Running the Annual Tests For Impairment of Acquisition Goodwilll

In early 2001, the Financial Accounting Standards Board (FASB) eliminated the use of the popular pooling-of-interest method for merger accounting. However, the adverse effect on future earnings of merged companies often associated with the surviving purchase method of accounting was substantially reduced because the FASB also issued a statement on nonamorization of goodwill incurred in acquisitions. The likely impact on financial statements because of these new accounting requirements is discussed below as well as the impairment test procedure for determining when goodwill must ultimately be written off because of a loss of its value. In addition, financial statement effects of the new approach are compared with previous methods of accounting for business combinations. Potential Impact on Financial Statements The pooling-of-interest method was popular because of the perceived negative impact on future earnings associated with the purchase method. The FASB now requires all combinations to be accounted for by the purchase method but has alleviated much of the adverse effect on future earnings. Earnings are now reduced for the following potential situations: * Research and development assets; * Goodwill impairment loss; and * Identifiable intangible asset amortization or impairment loss Research and Development Assets Write-Off The new requirements related to business combinations do not change how to account for acquired research and development (R&D) assets. The amounts assigned to tangible and intangible assets to be used in a particular R&D project that has no alternative future use are charged to expense at the date of the consummation of the combination. These R&D assets will only affect the current year’s income statement and will in no way impact future earnings. Goodwill Impairment Loss Goodwill is no longer amortized but is tested annually for impairment. So the only impact on future earnings as a result of acquired goodwill is the recognition of an impairment loss. The design of the goodwill impairment test is such that it minimizes the likelihood of loss recognition. Goodwill is assigned to reporting units, and each reporting unit is tested for impairment. The goodwill impairment test is a two-step approach. Step 1 compares the fair value of the reporting unit (FVRU) with its carrying value (CVRU). If the fair value is greater than the carrying value, there is no impairment and the process need not be carried further. If the fair value is less than the carrying value, there is potential impairment and it is necessary to go to Step 2, which compares the implied fair value of goodwill (FVG) with its carrying value (CVG). If the fair value is greater than the carrying value, there is no impairment. If the fair value is less than the carrying value, impairment results. The impairment loss is calculated as: Loss = CVG minus FVG The implied fair value of goodwill is the amount by which fair value of the reporting unit exceeds the fair value of the identifiable net assets. Note that this is the same method for calculating goodwill in a business acquisition. Exhibit 1 provides three separate situations for annual goodwill impairment testing. In Situation 1, no impairment loss is recognized even though the value of goodwill declined by $200,000. The identifiable net assets increased by $300,000 (to $3.3 million from $3 million), enough to offset the decline in goodwill and keep the fair value of the reporting unit greater than its carrying value. Remember, if in Step 1 the fair value of the reporting unit exceeds its carrying value, Step 2 is not performed. Therefore, if the identifiable net assets increase in value at least as much as goodwill declines in value, no impairment loss is recognized. In Situation 2, the fair value of the reporting unit is less than its carrying value, so Step 2 is performed. The acquired goodwill has declined in value, but internally generated goodwill (which cannot be recognized) has contributed to maintaining the implied fair value of goodwill ($3.9 million versus $2.85 million). Even though the original goodwill has declined, no impairment loss is recognized because the implied fair value of goodwill exceeds its carrying value. Therefore, as long as goodwill can be internally generated to maintain the value of acquired goodwill, no impairment loss is recognized. In Situation 3, Step 1 results in a potential impairment and Step 2 signals an impairment loss. Note that the fair value of identifiable net assets has increased by $50,000 but not enough to offset the $150,000 decline in goodwill value. So the entire $150,000 is recognized as an impairment loss. In order for an impairment loss to be recognized, and therefore reduce earnings, goodwill value must decline by more than the sum of the increase in fair value of identifiable net assets and fair value of internally generated goodwill. Identifiable Intangible Asset Amortization or Impairment Loss Intangible assets with definite lives now are amortized over their useful lives. There is no longer an arbitrary 40-year maximum amortization period. These assets will continue to be reviewed for possible impairment if that is suggested by occurrence of a specific event or a change in circumstances. Intangible assets with indefinite lives no longer are amortized but instead are tested for impairment annually. For example, a trademark that can be renewed indefinitely at little cost would not be amortized until management no longer intends to renew it. These types of assets will not affect future earnings unless they truly become impaired. Comparing Effects of the Changes Previous accounting rules allowed business combinations to be accounted for by the pooling-of-interest method if 12 criteria were satisfied. Otherwise, the purchase method was required. Now, purchase accounting is the only acceptable method. But since accounting for intangible assets acquired in the combination has substantially changed, the effect on financial statements has changed. A comparison of the financial statement effects between current and previous accounting is discussed below. Comparison With the Pooling Method The pooling method recorded net assets at their book values. The purchase method records the fair value of the acquisition currency (cash or stock). This amount is often much greater than book values because of the increased value of unrecognized intangible assets that are associated with many companies. Therefore, the dollar amount assigned to assets, including goodwill, is likely to be much greater with the current accounting than with the pooling method. The balance sheet will have higher assets and higher equity (fair value of shares issued) with the new requirements. The pooling method did not recognize previously unrecognized intangible assets, including goodwill. Therefore, there was no amortization expense that reduced future earnings. The purchase method recognizes the intangible assets, but the FASB’s statement on nonamortization is designed to minimize the impact on future earnings. Goodwill, which generally is the major intangible asset recorded, is no longer amortized. Intangible assets with indefinite lives also are not amortized. These assets are tested annually for impairment, but a loss is recognized only in very limited circumstances. Identifiable intangible assets with definite lives will be amortized and will reduce earnings over that useful period. The new accounting requirements, compared with the use of the pooling method, should result in greater assets and equity on the balance sheet. Future earnings also are likely to be reduced more than with the use of the pooling method, but this reduction should be minimal. Comparison With the Previous Purchase Method Current requirements, as with previous requirements, record the fair value of all net assets, including goodwill. However, the nonamortization of goodwill and other intangible assets will likely result in greater assets and equity on the balance sheet in future years. The nonamortized assets will remain on the balance sheet instead of being reduced in value over time by amortization. Although the current approach may reduce future earnings, it is likely that the reduction will be substantially less than that of previous requirements under the purchase method. The design of the goodwill impairment test minimizes the likelihood of loss recognition whereas previous accounting required amortization of the goodwill over a period not to exceed 40 years. The FASB has eliminated the pooling-of-interest method to account for business combinations but also has reduced the negative impact on future earnings with the nonamortization of goodwill. Application of the two new statements is likely to substantially increase the assets and equity reported on a combined company’s balance sheet but should substantially limit the future earnings reduction under the purchase accounting method. Although there may be additional costs involved with the record-keeping for the annual impairment tests, these costs should be more than offset with the cost savings of not having to deal with the complex criteria of the pooling method. Exhibit 1: Goodwill Impairment TestSituation 1Carrying Value of Reporting Unit $4,000,000Carrying Value of Identifiable Net Assets 3,000,000Carrying Value of Goodwill 1,000,000Fair Value of Reporting Unit 4,100,000Fair Value of Identifiable Net Assets 3,300,000Implied Fair Value of Goodwill 800,000Decision: No ImpairmentFair value exceeds carrying valueSituation 2Carrying Value of Reporting Unit $4,000,000Carrying Value of Goodwill 1,000,000Fair Value of Reporting Unit 3,900,000Fair Value of Identifiable Net Assets 2,850,000Fair Value of Acquired Goodwill 800,000Fair Value of Internally Generated Goodwill 250,000Decision: No ImpairmentFair value is less than carrying value but fair value of goodwill exceeds carrying value of goodwillSituation 3Carrying Value of Reporting Unit $4,000,000Carrying Value of Identifiable Net Assets 3,000,000Carrying Value of Goodwill 1,000,000Fair Value of Reporting Unit 3,900,000Fair Value of Identifiable Net Assets 3,050,000Implied Fair Value of Goodwill 850,000Decision: $150,000 Impairment LossFair value of reporting unit exceeds carrying value of reporting unit and fair value of goodwill is less than carrying value of goodwill