Goodwill. It’s what’s left over after you allocate the purchase price to the assets acquired and liabilities assumed based on their fair values in a business combination. When I graduated from college (a long time ago), accounting for goodwill was dead easy. It was amortized over a period of not more that 40 years (20 years for SEC registrants). However, since 2001, goodwill is no longer amortized, but is subject to an annual (and onerous) two-step impairment test. But goodwill accounting under ASC 350 is changing.
M&A Activity is Increasing and So Are Goodwill Impairments
As we discussed in this post, M&A activity hit an all-time high in 2015. Although 2016 is down over prior year, October 2016 was the highest deal making month on record! And all this deal-making is affecting corporate balance sheets. According to a study by Duff & Phelps, $458 billion of goodwill was added to the balance sheets of U.S. companies.
But goodwill has to be tested for impairment annually and this same study showed goodwill impairment levels doubled from 2014 to 2015, hitting their highest mark since the global financial crisis. According this Compliance Week blog post, public companies reported $57 billion in goodwill impairment in 2015, more than double the level in 2014 of $26 billion.
Amidst these facts, there is a renewed focus on goodwill accounting. Before we get to the recent and proposed changes, let’s briefly review the current requirements under ASC 350.
Since goodwill is not amortized, ASC 350 requires it be measured for impairment annually based on reporting units using a two-step test. Prior to testing for impairment, an entity must first determine its reporting units, defined as an operating segment or one level below an operating segment based on certain criteria. Then the entity must allocate its assets, including goodwill, and liabilities to each of the reporting units based on the guidance within ASC 350.
The first step of the impairment test involves comparing the fair value of each reporting unit to its carrying amount, which is the book value of the assets and liabilities allocated to it by the entity. If the fair value of the reporting unit is higher than its carrying amount, goodwill within that reporting unit is not impaired. However, if the fair value of the reporting unit is lower than its carrying amount, then the step 2 of the impairment test must be performed.
It is this second step that is so onerous and controversial. It requires an entity to assume that the fair value of the reporting unit is the hypothetical purchase price of the unit. The entity must then perform a “back of the envelope” business combination, allocating this hypothetical purchase price to all of the assets and liabilities within the reporting unit based on their fair values at the date of the impairment test. Seriously, you have to take the time and incur the expense to account for a business combination just to determine if goodwill is impaired.
Luckily, ASU 2011-08 was issued in 2011 to reduce the complexity and costs of goodwill impairment testing. As outlined in ASC 350-20-35-3A through 35-3G, an entity is permitted to make a qualitative assessment of whether it is more likely than not that a reporting unit’s fair value is less than its carrying amount before applying the two-step goodwill impairment test. This optional test is referred to as Step “0” as it is performed before the two-step impairment test discussed above.
Under this option, an entity first considers qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If an entity concludes that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, the entity is required to perform the two-step impairment test to determine whether goodwill is impaired. Conversely, if it is not more likely than not that the fair value of the reporting unit is less than its carrying amount, it is assumed that goodwill is not impaired and the entity is not required to perform the test.
Private Company Alternative
There is also some relief for private companies. ASU 2014-2 permits non-public companies an accounting alternative to amortized goodwill on a straight-line basis over 10 years, or less if the entity can demonstrate that another useful life is more appropriate. In addition, non-public companies are required to make an accounting policy election to test goodwill for impairment at either the entity level or the reporting level.
What are your feelings about step 2? In all honesty, I believe it’s pretty stupid, adding undue complexity to accounting for goodwill. Plus, it has created a difference with IFRS.
Well, the FASB has heard us! They have a narrow scope project with the objective of reducing the cost and complexity of the subsequent accounting for goodwill by simplifying the impairment test by removing step 2. Sweet! A final standard is expected by the end of the year with an effective date for fiscal years beginning after December 15, 2019 for public business entities and one year later for non-SEC filers.
Is your goodwill impaired? You can be assured based on recent economic events that your auditors and regulators will be asking you that same question. We hope this post has helped you by summarizing the current guidance, as well as informing you of changes coming down the pike. If you have any questions about goodwill accounting under ASC 350 or the pending changes, do not hesitate to give us a call!