The measurement of goodwill and subsequent tests for impairment under purchase accounting rules is complicated and sometimes a source of controversy between companies and their auditors and advisors. Fortunately, the Financial Accounting Standards Board (FASB) has come to understand that the cost of the rigorous analysis required does not meet the cost/benefit constraint that lies at the heart of accounting rules. Earlier this year FASB issued revised guidance for goodwill impairment testing designed to make the entire process more straightforward and economical.
Testing Goodwill for Impairment
Goodwill is a key component in an M&A transaction as it is an intangible asset that most often comes to light when a buyer acquires an operating business. Goodwill is the excess of the "purchase consideration" (the money paid to purchase the asset or business) over the total value of the net assets acquired. It is basically a company’s intrinsic special sauce and is generally a key component of higher profitability, which may, in turn, lead to a greater value of the enterprise. In other words, the more difficult it is to replicate the secret sauce, the more the company might be worth.
Under FASB rules, Goodwill is impaired when its “implied” fair value is less than its carrying amount (book value), inclusive of all deferred income taxes existing as a result of the transaction. Companies are expected to test Goodwill annually for impairment. Measuring the implied fair value of Goodwill can be a lengthy process, and is similar to a purchase price allocation done when Goodwill is initially recorded. The company is expected to recognize any impairment as a loss on its income statement. This includes reducing the carrying amount of Goodwill to its implied fair value. Back in 2011, FASB issued an amendment that gives companies the option to make a qualitative judgment as to whether to test for impairment. Companies are required to assess whether outside events and circumstances, such as regulatory factors and external news events, might have impacted the value of the enterprise (or reporting unit).
Now things are a bit different. For companies that do not amortize Goodwill (generally larger enterprises), ASU 2017-04 can be helpful. The idea behind ASU 2017-04 is that it requires Goodwill impairment losses to be measured as the excess of the carrying amount of a reporting unit over its fair value. This limits impairment losses to the carrying amount of Goodwill allocated to the reporting unit. In other words, companies no longer determine Goodwill impairment by calculating the implied fair value of Goodwill. The word “implied” has now been eliminated from impairment testing.
Of course, there are plenty of opinions regarding the amendment. The latest change is officially referred to as Accounting Standards Update (ASU) No. 2017-04, Intangibles — Goodwill and Other (Topic 350): Simplifying the Test for Goodwill. For the potential seller of a company, the value of a business’ Goodwill is of high importance. Keep an eye out for future changes from FASB as these could have a significant impact on exit value.
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