In January 2017, the Financial Accounting Standards Board (FASB) published Accounting Standards Update (ASU) No. 2017-04, Intangibles — Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment. Here’s how financial reporting will change under the updated guidance — and why three of seven FASB members dissented from the decision.
Reviewing the old rules
Typically, goodwill arises when one company acquires another. After the purchase price has been allocated among tangible assets and identifiable intangible assets — such as intellectual property and covenants not to compete — any remaining value is attributed to goodwill.
At one time, the FASB required companies to capitalize goodwill and amortize its cost over its estimated life (up to 40 years). In 2001, however, the FASB, recognizing that goodwill doesn’t necessarily lose value, adopted new rules for reporting goodwill.
The rules require companies to evaluate the carrying value of goodwill annually and write it down if it’s impaired — that is, if the goodwill’s fair value has dropped below its carrying (or book) value. Under certain circumstances, companies must conduct impairment testing in between annual tests. For example, interim testing may be required if certain “triggering events,” such as unanticipated competition or loss of a major customer or key employee, signal a potential loss of value.
Under the existing rules, testing goodwill for impairment is a two-step process, applied separately to each of a company’s reporting units. First, determine a reporting unit’s fair value and compare it to the unit’s book value. If the fair value is higher, no further testing is required. If fair value has dropped below book value, proceed to step two.
The second step is to calculate the “implied fair value” of goodwill — that is, the fair value of the reporting unit as a whole minus the fair value of its identifiable net assets. If the implied fair value of goodwill is less than its carrying amount, goodwill has been impaired.
Impairment testing can be somewhat complex. So, in 2011, the FASB offered a simpler, “qualitative” option that allows some companies to avoid quantitative impairment testing. This option allows management to evaluate certain qualitative factors and then determine whether it’s more likely than not that a reporting unit’s fair value has fallen below its carrying amount. If management determines that the chances of impairment are 50% or less, no further testing is required.
In 2014, the FASB decided to allow private companies to elect to amortize goodwill acquired in business combinations over a period of up to 10 years instead of testing it for impairment annually. But some private companies — especially those that are large enough to consider going public someday — continue to test for impairment, similar to public entities.
Focusing on public companies
Despite the FASB simplification efforts, many companies continued to complain about the complexity of the goodwill impairment test. So, the FASB recently issued ASU 2017-04 to further simplify postacquisition accounting for goodwill. Under the updated guidance, an impairment loss will equal the difference between the reporting unit’s carrying amount and its fair value.
But some companies wanted the FASB to retain the option to apply the second step of the impairment test, because it would offer a more precise measurement of goodwill impairment in some cases. In fact, three FASB members dissented from issuing the update. In their view, goodwill could be misstated in a one-step test.
“I would emphasize the fact that I don’t think it’s a simplification or an improvement when you run into situations where you could actually misidentify an impairment,” FASB member Harold Schroeder said during a FASB meeting. “By eliminating Step 2 you actually increase the cost, collectively to the system, by having misinformation in the marketplace.”
Although the FASB has made the goodwill impairment test easier, valuation expertise remains critical. Business valuation experts can help conduct qualitative assessment, determine appropriate reporting units and measure the fair value of those reporting units.
CPAs are specifically prohibited from providing valuation services for their public audit clients. The use of outside valuators helps maintain the auditor’s independence and gives stakeholders greater confidence in postacquisition financial results.