Goodwill Accounting and Potential FASB Updates

By September 18, 2019 October 23rd, 2019 Accounting
Two business men shaking hands in an office space | Potential FASB Updates Put the Spotlight Back on Goodwill Accounting

In July, the Financial Accounting Standards Board (FASB) announced they were considering making adjustments to the accounting protocol for certain identifiable intangible assets acquired in a business combination and subsequent accounting for goodwill.

The FASB issued an Invitation to Comment following preliminary outreach to public company stakeholders over the past few years. Feedback gathered from stakeholders indicated that the benefit of certain intangible asset and goodwill impairment information did not justify the cost of preparing and auditing the information. However, private company stakeholders have brought an alternative perspective to the topic. Private company stakeholders explain that private company accounting alternatives issued by the Private Company Council reduced the cost and complexity without decreasing the value and usefulness of the information.

Recently, the FASB extended the private company accounting alternatives to not-for-profit entities and is in the process of considering whether to offer public companies the same options. These accounting methods address concerns regarding goodwill amortization, goodwill impairment testing following a triggering event, and subsumable items reported as identifiable assets into goodwill. One drawback to this plan is the possibility of global comparability issues. Furthermore, some public company stakeholders support the current reporting methods for goodwill and intangible assets and find value in the information.

With the deadline for comments to the FASB Notice on October 7, 2019, it is worthwhile to assess the goodwill accounting standards as they currently exist, understand what goodwill is and how it can impact you as a business owner and/or stakeholder.

What is goodwill?

Goodwill is an intangible asset associated with the purchase of one company by another. More specifically, goodwill is recorded in a situation in which the price paid exceeds the sum of the fair value of all identifiable intangible assets purchased in the acquisition and the liabilities assumed in the process. The amount the acquiring company pays for the target company over the target’s book value usually accounts for the value of the target’s goodwill. This particular asset only arises from an acquisition and it cannot be internally generated.

Negative goodwill develops when the acquirer pays less for the acquired company than the fair value of its identifiable assets and liabilities. Typically, negative goodwill arises as part of a distressed sale.

Examples of goodwill are the value of a company’s brand name, solid customer base, good customer relations, good employee relations and any patents or proprietary technology.

What does goodwill indicate?

Goodwill is recorded as an intangible asset on the acquiring company’s balance sheet under the long-term assets account. Under both the Generally Accepted Accounting Principles in the United States (US GAAP) and the International Financial Reporting Standards (IFRS), companies are required to evaluate the value of goodwill on their financial statements at least once per year and record any impairments. Goodwill is considered an intangible (or non-current) asset, as it is not a physical asset such as a building or equipment.

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How to calculate goodwill

The goodwill accounting calculation is:

Goodwill = (Consideration paid + Fair value of noncontrolling interest) – (Assets acquired – Liabilities assumed)

However, there are competing approaches to goodwill accounting calculations. One reason for the variance is that goodwill represents a kind of workaround for accountants. For example, acquisitions typically factor in estimates of future cash flows and other considerations that are unknown at the time of acquisition. While this situation is not itself a problem, it does cause significant concern when accountants look for ways of comparing reported assets or net income between different companies.

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What are the limitations of using goodwill accounting?

First and foremost, the value of goodwill is highly subjective, especially because it does not generate cash flows. This yields considerable risk of overvaluing goodwill in an acquisition transaction. An overvaluation is detrimental for shareholders of the acquiring company, as they are likely to see their shares decrease when the company has to write down or impair goodwill at a later date.

Additionally, there is substantial risk that a previously successful company faces insolvency. When this occurs, investors deduct goodwill from their determination of residual equity. This is necessary because at the point of insolvency, the goodwill now has no resale value.

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How is goodwill different from other intangible assets?

Despite falling under the intangible asset category, goodwill differs significantly from other intangible assets. Goodwill is a premium paid over fair value during a transaction and cannot be bought or sold independently. Conversely, other intangible assets include patents and licenses which can in fact be purchased independently. Furthermore, goodwill has an indefinite lifespan, whereas other intangibles have a finite useful life.

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What is goodwill impairment?

Goodwill impairment is an accounting charge that companies record when goodwill’s carrying value on financial statements exceeds its fair value. It develops when the acquired assets’ ability to generate cash flows deteriorates and the fair value of the goodwill falls below its book value.

How does it work?

The goodwill impairment is an earning charge recorded on a company’s income statement following the identification of a decline in asset value. Typically, many companies acquire other businesses and pay a purchasing price which outweighs the value of identifiable assets and liabilities. The result is goodwill. However, unforeseen circumstances can develop and cause a decrease in expected cash flows from acquired assets. If this happens, the recorded goodwill could have a current fair value lower than originally booked. Thus, the acquiring company must record a goodwill impairment.

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What is a goodwill impairment test?

Accounting scandals in the early 2000s put a bright spotlight on goodwill impairment. Throughout those years, countless firms intentionally and artificially inflated their balance sheets by reporting excess goodwill values. At the time, that value was amortized over its estimated useful life. Amortizing an intangible asset decreases the amount of expense booked related to that asset in any single year.

In response to the scandals and abuse of goodwill valuation, the FASB modified goodwill accounting standards. As a result, public companies were required to perform annual goodwill impairment tests and goodwill was no longer amortized. (Since then, ASU 2014-02 partially rolled back the limitation on amortization. Private companies gained the option to elect to amortize goodwill on a straight-line basis over 10 years.)

Per the changes in the early 2000s, US GAAP demands companies review their goodwill for impairment at least once per year at a reporting unit level. A reporting unit is defined as the business unit that a company’s management reviews and evaluates as a separate segment. Reporting units typically reflect distinct business lines, geographic units or subsidiaries.

Generally, goodwill impairment is triggered by deteriorating economic conditions, increased competition, loss of key personnel, and regulatory action. It is identified in two steps:

  1. Company must compare the reporting unit’s fair value to its carrying value on the balance sheet.
  2. If the fair value is lower than the carrying value – indicating goodwill impairment – the company must apply the fair value to the identifiable assets and liabilities.

The excess value becomes the new goodwill and the carrying value is reduced by a goodwill impairment charge.

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What impact did goodwill impairment testing have?

Most notably, in 2002 the AOL Time Warner, Inc. merger resulted in a $98.7 billion impairment charge and a $54 billion write-off loss. At the time, it was the largest goodwill impairment loss ever reported by a company and it came at the hands of the FASB’s rule changes to goodwill impairment testing.

The large write-off resulted from a substantial decrease in valued assets at the time of the merger. More exactly, when the merger was first initiated the combined value of AOL and Time Warner was worth $290 billion. However, at the time of the acquisition the combined worth was $126 billion and on a path of an even steeper decline.

Therefore, due to the then-new accounting changes, AOL Time Warner was required to make a one-time adjustment that amounted to the balance sheet change. In this case the change was $98.7 billion and a loss of $54 billion.

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How did the most recent ASU impact goodwill?

In January 2017 the FASB issued ASU 2017-04, Intangibles – Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment. This was the most recent update to goodwill accounting standards.

Goodwill Impairment

The update effectively eliminated the calculation of implied goodwill fair value. In its place, companies are expected to record an impairment charge based on the excess of a reporting unit’s carrying amount of goodwill over its fair value. The update intended to simplify the accounting standard by requiring the impairment test be comprised of only a single quantitative step.

Goodwill Amortization

For a long time, goodwill was amortized for over a period of 40 years. However, following the aforementioned accounting scandals of the early 2000s, a 2001 decree eliminated the possibility of amortization for goodwill. The same decree implemented the now-required goodwill impairment test.

However, per ASU 2014-02 Intangibles – Goodwill and Other (Topic 350) Accounting for Goodwill: A Consensus of the Private Company Council, the FASB partially rolled back the restriction on goodwill amortization. Per the update, private companies were allowed to amortize goodwill on a straight-line basis over a period of up to 10 years. The subsequent 2017 ASU expanded these rights to public companies.

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What does this all mean for me?

The Financial Accounting Standards Board is once again considering changes to the goodwill accounting standards. This round of potential updates impacts the information available to stakeholders. While no particular update is set into motion, it is important to understand how the amount and quality of goodwill information impacts you and what it all actually means.

Previous updates – such as the ones instituting goodwill impairment tests – were put into place to hold companies accountable and ensure investors had access to accurate information. While there is no easy method of evaluating impairment risk, there are a few generalizations to pay attention to:

  • Did the company make a large acquisition in the past?
  • Does the company have high (greater than 70%) leverage ratios and negative operating cash flows?
  • Has the company’s stock price dropped considerably in the past 10 years?

Some signs are better than no signs. Even then, though, understanding the goodwill process as it relates to you or your company can be tricky. That is where we come in. From top to bottom, our highly trained professionals are here to guide you through the process. We also boast a stellar Mergers & Acquisitions practice that is prepared to answer your goodwill questions. Contact us today!

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Disclaimer: This material has been prepared for informational purposes only, and is not intended to substitute for obtaining accounting, tax, or financial advice from a professional tax planner or financial planner. All information is provided “as is,” with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information.