By: Theresa Zeidler-Shonat, Senior Associate - Business Valuation, AccuVal Associates, Inc.
When a company completes an acquisition, Accounting Standards Codification (ASC) Topic 805 (formerly SFAS 141R) requires that all acquired assets be valued so that the purchase price can be allocated. If the sum of fair values of these asset categories (including cash/equivalents and identifiable intangibles) is less than the purchase price, then the balance of the acquisition value is deemed to be goodwill and is booked as such as a balance sheet intangible asset. Companies, public or private, are then required to test this goodwill annually to determine if there is any impairment of goodwill. In short, if the fair value of the business enterprise has declined since the date of the acquisition, particularly if there has been no change in the "carrying value" of the assets, then goodwill impairment may exist.
Recently, the industry has seen plenty of changes in accounting guidance for goodwill impairment testing. Last September 15, the Financial Accounting Standards Board (FASB) published Accounting Standards Update (ASU) No. 2011-08, which relates to ASC Topic 350, Intangibles – Goodwill and Other. That led to modifications in the traditional two-step test for goodwill impairment for all entities, both public and nonpublic, with any goodwill reported in their financial statements.
Just two months later, the AICPA issued an exposure draft of its Testing for Goodwill and Impairment Accounting and Valuation Guide, incorporating changes to impairment testing. Because these alterations affect all industries, every company should be aware of how these changes affect financial reporting.
The FASB update modified the traditional two-step test by including a "qualitative assessment" option, or "Step Zero," to the process. During this step, an entity can first assess whether it is "more likely than not" that the fair value of a reporting unit is less than its carrying amount. If the answer is no, then the fair value of the reporting unit does not need to be measured, and Step One and Step Two are bypassed.
Companies are not required to perform Step Zero, however, and may choose to go directly to the first step for reasons to be explained. The report also addresses entities that have zero or negative carrying value, details factors that can help determine if interim testing is required and eliminates the "carry forward" of the determination of fair value for an entity from one year to the next.
On the surface, it might seem that Step Zero is an easy way for companies to avoid the time and expense of further impairment testing, but in reality and practice it might not be so simple.
While Step Zero was designed to make the impairment testing process easier for some entities, it won't result in less work, less time or less expense for all companies. The qualitative-assessment factors that must be considered in Step Zero include some for which good historical recordkeeping is essential to quality data, as well as other, broader indicators for which information is readily available but must be compared against company data; that requires a certain investment of time by any company using Step Zero. The rational for the conclusion of the qualitative assessment must also be clearly documented – another task that could be time-intensive.
The ASU includes a non-comprehensive list of qualitative factors to consider. This list includes macroeconomic conditions, industry and market considerations, cost factors, overall financial performance and entity-specific events, such as changes in management, key personnel, strategy or customer base. In addition, contemplation of bankruptcy and the potential for litigation are major considerations, along with any changes in composition or carrying amounts of net assets, a more-likely-than-not expectation of selling all or a portion or a reporting unit or, if applicable, a sustained decrease in share price (which should be considered both in absolute terms and relative to comparable companies). Positive and mitigating factors should also be considered.
To consider these factors for testing, significant documentation could be required. How much documentation? The amount will vary from company to company, but it will be impacted by the materiality of the company's goodwill balance compared to other assets, the availability of compelling qualitative data and the rigor of the audit process by the company's independent auditor.
If, after the Step Zero qualitative assessment is performed, the company determines that it is more likely than not that the fair value of the reporting unit or company is less than its carrying value, then the company needs to perform Step One of the goodwill impairment test. And it should be noted, these new regulations don't affect how the first and second steps of the goodwill impairment test work.
FASB's intent was to reduce the complexity of goodwill impairment testing for certain entities. However, for some companies, particularly those for which it is not readily apparent whether the "more likely than not" criteria has been met, using the qualitative-assessment option might result in more auditor scrutiny. The AICPA exposure draft notes that "measuring fair value requires specialized skill either within an entity or by using an external valuation specialist."
New reporting practices are effective for annual and interim impairment tests performed for fiscal years beginning after December 15, 2011, though early adoption is permitted under certain conditions. Companies choosing to use the Step Zero option should be aware that it's not a "get out of impairment testing free" pass and will require solid documentation to avoid additional testing steps. Companies wishing to avoid documentation requirements and added scrutiny may do so at a reasonable cost by hiring a qualified valuation company to jump straight to a Step One test.
AccuVal provides a broad range of valuation, advisory and asset management solutions that contribute to growth or help ensure survival. We appraise the business enterprise and shareholder equity; bonds; intangibles and intellectual property; machinery and equipment; inventory; real estate and accounts receivables in over 100 industries worldwide. Learn more at www.accuval.net.