Goodwill Amortization (#175)
/In this podcast episode, we discuss the new accounting standard for the amortization of goodwill for privately-held companies. Key points made are noted below.
The Nature of Goodwill
We have a new standard in Generally Accepted Accounting Principles, which is number 2014-02. This is about a different way to account for goodwill. Goodwill occurs in an acquisition, and it’s the difference between the price paid and the amount of the price that can be allocated to the assets and liabilities of the acquiree. So if you pay a high price for an acquisition, there’s going to be a lot of goodwill asset sitting on your balance sheet.
Previous Goodwill Accounting
Up until now, everyone had to do a periodic impairment test to see if the goodwill should be written off. The feedback that users were sending to the Financial Accounting Standard Board is that goodwill impairment testing is a pain in the butt. I happen to agree.
New Goodwill Accounting
So they’re now giving us an alternative. This alternative only applies to privately held entities. It doesn’t apply to publicly held companies or to nonprofits. There’s a project in the works to examine the same issue for those entities.
And the alternative is – to give you the option to amortize goodwill on a straight-line basis over a ten-year period. Or, if you can prove that a different useful life is more appropriate, you can even amortize it over fewer than ten years.
The one catch is that you still need to conduct impairment testing, but only if there’s a triggering event indicating that the fair value of the entity has dropped below its carrying amount. And, you can choose to test for impairment only at the entity level, not for individual reporting units.
Since the ongoing amortization of goodwill is going to keep dropping the carrying amount of the entity over time, this means the likelihood of an impairment test is going to decline as time goes by. And since impairment testing is only at the entity level, there’s even less work involved in whatever amount of residual impairment testing there might be. If you’ve ever been involved in impairment testing, you’ll realize that the large reduction in testing work will be awesome.
I suppose sort of a minor additional catch is that, once you elect to amortize goodwill, you have to keep doing so for all existing goodwill, and also for any new goodwill related to future transactions. So that means you can’t selectively apply amortization to the goodwill arising from just specific acquisitions.
And then we have some reporting requirements. On the balance sheet, you’d present the amount of goodwill net of any accumulated amortization and impairment charges, which is fairly obvious. This is the same logic we use in presenting fixed assets. And in the income statement, goodwill amortization is presented within continuing operations, unless it’s associated with a discontinued operation – and in that case, you present it with the results of the discontinued operation.
So what’s the real implication of all this? First, if a privately-held company has engaged in any sort of acquisitions activity, it’s probably built up a fairly substantial amount of goodwill. It’s quite possible that the goodwill asset is the largest line item on the balance sheet. Since goodwill doesn’t really mean much, this massive number tends to reduce the usefulness of the balance sheet. And, since impairment testing is a pain, I’d expect a lot of controllers and CFOs to be sitting with their company presidents right now, explaining why it would be a really great idea to start amortizing away all of that goodwill.
But – if you do that, there’s going to be a whopping amortization charge that offsets profits for a long time. As a reaction to that, I can see all of these private companies starting up campaigns to educate their investors and lenders about what they’re going to do, and how reviewing the income statement now means subtracting out the effects of amortization.
And it’s quite possible that all of this amortization is going to send people running for the statement of cash flows, since this is the least affected of the financial statements. The basic message is going to be, ignore what you see in the income statement, just look at how our cash flows are doing.
A minor additional factor is that this is just one more reason why smaller publicly-held companies might choose to go private. They may have built up a lot of goodwill assets while they were publicly-held, and now they have the chance to flush it out, but only if they go private.