Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 350 provides guidance on financial accounting and reporting related to goodwill and other intangibles for U.S. GAAP, other than the accounting at acquisition for goodwill and other intangibles acquired in a business combination or an acquisition by a not-for-profit entity.Per ASC 350, originally issued as Financial Accounting Standards No. 142 in June 2001 and subsequently updated by Accounting Standards Update (“ASU”) 2010-28, goodwill is not amortized, but tested for impairment at the reporting unit level (the operating segment or one level below).
Under the rules, if conditions exist that it is “more likely than not” that fair value of reporting unit is less than its carrying value, then a two-step impairment test is performed to identify potential goodwill impairment and measure the amount of loss to be recognized (if any). This goodwill impairment test is required at least annually, or more frequently if certain events occur and circumstances change.
Step One of the impairment test includes a valuation of a company’s fair value and a comparison of fair value to the reporting unit’s carrying value. If Step One of the impairment test results in a fair value less than recorded or carrying value, a Step Two test is necessary to measure the amount of impairment loss, if any.
For the Step Two test, the fair value of goodwill is compared to its carrying value. And, just as with a purchase price allocation per ASC 820 (formerly FAS No. 141), the fair value of goodwill is derived by subtracting the fair value of net tangible assets and identifiable intangible assets from the fair value of the reporting unit as of the test date. If the fair value of goodwill exceeds the carrying value of goodwill, there is no impairment. However, if goodwill’s carrying value is greater than the fair value, goodwill is impaired and the difference must be written off as an expense.
The Step Zero Test
In September 2011, the FASB issued ASU 2011-08 which is effective for fiscal years beginning after December 15, 2011. The stated purpose of this new rule is to simplify the process and reduce costs by which companies conduct goodwill impairment testing.
Under ASU 2011-08, a company is permitted to qualitatively assess whether the fair value of a reporting unit is less than its carrying amount. There is an unconditional option to skip the qualitative assessment process in which companies can proceed to perform the Step One test. However, if management deems that it is more likely than not (having a likelihood of more than 50 percent) that the fair value of a reporting unit is not less than its carrying amount, then the company would not need to perform any further impairment analysis. This qualitative assessment is being deemed the Step Zero test.
The FASB’s guidance regarding the qualitative considerations includes the following:
- Macroeconomic conditions such as a deterioration in general economic conditions, limitations on accessing capital, fluctuations in foreign exchange rates, or other developments in equity and credit markets;
- Industry and market considerations such as a deterioration in the environment in which an entity operates, an increased competitive environment, a decline in market-dependent multiples or metrics (consider in both absolute terms and relative to peers), a change in the market for an entity’s products or services, or a regulatory or political development;
- Cost factors such as increases in raw materials, labor, or other costs that have a negative effect on earnings and cash flows;
- Overall financial performance such as negative or declining cash flows or a decline in actual or planned revenue or earnings compared with actual and projected results of relevant prior periods;
- Other relevant entity-specific events such as changes in management, key personnel, strategy, or customers; contemplation of bankruptcy; or litigation;
- Events affecting a reporting unit such as a change in the composition or carrying amount of its net assets, a more-likely-than-not expectation of selling or disposing all, or a portion, of a reporting unit, the testing for recoverability of a significant asset group within a reporting unit, or recognition of a goodwill impairment loss in the financial statements of a subsidiary that is a component of a reporting unit; and
- If applicable, a sustained decrease in share price (consider in both absolute terms and relative to peers).
Again, if, after assessing the totality of events or circumstances such as those described above, an entity determines that it is more likely than not that the fair value of a reporting unit is not less than its carrying amount, then the first and second steps of the goodwill impairment test are unnecessary.
In concept, the consideration of qualitative factors rather than a quantitative valuation analysis may seem practical. However, there are certain things to consider.
- The previous guidance already provided for a “Carry Forward Option”. Per (now superseded) ASC 350 paragraph 20-35-29, a detailed determination of the fair value of a reporting unit may have been carried from one year to the next if all of the following criteria had been met:
- The assets and liabilities that make up the reporting unit had not changed significantly since the most recent fair value determination. (A recent significant acquisition or reorganization of an entity’s segment reporting structure is an example of an event that might significantly change the composition of a reporting unit);
- The most recent fair value determination resulted in an amount that exceeded the carrying amount of the reporting unit by a substantial margin; and
- Based on an analysis of events that have occurred and circumstances that have changed since the most recent fair value determination, the likelihood that a current fair value determination would be less than the current carrying amount of the reporting unit is remote.
- The FASB’s list of the qualitative factors to consider is not comprehensive. Companies may find certain auditors require consideration of other conditions.
- Qualitative factors can be difficult to audit. Thus, it is likely that (substantial) quantitative analysis will still be required to document these factors. Additionally, companies may find the information necessary to reach the “more likely than not” determination is not readily available and/or requires additional record keeping.
- It is likely, the Step Zero option will be considered less appropriate as time passes from a previous quantitative determination of fair value.
As discussed, the FASB’s stated goal with Step One is to reduce the complexity and costs associated with goodwill impairment testing. It is possible certain companies will benefit from these changes. However, in application, certain companies may find the documentation process and audit scrutiny to be more rigorous (and costly).
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