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Writing Off Goodwill

A weak economy makes unscheduled testing necessary.

In today’s volatile economy, companies must pay close attention to goodwill impairment. Under current accounting rules, companies are required to test acquired goodwill for impairment annually. But unscheduled impairment tests may be necessary if certain triggering events — including a “significant adverse change . . . in the business climate” — have a negative impact on fair value. These days, most companies should be screening regularly for goodwill impairment, and, if necessary, recognizing impairment losses.

Interim testing
When a company acquires another company, the purchase price is allocated based on the fair values of the acquired assets. Any amount by which the purchase price exceeds the value of the target’s identifiable net assets is treated as goodwill.

Under previous accounting rules, goodwill was treated as a “wasting asset,” which meant it was amortized over its useful life, up to 40 years. In 2001, however, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (FAS) 142, Goodwill and Other Intangible Assets, which provides that goodwill be tested annually for impairment (at the reporting unit level) and written down only if its carrying amount exceeds its fair value.

FAS 142 also requires companies to test for impairment between annual tests if “an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount.” Such triggering events include:

• A significant adverse change in legal factors or the business climate,
• An adverse regulatory action,
• Unanticipated competition,
• Loss of key personnel, or
• An anticipated (more likely than not) sale of a reporting unit or significant portion of a reporting unit.

In the current economic climate many — if not most — companies will find that a triggering event has likely occurred, requiring interim testing for impairment.

Two-step process
A triggering event doesn’t automatically require your company to write off goodwill. It simply means there’s a potential impairment that requires further investigation. Determining the existence of impairment is a two-step process. In step one, you determine the fair value of each reporting unit and compare that value to its carrying amount, including goodwill. If a unit’s fair value exceeds its carrying amount, goodwill isn’t considered impaired and step two isn’t necessary.

If, on the other hand, a unit’s carrying amount is greater than its fair value, you must proceed to step two. There’s a common misconception that the excess of a unit’s carrying amount over its fair value is equal to the amount of goodwill impairment. But the fair value shortfall is merely an indication of possible impairment and you can confirm impairment only by following step two.

In step two, you compare the “implied fair value” of a unit’s goodwill to its carrying amount. Performing this test is a complex process and typically requires the use of outside valuation expertise. It involves treating a unit’s fair value as if it were the purchase price in a business combination. Then that value is allocated among the unit’s assets and liabilities — including any intangible assets (other than goodwill) whether recognized by the company

If the unit’s step one fair value exceeds the value allocated to these net assets under step two, then the excess is the implied fair value of its goodwill. The excess, if any, of the carrying amount of goodwill over its implied fair value is the amount of the impairment loss that should be recognized.

A company potentially could go through step two and conclude that goodwill hasn’t been impaired. This might happen, for example, when the fair values of certain tangible or identified intangible assets have declined.

Value judgments
As the above suggests, fair value plays an important role both in accounting for business combinations and testing for goodwill impairment. You’re probably aware that the rules for measuring fair value have been the subject of intense controversy in recent months. And valuing financial assets in illiquid and inactive markets is particularly challenging right now, despite recent FASB guidance on the subject.

So if you’re planning a merger or acquisition, or testing for goodwill impairment, enlist the help of a qualified valuation professional who knows how to address fair value issues. The impact of FAS 142 will depend to a great extent on the selection of reporting units and allocation of goodwill and other assets among them. You have some flexibility in making these allocations, and a CPA can facilitate the process.

 

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.