'Tis the Season for Goodwill Scrutiny

A massive wave of goodwill write-offs swelled by the global recession has crested, but companies can expect regulators and auditors to be as skeptical as ever about goodwill that still exists on corporate balance sheets.

Goodwill is an intangible asset that appears on balance sheets following an acquisition. It represents the amount paid for a target company that exceeds the fair value of its collective assets. Companies are required to review the goodwill on their books at least annually and write it down if it is “impaired,” meaning its fair value has dropped below its book value.

As the economic crisis wrung excess value out of virtually everything in 2008 and 2009, U.S. public companies reported goodwill impairments in huge numbers. According to valuation firm Duff & Phelps, goodwill impairments jumped from $6 billion in 2006 to $188 billion in 2008, then dropped back to $26 billion in 2009.

Hambleton

Today markets are more stable, but uncertainty still abounds—and that makes goodwill hard to assess, says Wendy Hambleton, a national director at accounting firm BDO. She says cash flows are difficult to project (because recent history has been a lousy predictor of future results), and that makes the valuation process all the more tenuous. “There are a lot of unknowns out there for companies doing the goodwill analysis,” she says.

Macro-economic issues drove many companies to record goodwill impairments in 2008 and 2009, says Bert Fox, a partner at Grant Thornton. “In 2010, impairments will be driven more by micro issues or company-specific issues,” he says. “Impairments will be based on specific events: a product that failed or a market that's not doing well; things like that. It's still a hot-button topic right now.”

Fox

Impairments are under increased scrutiny because the Securities and Exchange Commission is still showing plenty of interest in the subject, Fox says. Staff comments on corporate filings are pouring out in almost form-letter fashion, especially for companies carrying material amounts of goodwill on balance sheets. “The staff is looking for advance warnings,” he says.

The SEC is telling companies that if goodwill is material, then the company should explain its impairment testing policy in both its footnotes and its critical accounting policies. If the company is not writing down goodwill, it should tell investors by what percentage the fair value of goodwill exceeds the book value.

The letters also include a litany of other directives: A company should explain how much goodwill is allocated to the reporting unit, how fair value was determined, what key assumptions were used, how the key assumptions were determined, what uncertainties might cloud the key assumptions, and what events or circumstances might have a negative effect on assumptions. “Just about any client we have with any material goodwill balance has received that comment in the last 12 months,” Fox says.

Goodwill Impairment Hunting

“Make sure you're updating all your information based on current market information. Historical information may be dated, and that could result in big differences.”

—Brian Marshall,

Partner,

McGladrey & Pullen

Near the end of 2009, SEC staff also challenged the method some companies used to test their goodwill to determine whether an impairment was warranted. That prompted the Emerging Issues Task Force of the Financial Accounting Standards Board to recommend a new rule about the testing process.

Marshall

The SEC raised a concern about the premise companies might follow when deciding whether goodwill should be reduced in the balance sheet. Some companies followed an “equity” premise, while others followed an “enterprise” premise. The difference between the two is the level of debt, says Brian Marshall, a partner with accounting firm McGladrey & Pullen.

On an equity basis, with the value of debt factored in, companies loaded with debt might easily arrive at a negative number, he says. Since fair value by definition can never be negative (that is, the market value of something can't be less than zero dollars), some companies were concluding that the value of their goodwill couldn't possible by impaired—therefore passing the first step of the goodwill impairment testing with no further action required.

Hauser

FASB recently approved an EITF recommendation that companies be required to perform not only a mathematical test, but also a qualitative test to determine if goodwill should be written down if the mathematical equation leads to a negative equity value. The rule will take effect with the opening of the 2011 reporting year for calendar-year companies, says Jan Hauser, a partner with PwC and a member of the EITF.

SEC COMMENT EXAMPLE

Below is a sample of the text in SEC comment letters on goodwill impairment, as provided to Compliance Week by a top accounting firm:

We note that goodwill represents x% or more of your assets as of December 31, 2009. In light of the significance of your goodwill balance, we expect robust and comprehensive disclosure both in your footnote and in your critical accounting policies regarding your impairment testing policy. This disclosure should provide investors with sufficient information about management's insights and assumptions with regard to the recoverability of goodwill. Specifically, please disclose the following information for each reporting unit (with material goodwill) that is at risk of failing step one of the goodwill impairment test:

Percentage by which fair value exceeded carrying value as of the most recent step-one test

Amount of goodwill allocated to the unit

Description of the methodology used to determine fair value

Description of the key assumptions used and how the key assumptions were determined

Discussion of the uncertainty associated with the key assumptions and any potential events and/or circumstances that could have a negative effect on the key assumptions.

Otherwise disclose, if true, in your critical accounting policies that none of your reporting units with significant goodwill is at risk of failing step one of the goodwill impairment test. Please provide us with your proposed disclosures.

“The EITF stopped short of recommending that FASB mandate a particular premise,” Hauser said. “But we did say irrespective of how you determine the carrying value, if the carrying value is zero or below zero, then the company is required to look at some qualitative factors to determine whether there could be an impairment.” Those qualitative factors include things like a significant adverse change in the business climate or legal factors, an adverse action by a regulator, unanticipated competition, loss of key personnel, or an expectation that some portion of the business will be sold or otherwise disposed.

The new guidance is expected to lead to at least some additional goodwill impairments, but the companies most likely affected are those with single reporting units and negative equity, Marshall says. “It's going to have some impact, but I have no idea how much,” he says.

Going forward, the best course for companies is to examine the SEC's expectations for impairment testing and disclosure, and not to assume that what was allowed in the past will work in the future. “We continue to stress being very vigilant about situations where reporting units may be close in terms of just passing the first step of the impairment test,” Hauser says. “If that's the case, the SEC is very keen about making sure companies have appropriate disclosures.”

Marshall says companies need to look at how they've grouped their assets and liabilities under various reporting units to assure the goodwill associated with them is sound and defensible. “Make sure you're updating all your information based on current market information,” he says. “Historical information may be dated, and that could result in big differences.”

Fox says companies should not to get too optimistic in their forecasting, which can inflate views and assumptions about the health of goodwill balances. (Anyone working on financial reports during the dot-com boom probably learned that lesson the hard way.) The SEC and the Public Company Accounting Oversight Board continue to hone in on assumptions and assertions of all kinds in the balance sheet, he says.