Simplified Impairment Test Proves Not as Simple as Hoped

As goodwill impairment season gets under way, some accountants are offering up lessons from last year's implementation of a new test for determining whether a write-down might be in order.

Although the test is meant to be simpler and less driven by complex calculation, experts warn that in some situations it can be tricky and and will probably involve some calculations that companies were hoping to avoid.

Late third quarter and into the fourth quarter is traditionally the time when companies with calendar-year financial periods begin to think about whether they will need to write down, or “impair,” some of the goodwill that is carried on their balance sheets, says Tom Viggiano, a partner and director of the audit group in the national office of Deloitte & Touche. “We will start to see a wave of discussions and consultations as the year wears on, when the majority of entities have their measurement dates falling,” he says.

Goodwill is an intangible asset that appears on balance sheets as a result of an acquisition, when the purchase price for a business unit exceeds the fair value of its collective assets. Public companies are required to test goodwill each year to determine if its carrying value on the books is still held up by the fair value of the reporting unit. If the carrying value on the books exceeds the current fair value, companies are required to take an impairment, or write down the excess amount.

The early results of an annual goodwill impairment study by financial advisory firm Duff & Phelps suggest goodwill impairments have held steady the past three years after a massive spike in 2008 to $188 billion, when the financial crisis wrung significant value out of capital markets. In 2011, the firm says, goodwill impairments totaled $29 billion, compared with $30 billion in 2010 and $26 billion in 2009.

The concern over whether goodwill might be impaired isn't reserved for the financial services sector. Only 20 percent of impairments in 2011 originated with companies in financial services, while the balance was spread fairly evenly among companies in consumer staples, consumer discretionary goods, healthcare, technology, and others.

The Financial Accounting Standards Board has acknowledged the complexity of the two-step testing process prescribed in U.S. accounting rules for how an entity would determine if a company needs to book a goodwill impairment. In Accounting Standards Update No. 2011-08, which took effect last year, the board offered a simplified preliminary test to screen out cases where it seems reasonably clear that an impairment shouldn't be necessary. Auditors have affectionately labeled it the “step-zero” test because it precedes the existing two-step test.

The step-zero test allows entities to perform an assessment of qualitative factors that might suggest the carrying value of the goodwill on its balance sheet is likely still supported by the underlying fair value, and therefore in no need of an adjustment. If a company passes the step-zero test and the auditors concur with the assessment, then it can skip the following two steps. If it fails the qualitative test, then it must continue with the two-step test, which usually leads to a detailed valuation exercise of all the assets and liabilities within the reporting unit.

Some companies passed up the opportunity to apply the step-zero test primarily because of timing, says Larry Dodyk, a partner with PwC. The standard was adopted late in the year, and companies needed to develop the process and controls for applying the test, which takes some time and effort. He expects more companies may apply the test in the next cycle as a result.

“You still have to have controls in place and high quality documentation to support the qualitative assessment. You wouldn't want to do all that work and then find you still need to do a valuation.”

—Larry Dodyk,

Partner,

PwC

As they do, Dodyk offers some tips based on last year's first round of applying the new test, beginning with deciding whether to use the test at all. If a reporting unit is not likely to pass the step-zero test with flying colors, it may not make sense to go through the exercise, he says. “You still have to have controls in place and high-quality documentation to support the qualitative assessment,” he says. “You wouldn't want to do all that work and then find you still need to do a valuation. Now you'll have less time and it may be more costly to do that analysis.”

Further Considerations

In Dodyk's view there are some cases where applying the step-zero test probably doesn't make much sense, such as for an at-risk unit where the Securities and Exchange Commission has recently required additional disclosures, or for a recently acquired unit where there was little difference between the fair value at the time of the acquisition and the present carrying value.

Brian Marshall, a partner with the national accounting standards group at McGladrey, says there's no stated margin by which an entity should pass the step-zero test to assure it won't need to proceed further with the full test or possibly book an impairment. FASB's guidance lists a few dozen factors companies need to consider as part of their qualitative assessment, and the facts and circumstances can vary considerably from one company to another. “When you're doing a qualitative test and trying to evaluate qualitatively whether you might fail, it becomes very judgmental,” he says.

IMPAIRMENTS BY INDUSTRY

The following chart from Duff & Phelps shows the percentage of impairments by industry in 2010 and 2011.

Source: Duff & Phelps.

Companies need a solid, recent fair value to serve as a starting point, says Viggiano. “You need a good solid goal post from the past to reach conclusions about the fair-value drivers,” he says. FASB was not explicit in its guidance about how recent a valuation should be, but it pointed out that an aging valuation would be a concern. “This is a common issue we find ourselves talking through with clients and amongst ourselves as we navigated this,” he says.

Viggiano also warns companies not to take the step-zero test lightly. “We've seen in practice companies going right to the conclusions without making positive assertions leading to the conclusion,” he says. “We've found that the quality of the analysis is often directly correlated with management's involvement and comprehension of the fair-value drivers of the business and knowledge of the literature itself.”

Gary Roland, managing director at Duff & Phelps, says the firm's recent Webcast to discuss the emerging results of its study suggest preparers aren't well aware of some emerging guidance that might be helpful to them in assessing goodwill for impairment. He is advising companies to watch for guidance expected from the Financial Reporting Executive Committee of the American Institute of Certified Public Accountants and from the Appraisal Foundation that should facilitate the process. “Auditors will turn to those guides so we can get some convergence of thought around valuation practices,” he says.