SEC Trends & Developments - Winter 2011 - FASB's Recent Guidance Simplifies Testing Goodwill for Impairment
In September, the FASB issued Accounting Standards Update ASU 2011-08 which amends the manner in which companies test goodwill for impairment. For many, this ASU was welcomed in that it:
- Potentially simplifies existing guidance in an era where a significant amount of new accounting literature has been exceedingly complex and costly to adopt.
- Allows for early adoption.
Historically, companies have been required to perform a two-step process when performing their impairment assessment of goodwill, at least annually. These steps consist of:
- Determining whether the carrying amount (including goodwill) of a reporting unit exceeds its fair value. If it does, one would proceed to step 2, otherwise further testing of goodwill for impairment was not performed.
- Calculating the implied fair value of the goodwill of the reporting unit as if the reporting unit had been acquired in a business combination. Impairment will be recognized if the implied fair value is less than the carry amount of the goodwill.
The revised standard in ASU 2011-08 provides entities with the option to perform a qualitative assessment on none, some or all of its reporting units before proceeding to step 1 of the annual goodwill impairment test. This revision is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011, with early adoption permitted provided that the entity has not yet issued its financial statements for the period the includes its annual test.
When electing to perform a qualitative assessment, entities would determine whether it is more likely than not (i.e., a likelihood > 50%) that the fair value of the reporting unit is less than the carrying amount. If so, they would proceed to step 1 of the goodwill impairment analysis. Otherwise, further testing of goodwill for impairment would not be performed. Because the qualitative assessment is optional, entities may bypass it for any reporting unit in any period and begin their impairment analysis with step 1. This election does not constitute a formal accounting policy of the company, and as such management can elect to utilize the qualitative assessment in future periods on a reporting unit by unit basis.
The addition of this qualitative option was intended to alleviate the concerns expressed by preparers about the cost and complexity of calculating a reporting unit's fair value under step 1 of the goodwill impairment test. Such calculation typically requires various valuation techniques (e.g., multiples of earnings or revenue or a similar performance measure) as the fair value of the entity as a whole, if known, may not be reflective of the fair value of the reporting unit being considered, especially for private reporting entities.
EXAMPLES OF THE QUALITATIVE FACTORS TO CONSIDER
The revised standard also includes examples of events and circumstances that an entity should consider when performing the qualitative assessment. Some of the examples that might indicate that a reporting unit's fair value is less than its carrying amount listed below are not all inclusive:
- Macroeconomic conditions - such as a deterioration in general economic conditions.
- Industry and market considerations - such as deterioration in the environment in which an entity operates.
- Cost factors - specifically those that have a negative effect on earnings and cash flows.
- Overall financial performance - examples would include negative or declining cash flows; decreases in revenues and/or earnings compared to actual and/or projected results.
- Entity or reporting unit specific events - such as changes in management, key personnel, strategy, customers, litigation.
- A sustained decrease in share price (in absolute terms as well as in comparison to peers).
OTHER KEY CONSIDERATIONS
Here are some additional considerations for preparers on whether to choose the qualitative assessment before the two-step process for the goodwill impairment assessment:
The qualitative assessment will likely be more cost effective for reporting units whose fair value was substantially greater than its carrying amount in the prior period. The smaller the historical “cushion” in a reporting unit's step 1 analysis, the less meaningful this qualitative assessment will be.
The FASB noted that the more time that has elapsed since a recent fair value (step 1) calculation, the more difficult it may be to support a conclusion based solely on a qualitative assessment.
Companies will likely need to prepare documentation supporting these considerations, which may potentially include supporting quantitative information, in order to provide external auditors with sufficient audit evidence.
The economic conditions of the past few years have resulted in staggering impairments to the amount of goodwill being carried. In addition, considering the continuation of the weak economic climate, it would appear that the large majority of companies would trigger one or more of the qualitative factors set forth in the standard and have to apply the traditional two-step model.
The FASB acknowledged that a longer-term project to further evaluate the accounting for goodwill may be appropriate, and other alternative approaches, including amortization and direct write off, may replace the current practice as convergence efforts continue.
It is also important to keep in mind that the revised standard does not change:
- existing guidance on when to test goodwill for impairment (i.e., annually and when events or circumstances change)
- existing guidance for other instances that require an entity to calculate the fair value of a reporting unit
- the current impairment guidance for other long-lived assets, including indefinite-lived intangibles.
- the measurement of impairment losses under step 2. Companies will continue to measure goodwill impairments by comparing the implied fair value of the reporting unit's goodwill to its carrying amount.
- Therefore, this ASU will not impact the dollar amount of impairment or the period in which it should be recognized.
Those companies expecting to benefit from adopting this ASU can choose to early adopt the revised standard even if its annual test date is before September 15, 2011 (the date on which the revised standard was issued), provided that the entity has not yet issued its financial statements for the period that includes its annual test date. This could include (i) calendar year-end registrants with a third or fourth quarter annual test date; registrants whose year-end is September 30 with a fourth quarter annual test date; or (iii) nonpublic companies that have not issued their 2011 annual financial statements.
The FASB's efforts with respect to this ASU have been seen as positive signs of change. Reducing the complexity and cost of implementing new standards should be one of the critical factors when deliberating new standards. Users and preparers hope that the current economic environment and the pending convergence with international standards will not ultimately temper the benefits and savings that ASU 2011-08 intends to provide for public and private companies alike.
SEC Trends & Developments - Winter 2011 Issue
- SEC Tightens Listing Standards for Reverse Mergers
- PCAOB Adopts Risk Assessment
- From the Bar…Recent Patent Law Changes Affecting Businesses
- FASB's Recent Guidance Simplifies Testing Goodwill for Impairment
- SEC Provides Disclosure Guidance Relating to Cybersecurity Risk Disclosure
- Latest Comments from the Commission
- Accounting Standards Update
- Recent SEC Enforcement Actions