In today’s rapidly evolving business environment, the value of your company goes beyond its tangible assets and financial metrics. Intangible assets such as brand reputation, customer relationships, and innovative technologies are likely the key drivers of your company’s long-term success and competitive advantage. However, the value of these intangible assets can be susceptible to changes in market conditions, advances in technology, and shifts in consumer preferences. To ensure accurate financial reporting and well-informed decision-making, business owners and financial executives must recognize and adhere to the guidelines laid out in Accounting Standards Codification 350 (ASC 350). In this article, we delve into the critical importance of goodwill and intangible asset impairment testing as stipulated in these standards.
Understanding Goodwill and Intangible Assets
“Goodwill” is defined as the residual amount recognized in a business combination after all identifiable assets acquired and liabilities assumed have been recognized at fair value. Under GAAP (generally accepted accounting principles), upon an acquisition, companies are required to carry goodwill on their financial statements at its initial value. Goodwill represents the premium your company pays when acquiring another business that goes beyond the fair value of the net identifiable assets acquired. Net identifiable assets acquired not only encompass tangible assets such as your organization’s plant, property, and equipment, but also identifiable intangible assets such as your company’s patents, copyrights, trademarks, software, and customer lists. Intangible assets are integral to your company’s ability to innovate, generate revenue, and establish a strong market presence.
An intangible asset is deemed identifiable if it meets either of the following criteria:
It arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations.
It is separable—that is, capable of being separated or divided from the entity and sold, transferred, licensed, rented, or exchanged, either individually or together with a related contract, identifiable asset, or liability, regardless of whether the entity intends to do so.
The Impairment Testing Process Under ASC 350
Before the implementation of ASC 350 (formerly known as SFAS 142 – Goodwill and Other Intangible Assets, effective June 2001), goodwill was handled differently. GAAP dictated that companies amortize goodwill over a finite life, not to exceed 40 years. Goodwill impairment was infrequently recognized.
ASC 350 introduced the concept of potentially perpetual goodwill. Outlined below is an overview of how goodwill impairment was typically handled under ASC 350, before subsequent simplifications were introduced:
Qualitative Assessment: Companies assessed goodwill qualitatively to determine whether it was more likely than not that the fair value of a reporting unit was less than its carrying amount, which could indicate potential goodwill impairment. If this qualitative assessment indicated no impairment, no further testing was required.
Quantitative Assessment: If the qualitative assessment indicated a likelihood of goodwill impairment, companies performed a two-step quantitative test:
Step 1: The fair value of the reporting unit was compared to its carrying amount, including goodwill. If the fair value exceeded the carrying amount, no impairment was recognized.
Step 2: If the carrying amount of the reporting unit exceeded its fair value, companies calculated the implied fair value of goodwill by deducting the fair values of all other assets and liabilities from the fair value of the reporting unit. If the carrying amount of goodwill exceeded the implied fair value of goodwill, an impairment loss was recognized.
Step 2 was significant in that it forced the company to essentially replicate a purchase price allocation, identifying all tangible and intangible assets and then valuing each separately. This exercise could be complex and expensive.
The limitations of this approach included the subjectivity of the qualitative assessment and the potential for subjectivity in estimating the fair value of reporting units. Additionally, the two-step process could be complex and involve subjective judgment, potentially leading to inconsistencies in reporting across companies.
However, ASC 350 provided more specific guidance for the recognition, measurement, and impairment of goodwill and other intangible assets. Furthermore, ASC 350 established a systematic framework for goodwill impairment testing, improving consistency and transparency in financial reporting.
Under ASC 350, goodwill impairment assessment was conducted both qualitatively and quantitatively. The introduction of ASC 350 brought more structured and standardized guidelines for assessing goodwill impairment, contributing to enhanced financial reporting practices.
Private Company Goodwill Accounting Alternative
In January 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2014-02 Intangibles – Goodwill and Other, allowing private companies to elect an accounting alternative to the traditional GAAP standards for goodwill. Private companies that elect the accounting alternative adhere to the following procedures:
Amortize goodwill on a straight-line basis over 10 years—or less, if the entity demonstrates that a shorter useful life is more appropriate. (Prior to ASU 2014-02, there was no amortization of goodwill, although an impairment write-down was possible.)
Test goodwill at either the entity level or the reporting unit level. (Previously, all testing was at the reporting unit level only.)
Test goodwill for impairment not annually (as required previously) but whenever an entity or reporting unit experiences an event or a change in circumstances that indicates a likelihood of its fair value being below its carrying amount—known as a “triggering event.”
Measure goodwill for impairment by comparing the entity’s or reporting unit’s fair value with its carrying value (rather than using the two-step goodwill impairment test described above).
If your company elects this accounting alternative, you will no longer monitor for goodwill impairment triggering events during the period. Instead, your management evaluates facts and circumstances at the end of each reporting period to determine whether a triggering event exists and, if so, whether it is more likely than not that the goodwill is impaired. Examples of a triggering event, as defined above, include a deterioration in general economic conditions, an increased competitive environment, an increase in the cost of raw materials or labor, negative or declining cash flows, and changes in key personnel.
Simplifying the Test for Goodwill Impairment
In January 2017, the FASB issued ASU 2017-04 Intangibles – Goodwill and Other, which simplified testing for goodwill impairment. Under ASU 2017-04, you should perform an impairment test at least annually and potentially in interim periods if there is a triggering event.
The impairment testing process outlined in ASU 2017-04 involves five key steps:
Identify Reporting Units: Your company needs to ascertain the appropriate reporting units for conducting impairment testing. These units can be individual business segments or groups of assets.
Estimate Fair Value: Fair value is determined through appropriate methods, such as market comparisons or discounted cash flow analysis. It’s important you select the method that best aligns with the nature of the asset being tested.
Compare to Carrying Value: The fair value of the asset or reporting unit is compared with its carrying value. If the fair value is lower, an impairment loss is recognized. This is notably different from ASC 350. As previously mentioned, before ASU 2017-04, a company essentially had to replicate a purchase price allocation, identifying all tangible and intangible assets and then valuing each separately.
Calculate Impairment Loss: The impairment loss is calculated as the excess of the carrying amount over the fair value. This loss is then reported in your company’s financial statements, leading to a more accurate representation of the asset’s value.
Ensure Disclosure and Transparency: ASU 2017-04 necessitates detailed disclosures about impairment testing, including the assumptions used and the resultant impact on the financial statements. Transparent communication enhances your stakeholders’ understanding and trust.
The Relevance of Impairment Testing under ASU 2017-04
ASU 2017-04 offers comprehensive guidance on the recognition, measurement, and impairment of these assets. Impairment testing is a systematic process that ensures the carrying value of goodwill and intangible assets is in line with their recoverable amount—the amount that can be obtained from using or selling these assets.
Understanding the significance of impairment testing under ASU 2017-04 is paramount for the following reasons:
Accurate Financial Reporting: Impairment testing ensures that your company’s financial statements accurately portray the value of its goodwill and intangible assets. This level of accuracy enhances transparency and builds trust among stakeholders, including investors, creditors, and regulatory bodies.
Informed Decision-Making: As a business owner or financial executive, you heavily rely on precise asset valuations to make strategic decisions. Impairment testing provides a clear and up-to-date understanding of the current value of these assets, enabling effective resource allocation, investment planning, and development of overall business strategy.
Compliance with Accounting Standards: ASU 2017-04 mandates regular impairment testing and prescribes specific guidelines for conducting these tests. Noncompliance can result in legal and financial consequences, potentially harming your company’s stability and reputation.
Boosting Investor Confidence: Transparent and accurate financial reporting cultivates confidence among investors, leading to enhanced investor relations, improved access to capital, and potentially higher stock valuations.
Effective Risk Management: Regular impairment testing allows your company to identify potential risks associated with goodwill and intangible assets. This foresight enables proactive risk mitigation and the development of robust strategic plans.
In today’s business landscape, where intangible assets can be of significant value, accurate valuations of intangible assets are a strategic imperative. Current accounting standards provide a structured, periodic framework for impairment testing, ensuring that your company’s financial statements and decision-making processes are grounded in reality. By embracing the principles and guidelines set forth in these standards, you can confidently navigate the complexities of the business world, effectively manage risks, and harness the true potential of their intangible assets. Doing so paves the way for sustained value creation, long-term prosperity, and triumph in the competitive marketplace.
The conscientious application of impairment testing is not merely a regulatory obligation; it is a strategic tool that empowers business owners, investors, and stakeholders to understand the true value of their assets, enabling you to assist in making sound business and investment decisions in an ever-evolving global economy. As we continue to witness the transformative power of intangible assets, embracing and mastering impairment testing is an essential step toward ensuring business resilience, growth, and a secure future.
Why Hire a Valuation Professional to Test Your Goodwill and Intangibles Assets?
As you can see, testing goodwill and intangible assets can be a very complex exercise. A great deal of research, thought, and experience are required to properly assess and value the subject assets, and a number of GAAP-related considerations and potential valuation methodologies can be employed. To test goodwill and intangible assets, therefore, you should always employ a qualified valuation professional—the benefits of doing so far outweigh the costs.