill impairment losses is generally to be presented as a separate line item in the operating section of the income statement. The exception to this rule is when the goodwill impairment loss is associated with a discontinued operation, in which case the impairment loss will be included, on a net-of-tax basis, within the results of discontinued operations. The portion of goodwill associated with net assets to be disposed of is recognized as part of the gain or loss on disposal and is not included in the calculation of impairment loss.
Disclosures about business combinations are to include the primary reason for the acquisition, including a description of the factors that contributed to a purchase price that reflects a premium that results in recognition of goodwill or a discount that results in recognition of an extraordinary gain (negative goodwill).
If goodwill is material in relation to the total cost of a business acquisition, disclosure is required of the amount of acquired goodwill. The amount of acquired goodwill related to each segment (only for those entities that are required to report segment information) and the amount of acquired goodwill that is deductible for income tax purposes must also be disclosed.
For each period for which a balance sheet is presented, the notes to the financial statements must disclose the changes in the carrying amount of goodwill during the period. This must include the amount of goodwill acquired, the amount of impairment loss recognized, and the amount of goodwill included in the gain or loss on disposal of all or a portion of a reporting unit. For publicly held entities, this information is to be provided for each segment, and disclosure is to be made of any significant changes in the allocation of goodwill by segment.
For each goodwill impairment loss recognized, disclosure must be made of the following information: a description of the facts and circumstances leading to the impairment; a description of the reporting unit for which the impairment loss is recognized, the adjusted carrying amount of goodwill of that reporting unit, and the amount of the impairment loss; if applicable, the fact that the impairment loss is an estimate that has not yet been finalized, with the reasons therefore and, in subsequent periods, the nature and amount of any significant adjustments made to the initial estimate of the impairment loss; and, when salient, the segment to which the impaired goodwill pertains.