New Step Could Make Testing for Goodwill Impairment Easier

Companies now have some new, simpler guidance to follow to determine whether they need to perform a full-blown test of the goodwill balance in their financial statements, but that doesn’t necessarily mean it will be easy to apply.

The Financial Accounting Standards Board finalized guidance on a new step to determine if the goodwill on a company’s balance sheet needs to be written down. The preliminary step gives companies a simpler way to check for potential impairment, before they are required to conduct the more complex two-step fair-value measurement. Auditors are affectionately referring to it as “step zero” of the current two-step test, says Susan Lister, a partner and national director of auditing for BDO USA, since it gives companies a way to escape a complicated valuation exercise where it seems obvious enough that it isn’t necessary.

The reaction from companies on the updated standard has been generally enthusiastic, says Larry Dodyk, a partner with PwC, because it gives them some opportunity to simplify the accounting and reduce the cost that typically goes into goodwill analysis. “It’s not a long standard, and it’s pretty easy to get your arms around it,” he says.

Implementation, however, could get tricky, says Chuck Evans, a partner with the accounting principles group at Grant Thornton. “It’s going to be a judgment-based assessment,” he says. “Judgments are often pretty hard to audit, and they’re subject to second-guessing. On the auditing side, there’s a lot of concern.”

Goodwill is an intangible asset that appears on corporate balance sheets as a result of merger or acquisition activity. It represents any premium paid that exceeds the fair value of the target company’s collective assets and liabilities.

Companies have long applied accounting rules that require them to test the goodwill balance annually and decide whether it should be written down. The two-step test requires companies to first establish a current fair value for the business or reporting unit that gave rise to the goodwill balance and compare that to the carrying value on the balance sheet. If the fair value is greater than the book value, goodwill is sound and no further action is needed. If the fair value falls below the carrying amount, however, then companies must value all the assets and liabilities in that reporting unit to arrive at a fresh goodwill number. If that number is lower than the one in the books, goodwill is “impaired” and must be marked down.

FASB’s new, simplified test, described in Accounting Standards Update No. 2011-18, Intangibles – Goodwill and Other (Topics 350): Testing Goodwill for Impairment, establishes a new step in front of those two existing steps. It allows companies to make a qualitative assessment to determine whether it is more likely than not that goodwill is impaired before they are required to do any fair-value measurement. If companies determine based on their qualitative analysis that the goodwill in the balance sheet is still valid, they are spared the valuation exercises in the next two steps.

The guidance provides some broad categories of factors companies should take into account in making the qualitative assessment, but the list is not all-inclusive, says Greg Forsythe, a director with Deloitte Financial Advisory Services. “That’s the nature of FASB’s literature these days,” he says. “It’s principles-based.” It tells companies, for example, to look at macro-economic conditions, industry and market considerations, changes in costs for raw materials and labor, overall financial performance, and any entity-specific factors that might affect goodwill.

“It’s going to be a judgment-based assessment. Judgments are often pretty hard to audit, and they’re subject to second guessing. On the auditing side, there’s a lot of concern.”

—Chuck Evans,

Partner,

Grant Thornton

One thing is clear, Dodyk says: “This assessment is not intended to be done with a check-the-box mentality.” Auditors will be looking for some robust analysis that carefully considers the range of possible factors that affect the value of the reporting unit, he says. He advises companies to begin by looking at last year’s impairment test. “We tell people to consider the amount of headroom or cushion they have in the difference between their last fair-value determination of a reporting unit and the carrying amount,” he says. If fair value only cleared the carrying amount by a narrow margin, asserting that margin is still safe in a subsequent period will be a hard sell, he says.

After looking at the margins in prior tests, companies then need to decide which units will get the preliminary qualitative assessment and which will move straight to step one, says Brian Marshall, a partner in the accounting standards group at McGladrey & Pullen. It would be a waste of time and money to assess every unit qualitatively if close calls in prior periods would clearly indicate that those units need to move to step one of the full test, he says. “You wouldn’t want to evaluate all the reporting units qualitatively and determine a number didn’t pass the qualitative test,” he says. “One of the reasons for issuing this guidance was to reduce some of the cost and complexity in testing goodwill for impairment. The last thing you want to do is incur more cost.”

Judgment Way

 

DOING THE TWO-STEP

In the following excerpt and chart from FASB In Focus, the board explains when the two-step test for goodwill impairment will be necessary:

 

If, after considering all relevant events and 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 will be unnecessary. If the entity concludes that the opposite is true, then it will be required to perform the first step of the two-step impairment test by calculating the fair value of the reporting unit and comparing the fair value with the carrying amount of the reporting unit as explained in current guidance. If the carrying amount of a reporting unit exceeds its fair value, then the entity will be required to perform the second step of the goodwill impairment test to measure the amount of the impairment loss, if any. Under the new guidance, an entity may choose to bypass the qualitative assessment for any reporting unit in any period and proceed directly to performing the first step of the two-step test.

 

Source: FASB In Focus Explaining the Guidance.

 

 

The qualitative analysis will lean heavily on judgment, where differences of opinion could arise, Lister says. There may be some “slam dunk” cases where companies can easily assert goodwill is not impaired, she says, but for many companies there will be plenty of positive and negative indicators that will be debatable. “We don’t know how many companies will say, ‘Yippee, we don’t have to do the math!’” she says. Where companies assert goodwill is sound without doing the math, she says, “that’s probably going to give auditors some headaches.”

Marshall and Dodyk both advised companies communicate with auditors early to avoid last-minute surprises. If auditors disagree with a qualitative pass on the full impairment test, that could lead to a scramble to conduct a test that could have been performed earlier.

“From a pure accounting standpoint, it’s fairly straightforward,” says Evans. “A lot of companies will have situations where they clearly pass the qualitative test. Companies will have situations that obviously won’t pass qualitatively. It’s the ones in the middle that are going to be harder.”

As companies gear up for qualitative assessments, FASB is taking a fresh look at whether a similar approach could also be applied to “indefinite lived intangible” assets, such as trademarks, trade names, licenses, and other similar assets. FASB opened a project in part because of feedback on the simplified goodwill impairment test that suggested the same approach could be applicable. FASB expects to float a proposal on the topic and finalize a new rule in the first half of 2012.