When companies are testing for possible impairment of goodwill in a seemingly troubled reporting entity, the staff of the Securities and Exchange Commission has signaled it won’t be fooled by attempts to spin negative equity into a rationalization that an impairment doesn’t exist.

Evan Sussholz, professional accounting fellow for the SEC, said at the recent national conference of the American Institute of Certified Public Accountants that the staff has heard a number of questions about which valuation approach is required by Accounting Standards Codification Topic 350 Intangibles.

The rules map out a two-step test for determining whether goodwill might be impaired, or whether it may have lost some value since it was last determined and booked. The purpose of the first step, said Sussholz, is to identify potential impairment by comparing the fair value of a reporting unit to its carrying amount, including goodwill.

Fair value, according to accounting rules, is the price that would be received to sell the reporting unit as a whole, but the standard doesn’t specify whether entities should begin the analysis with “enterprise value” or “equity value.” Enterprise value is commonly defined as the sum of the fair value of debt and equity, whereas equity value refers to the sum of all ownership interests in the company, such as through stock, stock options, and other securities convertible to equity.

Sussholz said the SEC staff generally doesn’t expect the selection of the equity or enterprise value will impact the outcome of the goodwill impairment test, but it could be important if debt surpasses equity. He points out that the fair value of a reporting unit cannot be less than zero.

“In a circumstance when the carrying value of equity is negative, a reporting unit would seemingly always ‘pass’ a step-one goodwill impairment test performed on an equity basis, despite the fact that significant goodwill may exist and the underlying operations of that entity may be deteriorating,” he said. “In this example, a step-one test performed on an enterprise basis would likely provide a better indication of whether a potential impairment of goodwill exists and a step-two test should be performed.”

The second step of the impairment test requires companies to measure all assets and liabilities within the reporting unit at fair value to determine exactly what the impairment is—a significant undertaking that companies generally would prefer to avoid. But they shouldn’t try to avoid it by trying to work with a negative equity value, said Sussholz.

“In absence of further authoritative guidance, the SEC staff believes that a reporting entity may want to consider whether utilizing an alternative approach to a step-one test such as enterprise value would be a better economic indicator of goodwill impairment,” he said. The analysis should look at market participant assumptions, the potential structure of a hypothetical sale transaction, and other factors, he said.