In January 2017, the Financial Accounting Standards Board (“FASB”) issued revised guidance for goodwill impairment testing that’s intended to make the process easier and less costly. The latest amendments, found in Accounting Standards Update (“ASU”) No. 2017-04, Intangibles — Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment, establish a one-step process for testing goodwill for a decrease in value. The information below explains what goodwill is, why and how companies test for goodwill impairment, and how the FASB has simplified the process over the years. Bear in mind that, though companies welcome a simpler goodwill reporting model, some FASB members have expressed concerns about the latest update.
Testing Goodwill for Impairment under Current Standards
The term “goodwill” refers to the residual asset recognized in a business combination (such as a merger) after recognizing all other identifiable assets acquired and liabilities assumed. This premium is considered an intangible asset that generally includes the reputation of the purchased business and its competitive advantage in the market. Under accounting principles generally accepted in the United States (“GAAP”), goodwill is carried on the books at its initial value, less any impairment.
The current standards state goodwill is considered to be impaired when the implied fair value of goodwill in a “reporting unit” of a company is less than its carrying amount, or book value, including any deferred income taxes. (A reporting unit is an operating unit that has its own discrete financial information, separate from the overall company.)
Assuming management doesn’t adopt one of the simplified alternatives (described later in this article), under current GAAP, a company must test goodwill for impairment annually using this two-step process (and more frequently if certain conditions exist):
- The company calculates the fair value of the reporting unit and compares that amount with the carrying amount of the reporting unit, including goodwill. If the carrying amount exceeds the fair value, the company must perform the second step. If not, testing stops.
- The company measures the amount of goodwill impairment, if any, by comparing the implied fair value of the reporting unit’s goodwill with the carrying amount of that goodwill. Measuring the implied fair value of goodwill requires a process similar to the one in which goodwill was created, which includes measuring the identifiable assets and liabilities in performing a hypothetical application of the acquisition method.
The company must then recognize any impairment as a loss on its income statement. The carrying amount of goodwill is also reduced to its implied fair value.
A common complaint from companies has been that the benefits of impairment testing didn’t justify the costs, including the fees paid to outside business valuation experts to estimate fair value. They told the FASB that the test was too complicated and asked for simplified guidance.
In 2011, the FASB responded by issuing a standard that gives companies the option of making a qualitative evaluation to determine whether they must test for goodwill impairment. If a company chooses this option, it assesses whether relevant events and circumstances — such as general economic conditions, regulatory changes, and the company’s financial performance — make it “more likely than not” that the fair value of the reporting unit’s goodwill is less than its carrying amount. If the company determines that it is more likely than not that the fair value of goodwill exceeds its carrying value, impairment testing isn’t required. However, if the company determines that there is less than a 50% chance that the fair value of a reporting unit’s goodwill exceeds its carrying amount, the company would perform the two-step goodwill impairment test.
In 2014, the FASB issued an update to give private companies the option of amortizing goodwill on a straight-line basis over a period of ten years (or less if the company demonstrates that another useful life is more appropriate). A private company that elects this alternative must test for goodwill impairment only when a triggering event or circumstance— such as a significant adverse change in business climate, legal issues, or loss of key personnel — occurs that indicates the fair value of the company or a reporting unit may be below its carrying amount.
This private company alternative also drops the second step of the existing impairment test. Instead, any impairment would be equal to the amount by which the carrying amount of the entire company or reporting unit exceeds its fair value. The goodwill impairment loss can’t, however, exceed the carrying amount of the company’s or reporting unit’s goodwill.
Elimination of Second Step
With the release of ASU 2017-04, the FASB has decided to simplify goodwill impairment testing again, this time for public companies as well as for private companies that haven’t elected to amortize goodwill. This update eliminates the second step of the goodwill impairment test. Therefore, a goodwill impairment loss is measured as the excess of the carrying amount of a reporting unit (that includes goodwill) over its fair value. Impairment losses are limited to the carrying amount of goodwill allocated to the reporting unit. Also, under the updated guidance, companies will no longer determine goodwill impairment by calculating the implied fair value of goodwill. The word “implied” has essentially been removed from the FASB’s definition of goodwill impairment.
Unlike the private company reporting alternative, the latest update doesn’t give public and not-for-profit companies the option to amortize goodwill. That part of the FASB’s goodwill reporting project has been moved to the board’s research agenda. In the meantime, the FASB will monitor the effectiveness of the latest update before proposing any additional changes to the goodwill reporting model.
The FASB acknowledges that calculating goodwill impairment by comparing the carrying amount of a reporting unit with its fair value could result in a less precise measurement of goodwill impairment than under the existing two-step process. But many financial statement users have told the FASB that the most useful information is identifying impairment, not measuring the precise amount of that impairment.
There are some who were opponents to the issuance of the updated standard. They contend that there are situations in which applying a one-step test could result in the misidentification of a goodwill impairment.
In some cases, it could cause impairment to be identified when it doesn’t actually exist. For example, in a rising interest rate environment, the fair value of reporting units of financial institutions and other entities with significant financial assets (such as insurance companies) could possibly fall below their carrying amounts. Applying the updated guidance could result in a goodwill impairment even though the decrease in the fair value of the reporting unit may actually be caused by a reduction in the fair value of financial assets carried at amortized cost.
In other cases, it could result in under-identification of impairment. This could occur if the fair value of liabilities is less than the carrying amount, which might allow a company to avoid reporting an impairment charge when it would have been warranted had the two-step test been applied.
In light of these scenarios, the dissenting members would have preferred for companies to be given the option to continue applying the existing two-step impairment test to acquired goodwill.
The amendments in this ASU should be applied on a prospective basis. A company is required to disclose certain information upon transition in the first annual period, and in the interim period within the first annual period, when the entity initially adopts the amendments in this ASU. The disclosure must contain the nature of and reason for the change in accounting principle upon transition.
Public companies that file reports with the U.S. Securities and Exchange Commission (“SEC”) must adopt the updated standard for annual or interim periods in fiscal years beginning after December 15, 2019. Public companies that aren’t SEC filers must adopt the standard for annual or interim periods in fiscal years beginning after December 15, 2020. All other organizations, including not-for-profit companies, must adopt this standard for the annual or interim periods in fiscal years beginning after December 15, 2021.
Early adoption of the updated standard is permitted for interim or annual periods after January 1, 2017. Because this standard is expected to be simpler and less costly than the existing guidance, it will likely be adopted early by many companies that report goodwill and are required to test it for impairment under GAAP.
If you have questions regarding impairment testing requirements or would like to know if early adoption of the updated standard makes sense for your company, please contact your Untracht Early advisor.