Standards Evolve for Goodwill & Intangible Assets Impairment Testing
Goodwill impairment testing in the United States has evolved significantly over the last 20 years, moving from a loosely defined set of rules to specific testing requirements and guidelines. Prior to 2001, post-acquisition accounting of goodwill was governed by Accounting Principles Board (APB) Opinion No. 17 – Intangible Assets (APB 17). APB 17 presumed that goodwill and all other intangible assets were wasting assets, like machinery and equipment, and required amounts assigned to them to be amortized by systematic charges to income over the period estimated to be benefited by the asset, up to a maximum of 40 years.
APB 17 was quite vague about the issue of impairment, stating that companies should review amortization periods continually to determine whether subsequent events and circumstances warranted an adjustment to the amortization period. If the amortization period had changed, the unamortized cost should be allocated over the revised estimate of the asset’s remaining useful life subject to a maximum of 40 years. Simultaneously, estimates of the intangible asset’s value and its future benefits may indicate that the unamortized cost should be significantly reduced by a deduction in determining net income. In other words, if the value of the intangible asset has dropped, it may be necessary to take an impairment charge against earnings. APB 17 cautioned entities that a single loss year or even a few loss years combined do not necessarily justify an impairment charge for all (or a large part) of the unamortized cost of intangible assets. Lastly, APB 17 noted that the reason for an unusual deduction should be disclosed.
Newer Approach – Fair Value Testing
Beginning in 2001 with the adoption of Statement of Financial Accounting Standards (SFAS) No. 141, Business Combinations (SFAS 141), and SFAS No. 142, Goodwill and Other Intangible Assets (SFAS 142), the FASB took a very different approach with respect to the measurement of and the accounting treatment for goodwill and other intangible assets subsequent to their initial recognition. With the adoption of SFAS 142, the FASB replaced the amortization of goodwill with annual impairment testing at the reporting unit level.
In adopting SFAS 142, the FASB noted that previous standards provided little guidance about how to determine and measure goodwill impairment. As a result, accounting for goodwill impairments was not consistent or comparable and created information of little usefulness. In contrast, SFAS 142 provided specific guidance for testing goodwill for impairment in the form of a two-step impairment test. The first step of the test was designed to screen for potential impairment, and the second step measured for any impairments.
The first step of the goodwill impairment test under SFAS 142 compares the fair value of a reporting unit with its carrying amount, including goodwill. If the fair value of a reporting unit exceeds its carrying amount, the goodwill of the reporting unit is considered unimpaired, and the second step of the impairment test is unnecessary. If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill impairment test should be performed to measure any amount of impairment loss.
The second step of the goodwill impairment test compares the implied fair value of reporting unit goodwill with the carrying amount of that goodwill. If the carrying amount of reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss should be recognized in an amount equal to that excess. The loss recognized cannot exceed the carrying amount of goodwill.
FASB 142 notes that the implied fair value of goodwill should be determined in the same manner as the amount of goodwill recognized in a business combination. An entity should allocate the fair value of a reporting unit to all of the assets and liabilities of that unit (including any unrecognized intangible assets) as if the reporting unit had been acquired in a business combination as of the testing date and as if the fair value of the reporting unit was the price paid to acquire the reporting unit. The excess of the fair value of a reporting unit over the amount assigned to its assets and liabilities is the implied fair value of goodwill. SFAS 142 further notes that the allocation process should be performed only for purposes of testing goodwill for impairment. An entity should not write up or write down a recognized asset or liability, nor should it recognize a previously unrecognized intangible asset because of the Step 2 allocation process.
Fair Value Measurement
Fair value is defined as the amount at which an asset or liability could be bought, incurred, sold, or settled in a current transaction between willing parties other than in a forced or liquidation sale. The fair value of a reporting unit refers to the amount at which the unit as a whole could be bought or sold in a current transaction between willing parties.
As a basis for measuring the fair value of a reporting unit, SFAS 142 states that quoted market prices in active markets are the best evidence of fair value and should be used as the basis for the measurement if available. If quoted market prices are not available, the estimate of fair value should be based on the best information available, including prices for similar assets and liabilities and the results of using other valuation techniques, which include present value techniques and multiples of earnings or revenue.
Testing must be done annually or more frequently if events or circumstances dictate. Goodwill of a reporting unit should be tested for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Examples of such events or circumstances include, but are not limited to:
- A significant adverse change in legal factors or in the business climate,
- An adverse action or assessment by a regulator,Unanticipated competition,
- A loss of key personnel,
- A more-likely-than-not expectation that a reporting unit or a significant portion of a reporting unit will be sold or otherwise disposed of,
- The testing for recoverability under Statement 121 of a significant asset group within a reporting unit, and
- Recognition of a goodwill impairment loss in the financial statements of a subsidiary that is a component of a reporting unit.
Some Simplification: Qualitative Test – Step 0 Test
In response to private companies’ concerns about the cost and complexity of performing the first step of the two-step goodwill impairment test, in September 2011 the FASB issued Accounting Standards Update (ASU) No. 2011-08, Intangibles–Goodwill and Other (Topic 350), Testing Goodwill for Impairment. ASU 2011-08 amended the goodwill impairment testing rules to provide entities (both private and public) the option to forego the quantitative two-step test if they could demonstrate that it is more likely than not that the fair value of the reporting unit was greater than the carrying amount of the unit based on an examination of qualitative factors. If it could be qualitatively shown that the reporting unit was more likely than not to have a fair value greater than its carrying value, then no further quantitative testing would be needed. This qualitative test became known as the step 0 test since it preceded step 1 of the two-step test.
The FASB provided several examples of events and circumstances entities should consider when comparing a reporting unit’s fair value with its carrying amount. Those examples are as follows:
- Macroeconomic conditions such as a deterioration in general economic conditions, limitations on accessing capital, fluctuations in foreign exchange rates, or other developments in equity and credit markets.
- Industry and market considerations such as a deterioration in the environment in which an entity operates, an increased competitive environment, a decline in market-dependent multiples or metrics (consider in both absolute terms and relative to peers), a change in the market for an entity’s products or services, or a regulatory or political development.
- Cost factors such as increases in raw materials, labor, or other costs that have a negative effect on earnings and cash flows.
- Overall financial performance such as negative or declining cash flows or a decline in actual or planned revenue or earnings compared with actual and projected results of relevant prior periods.
- Other relevant entity-specific events such as changes in management, key personnel, strategy, or customers; contemplation of bankruptcy; or litigation.
- Events affecting a reporting unit such as a change in the composition or carrying amount of its net assets, a more-likely-than-not expectation of selling or disposing all or a portion of a reporting unit, the testing for recoverability of a significant asset group within a reporting unit, or recognition of a goodwill impairment loss in the financial statements of a subsidiary that is a component of a reporting unit.
- If applicable, a sustained decrease in share price.
The FASB cautioned entities that the above examples are not entirely all-inclusive, and an entity shall consider other relevant events and circumstances that affect the fair value or carrying amount of a reporting unit in determining whether to perform the first step of the goodwill impairment test. An entity shall consider the extent to which each of the adverse events and circumstances identified could affect the comparison of a reporting unit’s fair value with its carrying amount. An entity should place more weight on the events and circumstances that most affect a reporting unit’s fair value or the carrying amount of its net assets. An entity should also consider positive and mitigating events and circumstances that may affect whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If an entity has a recent fair value calculation for a reporting unit, it should also consider the difference between the fair value and the carrying amount when reaching its conclusion about whether to perform the first step of the goodwill impairment test.
If, after assessing all relevant events or circumstances, an entity determines that the fair value of a reporting unit is less than its carrying amount, then the first and second steps of the goodwill impairment test are unnecessary.
More Simplification: Private Company Option
Despite the addition of the step 0 test, many private companies continued to complain about the two-step impairment testing, raising many of the same issues that were raised previously, namely that two-step testing was costly and complicated and goodwill impairment was not a measure of particular importance to their stakeholders. In light of those complaints, the FASB issued Accounting Standards Update (ASU) No. 2014-02, Intangibles–Goodwill and Other (Topic 350), Accounting for Goodwill, a consensus of the Private Company Council in January 2014. ASU 2014-02 provided relief to private companies in the form of an accounting policy election, whereby, if elected, private companies would be required to:
- Amortize goodwill over 10 years or a shorter period if reasonable.
- Test goodwill at the entity or reporting unit where the goodwill loss is determined by comparing the fair value of the reporting unit (or entity) to the carrying value of the reporting unit (or entity). Under this framework, a loss is recognized if the carrying amount of the reporting unit exceeds the fair value of the reporting unit with the loss being limited to the book value of goodwill.
- In lieu of annual testing, assess the need to test goodwill whenever a triggering event has occurred.
For companies that elect the Private Company Option, goodwill impairment testing is still needed upon the occurrence of a triggering event. ASU 2014-02 states that goodwill of an entity (or a reporting unit) shall be tested for impairment if an event occurs or circumstances change that indicate that the fair value of the entity (or the reporting unit) may be below its carrying amount. Therefore, whereas the addition of the Step 0 gives entities the option to examine qualitative factors to determine if they needed to perform a step one test, the Private Company Option is more lenient in that private companies that elect the Private Company Option only need to examine those qualitative factors, and potentially quantitative analysis, following a triggering event. It is important to note that the Private Company Option is an all or nothing proposition, meaning entities that elect for the option must apply the private company accounting policy from that point forward.
Additional Private Company Simplifications
There is an alternative method of accounting for goodwill and some other intangible assets when they are acquired in a business combination that is related to private company goodwill testing. Accounting Standards Update (ASU) No. 2014-18, Business Combinations (Topic 805), Accounting for Identifiable Intangible Assets in a Business Combination, a consensus of the Private Company Council provides private companies an accounting policy alternative whereby if elected, the private company entity no longer needs to recognize customer relationships and non-competition agreements acquired in a business combination. Private companies that adopt this alternative are also required to amortize goodwill as put forth in ACU 2014-02. However, the reverse is not true; private companies that choose to amortize goodwill under ASU 2014-02 are not required to follow ASU 2014-18.
Simplifying the Test for Goodwill for Public Companies and Not-for-Profit Entities
Following the release of ASU No. 2014-02, the FASB set out to determine if the simplified goodwill impairment test permitted under the private company option (i.e. determine goodwill loss by comparing the fair value of the report to its carrying value) should be applied to public companies and not-for-profit entities. After due consideration, the FASB issued Accounting Standards Update (ASU) No. 2017-04, Intangibles–Goodwill and Other (Topic 350), Simplifying the Test for Goodwill Impairment, in January 2017. ASU 2017-04 eliminated Step 2 of the goodwill impairment test for public and non-for-profit business.
Under ASU 2017-04, the goodwill loss for public and not-for-profit business is measured by comparing the carrying value of the reporting unit to the fair value of the reporting unit. If the carrying value of the reporting unit exceeds the fair value of the reporting unit, a goodwill loss equal to the lesser of the difference or the goodwill on the books is recognized. Private companies are required to test goodwill for impairment on the occurrence of a triggering event (if ASU 2014-02 is elected), however public companies must continue to test goodwill for impairment annually and more frequently if conditions dictate.
There are three effective dates for ASU No. 2017-04:
- Public business entities that are U.S. Securities and Exchange Commission (SEC) filers should adopt the amendments in the update for its annual or any interim goodwill impairment tests in fiscal years beginning after December 15, 2019.
- Public business entities that are not SEC filers should adopt the amendments in the update for its annual or any interim goodwill impairment tests in fiscal years beginning after December 15, 2020.
- All other entities, including not-for-profit entities that are adopting the amendments in the update should do so for their annual or any interim goodwill impairment tests in fiscal years beginning after December 15, 2021.
Early adoption has been common and is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017.
ORDER OF TESTING
Goodwill is often not the only asset that is impaired when companies are challenged by unusual circumstances or unforeseen events. Therefore, it is critical that companies understand the order of impairment testing for all assets. Impairment testing generally starts with current assets such as accounts receivable and inventory and proceeds sequentially to the following asset categories:
- Indefinite-lived intangible assets (i.e., intangible assets not subject to amortization)
- Long-lived assets including definite-lived intangible assets (and fixed assets)
Indefinite-lived Intangible Assets (i.e., intangible assets not subject to amortization)
The impairment test for indefinite-lived intangible assets compares the fair value of the asset to its carrying value. If the carrying value exceeds the fair value, the entity is to recognize a loss equal to the excess of the carrying value over the fair value subject to a limit equal to the carrying value of the asset. Entities are required to test indefinite-lived intangible assets for impairment annually or more frequently if events or circumstances indicate that it may be more than likely that the subject intangible assets are impaired.
Long-Lived Assets including Definite-lived Intangible Assets
Since most long-lived assets do not independently generate cash flows, testing is generally performed on an asset group. An asset group is determined by the combination of assets that produces the lowest level of independent cash flows. For example, if a single production line produces the lowest level of independent cash flows, then the production line represents the asset group.
If indicators of impairment are present, the impairment test involves determining whether the carrying amount of the asset group is recoverable. The carrying amount of an asset group is considered recoverable and not impaired if the total undiscounted future cash flows from the asset group are greater than the carrying amount of the asset group. If the undiscounted cash flows from the asset group are less than its carrying amount, the asset group is considered to be impaired and testing advances to a second step.
In the second step, the fair value of the asset group is determined and compared to its carrying amount to determine the impairment loss. If the fair value of the asset group is less than its carrying amount, the difference is recognized as an impairment loss and the carrying value of the subject long-lived asset is adjusted and depreciated or amortized over its remaining useful life.
Given the current challenging economic environment and its extreme uncertainties, it is important to emphasize that all companies are required to assess the need to test goodwill and intangible assets when a triggering event occurs. While the tests are simpler now than in the past, testing is often needed to comply with GAAP. IFRS has similar measures and requirements.
Gordon Brothers is a multi-discipline, full service valuation firm that regularly performs impairment testing of goodwill, intangible assets, and fixed assets. Please contact us if you have any questions about impairment testing or valuation issues concerning financial reporting.