Goodwill Impairment Testing (#136)
/In this podcast episode, we discuss a new accounting standard for goodwill impairment testing. Key points made are noted below.
Background on Goodwill Impairment Testing
This episode is about the new Accounting Standards Update about testing goodwill for impairment. If you do acquisitions, this might apply to you. First, for some background. Under GAAP, you record a goodwill asset when you make an acquisition and some of the amount paid can’t be assigned to specific assets or liabilities. This happens most of the time. Then you’re supposed to test the goodwill asset every year or so to see if any of it should be written off. The way you’ve been required to test for goodwill - up until now – is a two-step process. First, you compare the fair value of a reporting unit with its carrying amount on the books, and if the carrying amount is greater than the fair value, then you go to the next step, to figure out the amount of the impairment loss. If not, then you’re done and there’s no impairment. In the second step, you measure the amount of the impairment loss, which is what you’re going to write off. I won’t get into the details of how the second step works, since the rules change doesn’t impact it.
Enhancements to the Testing Process
Now – the folks at the Financial Accounting Standards Board have been hearing some complaints about the “cost and complexity” of that first step. So they’ve decided to change the testing requirement. Under the new approach, you have the option to change the first step in the impairment testing process. Now, you can run through some qualitative factors to decide if it’s more likely than not that the fair value of a reporting unit is less than its carrying value. If so, then you still have to complete the original first step, which was to calculate the fair value of the reporting unit. And in case you’re curious, the more-likely-than-not threshold is defined has having a likelihood of more than 50 percent.
Qualitative Factors
So what are these qualitative factors? Well, the FASB is being pretty open-ended about it. What they state is what they call “examples” of events and circumstances that should be assessed. That means you should consider what they list, but you could use other factors, too.
There are seven of these “examples,” and some are pretty broad. The first is as broad as you can get.
It’s macroeconomic conditions, such as a deterioration in general economic conditions, or fluctuations in foreign exchange rates.
The second example is the same thing, but at the industry level, so now it’s a deterioration within the industry, or an increasingly competitive environment, or changes in the regulatory environment.
Then we get into cost factors, such as an increase in the cost of goods sold that negatively impacts profits.
The fourth example is a decline in overall financial performance, such as declining cash flows or a declining trend in revenues or profits.
Then they change gears and get a bit more specific in the fifth example, which is changes in management or key employees, changes in customers, new litigation, and so on.
The sixth example involves major business events, such as an expectation to sell the reporting unit.
And the last example is a sustained decrease in the share price, both in absolute terms and in relation to the share prices of competitors. This last example obviously only applies to public companies.
When you go through this analysis, you’re supposed to place the most emphasis on those factors that could affect the fair value of the reporting unit. And whatever you decide, you certainly need to document it thoroughly, since the auditors are bound to review it.
That’s how the new variation on impairment testing works.
Whenever you want to do an impairment test, this new approach is always available as an option. So if you don’t elect to use it one year, it’s still available for use in a later year.
Now, why do we bother with this new variation? Because under the old approach, you may have to hire an appraiser to determine the fair value of the reporting unit – which can be expensive. With the new approach, you can potentially avoid the expense.
And the time needed to do the qualitative analysis probably goes down after the first year, since you’ll only have to update the documentation you already created in the preceding year.
On the other hand, this can lead to some pretty mushy impairment evaluations. A lot of businesses could potentially use this approach to avoid impairment charges; so I would expect some businesses to come up with documentation for some pretty rosy outlooks.
So, the net result of all this is a reduced level of effort for impairment testing, and I would guess at a reduced number of impairment charges, too.
And by the way, this standard applies to both public and privately-held businesses. Also, this approach is only available under GAAP. It is NOT available under International Financial Reporting Standards. In fact, this creates a greater divergence between the GAAP and IFRS accounting for goodwill.