As companies begin filing first-quarter financial statements, the task is being done with a bit of guesswork about how the Securities and Exchange Commission will react to their treatments of goodwill.

Goodwill is an intangible asset that gets booked on a company’s balance sheet when it buys another business. The asking price for a business typically exceeds the sum of the value of its individual assets and liabilities, giving rise to this “goodwill” figure that gets booked as an intangible asset.

When business is humming, goodwill typically just sits obediently in its place on the asset side of the balance sheet. But if there is evidence the company is stumbling—which companies are prone to do during the worst economic climate in 80 years—then accounting rules require the company to review whether goodwill might be “impaired,” or in need of a mark down. That ultimately results in a charge to earnings.

Hanson

Some long-standing conventions do exist about how companies must determine if goodwill should be written down, says Jay Hanson, national director of accounting for McGladrey & Pullen, but at times those practices produce answers that don’t seem to make sense. Accounting Standards Codification 350, Intangibles: Goodwill and Other and ASC 820, Fair Value Measures and Disclosures, prescribe a two-step test for determining whether a company should write down goodwill, and if so by what amount.

“The first step is a screen to identify if there could be impairment in goodwill,” says Gary Roland, managing director at Duff & Phelps. The company must test the value of goodwill at a high level, by comparing the fair value and the book value of the reporting unit as a whole.

If book value exceeds fair value that could (but not always) mean goodwill is impaired. If a company fails that first step, accounting rules then require a more thorough valuation exercise to determine if goodwill is indeed impaired, and if so by how much.

Roland

As companies have pursued this process under current market conditions, they’ve seen how valuation and accounting differ, Roland says. “The valuation question is butted against the accounting question.”

Valuation methods generally dictate that a company should perform that first step by looking at “enterprise value,” which can be defined basically as total assets minus operating liabilities. Accountants following accounting rules, however, typically perform the first step of the evaluation by establishing an equity value, which for a single reporting unit generally is the market capitalization of the company compared to the carrying value of equity currently on the books.

That distinction between enterprise and equity value is important, because debt can radically affect the final value when the fair value of debt instruments diverges from their expected cash flows. In that environment—which is exactly what happened when debt-based instruments crashed in market value last year—the enterprise-value equation will say that goodwill is impaired, while the equity-value equation will say it isn’t.

Patel

“It was a matter of interpretation to say which approach you should be using to do your impairment testing,” says P.J. Patel, managing director at Valuation Research Corp.

Hanson says the equity value requirement also leads to a counterintuitive result, where a suffering company ends up in a negative equity situation. The liabilities may exceed assets, yet accounting rules provide no room for equity to be less than zero.

“The company could be losing money, yet you run into a situation where by arithmetic, you can’t fail step one, regardless of the economics,” he explains. “If shareholder equity is negative, you’re precluded from going to step two. The standards won’t allow you to go past step one because you didn’t fail it.”

FIRST STEP TEST

The following charts from the Emerging Issues Task Force explain what happens when a significant difference exists between the carrying amount and fair value of debt.

Consider the following illustration involving a single-reporting-unit entity for which the fair value of the debt is significantly less than its carrying amount:

The illustration presented above indicates that when an Enterprise Value premise is used, the reporting unit fails the first step of the goodwill impairment test thus requiring performance of the second step of the goodwill impairment test to measure the amount of impairment loss, if any. If an Equity Value premise is used, the reporting unit passes the first step of the goodwill impairment test and thus the second step is not performed.

Assume in the following example that the fair value and carrying value of all assets, excluding goodwill, and all liabilities, excluding debt, are equal and that the carrying value of debt is equal to its par value as follows.

Although the illustration indicates an underlying $200 impairment of goodwill, the reporting unit passes the first step of the goodwill impairment test using an Equity Value premise because the fair value of the debt is significantly less than par. The reporting unit would fail the first step if the par value of debt was subtracted from the Enterprise Value ($9,800 - $1,500 = $8,300).

EITF Meeting on Impairment (Feb. 2, 2010)

The outcry led the SEC to signal in late 2009 that companies reaching illogical conclusions when they follow accounting rules could change the way they evaluate whether goodwill should be impaired. Evan Sussholz, a staff accountant at the SEC, said in a speech at an annual conference of the American Institute of Certified Public Accountants, that companies may want to consider whether an enterprise value test would be a more appropriate indicator of goodwill impairment.

“It created a little confusion,” says Jan Hauser, a partner at PricewaterhouseCoopers in the firm’s national professional services group. “Since the speech, questions have arisen about which methodology is either required or preferred.”

In light of recent events, the Emerging Issues Task Force of the Financial Accounting Standards Board is launching a project to try to define more precisely how a company is to determine whether goodwill should be impaired. The AICPA also has formed a task force seeking to establish best practices around this and other goodwill and intangible asset issues.

Until that additional help arrives, Hanson says, companies are still left choosing some way to analyze goodwill. Do they go with a method that’s prescribed in accounting literature, even if it produces an answer that seems dead wrong? Or do they climb out on a financial reporting limb and adopt an accounting change based on an isolated SEC staff remark?

Dodyk

Making a change to an accounting practice isn’t a decision to be made lightly, warns Larry Dodyk, a partner with PricewaterhouseCoopers. Companies must get an auditor’s agreement that the new approach is preferable, which raises the prospect of more procedures and documentation.

“Previously, the interpretation of the literature was fairly consistent, yet the SEC speech somewhat opens the door for another view,” Dodyk says. “If companies follow the proposed alternative, it could represent an accounting change."

Valuation firms are encouraging companies to take a closer look at the enterprise approach, Patel says. “We’ve always viewed the enterprise level as the most appropriate level to test at.”

Hanson says he sees companies showing little appetite so far for changing the way they’ve always done the impairment testing, in part because making a change is such a complex process watched closely by the SEC.

Schnurr

Jim Schnurr, senior national professional practice director for Deloitte & Touche, says the SEC is already looking for careful disclosure about impairment testing. Through the SEC comment letter process, “They’re looking to identify and disclose those situations where the margin of error is relatively small.”

Hanson hopes that the EITF (he and PwC’s Hauser are both members) can help resolve the uncertainty. “This is something we have to do to improve the situation,” he says. “It’s up to the EITF to put some rules around this and come up with something we can operationalize.”

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