September 2011

In September 2011, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update 2011-08, entitled “Testing Goodwill for Impairment”.  This amends guidance in Generally Accepted Accounting Principles (GAAP) Topic 350 involving goodwill and other intangible assets.  Because early adoption is allowed, and the new guidance significantly simplifies the current procedures, expect the new guidance to be widely implemented immediately.

The new guidance simplifies the work currently required in the annual assessment of whether intangible assets need to be written down.  The FASB summarized the change as follows:

“Previous guidance under Topic 350 required an entity to test goodwill for impairment, on at least an annual basis, by comparing the fair value of a reporting unit with its carrying amount, including goodwill (step one). If the fair value of a reporting unit is less than its carrying amount, then the second step of the test must be performed to measure the amount of the impairment loss, if any.

Under the amendments in this Update, an entity has the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount.  If, after assessing the totality of events or circumstances, an entity determines it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then performing the two-step impairment test is unnecessary.”

[Emphasis added]

The FASB’s update includes examples of events and circumstances when an entity should consider performing the more formal tests.  The examples are not all-inclusive.

The only losers in this change are the business valuation firms that will no longer receive annual “annuity” business valuation assignments to make the more formal assessments that are no longer required.

What is Goodwill? What is its Proper Accounting?

When a company buys another firm, the purchase price is allocated among the various components of the acquired business. This allocation is based on the appraised value of the underlying assets. If the purchase price is higher than the fair market value of the acquired business’s identifiable net assets, the excess purchase price is labeled goodwill.

Prior to SFAS 142, goodwill was written off as an expense (called “amortization”) over the estimated life of the goodwill, but in no case more than 40 years. This caused the goodwill value to be reduced gradually. Under the current rules, goodwill is no longer written off slowly. Instead, a company must evaluate the value of goodwill each year, and write down any goodwill in excess of its current value. Accountants call these write-downs “impairment”. When goodwill impairment occurs, it must be presented as a separate line item on the income statement.

Goodwill is identified at the reporting unit level. Generally, companies with different types of operations or businesses will have multiple reporting units. Testing for goodwill impairment requires that each reporting unit with goodwill be assessed annually.

Potential goodwill impairments are identified by comparing the fair value of each reporting unit to that reporting unit’s accounting carrying amount (including goodwill). Goodwill is not impaired as long as the fair value of the entire reporting unit is greater than its entire book value. If the fair market value of the entire reporting unit is less than its book value, then a goodwill impairment loss is recognized for the deficit.

SFAS 157’s fair value accounting is now mandatory in making these assessments. SFAS 157 eliminated some of the diversity in practice that had previously existed in goodwill assessments. Most importantly, SFAS No. 157 defines fair value as an exit price, or how much could be obtained upon sale of the asset.  Considerations of entity-specific rationales that are not reflective of what the marketplace would pay are no longer acceptable.

Private Company Compliance is Generally Poor

Most large, publicly-traded companies are aware of the rules, and their outside auditors are checking compliance. The financial statements of these companies probably comply with the above rules. But the same cannot be said for the financial statements of private companies.

Regardless of whether your (or your client’s) company is public or private, these rules apply. Appropriately determining value (even if not done formally each year) requires business appraisal expertise, which most moderate and small companies do not have internally.

For obvious reasons, some private companies might ignore the need for an annual assessment, but this could lead to violation of contractual obligations and fraud allegations. Without a proper assessment, the potential results include:

  1. Most acquisitions include representations and warranties that the financial statements are prepared in accordance with GAAP. Without the required analysis, these representations cannot be made responsibly.
  1. Commercial loan agreements generally require periodic submissions of GAAP financial statements to the lender. To be in compliance with these requirements, an annual goodwill assessment (even an informal one) is needed.
  2. Commercial loan agreements often include financial covenants based on GAAP financial statements. Once goodwill write-offs occur, loans may be in default. Proactively addressing this situation with the lender is almost always preferable to having the lender raise the issue.
  3. In the event that proper assessments are not made and losses occur, plaintiffs will likely claim that the accounting failure was so great as to indicate a purposeful hiding of the truth, or fraud. Executives and professionals involved with such financial statements could become personally exposed.

Fulcrum Inquiry performs business appraisals for a wide variety of financial reporting, tax, transaction, intellectual property, and litigation purposes.