Goodwill Impairment in these Economic Times
As a result of the weak economy over the past several years, goodwill impairment has been and will continue to be a hot accounting topic. 2008 was a year when companies incurred significant goodwill impairment charges. Although the number of goodwill impairment charges started to decline in 2009, industries such as technology hardware and equipment, telecommunications services and software were hit hard. It was very common for companies in these industries to have made acquisitions during strong economic times and overpay for assets. As a result, goodwill has been sitting on their balance sheets and inflating their financial position. Weak economic times cause these companies’ performance to decline, which in turn may result in impairment of goodwill.
As outlined in Financial Accounting Standards Board Accounting Standards Codification 350: Intangibles – Goodwill and Other (formerly Statement of Financial Accounting Standards No. 142), goodwill is defined as the excess of the purchase price compared to the net assets acquired. Goodwill is an asset that is not subject to amortization, however, it must be tested for impairment on an annual basis. The test for goodwill impairment in subsequent periods is whether the fair value of the reporting unit exceeds its carrying value. Note that it is not the goodwill amount per se that is tested, but the carrying value of the reporting unit in which the goodwill resides.
The annual goodwill impairment test may be performed at any time during the year as long as the test is performed at the same time each year. Goodwill may need to be assessed for impairment in between these annual periods if certain events or circumstances (otherwise known as triggering events) exist that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Some examples of such triggering events include: (1) a significant adverse change in legal factors or business climate, (2) an adverse action or assessment by a regulator, (3) unanticipated competition, (4) a loss of key personnel, (5) a more likely than not expectation that a reporting unit will be sold or disposed of, etc. Again, goodwill is tested for impairment at the reporting unit level. A reporting unit is defined as an operating segment or one level below an operating segment. The logic behind analyzing goodwill impairment at the reporting unit level is that most of the acquired assets and assumed liabilities typically become integrated into the company and are indistinguishable from the companies’ other assets and liabilities. Therefore, the goodwill is no longer related to just the acquired assets and assumed liabilities but associated with a larger component of the company, or the company as a whole.
When impairment is tested as a result of a triggering event or annual period, a two-step process is followed. The first step compares the fair value of the reporting unit to the carrying value. If the fair value exceeds the carrying value, no impairment on the goodwill is indicated. If the carrying value exceeds the fair value, goodwill is impaired, and step two is performed to measure the amount of the impairment. Basically in step two, the fair value of the reporting unit as determined in step one, is reallocated to the net assets at their current fair values. The amount of the impairment would reduce the value of the goodwill and the charge would be recorded as an expense in the income statement. The adjusted carrying amount of the goodwill becomes the new basis. Once goodwill is impaired and written off, any subsequent reversals or write ups are prohibited.
In December 2010, the FASB issued ASU No. 2010-28, Intangibles – Goodwill and Other (Topic 350): When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts. Carrying value may be defined with reference to book equity or total invested capital. Many Companies that had reporting units with zero or negative equity carry amounts were taking the position that step one was passed because the fair value of the reporting unit was generally greater than zero. However, the concern here is that step two was not being performed despite the fact that triggering events for impairment could have existed. Therefore, this new standard states that step two of the impairment test shall be performed if it is more likely than not that a goodwill impairment exists as a result of any adverse qualitative factors existing, as described above. For public entities, this standard is effective for fiscal years, and interim periods within those years, beginning after December 15, 2010. Early adoption is not permitted. For nonpublic entities, this standard is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. Nonpublic entities may early adopt using the effective date for public entities.
As your Company is starting the process of closing out the fiscal year and preparing year-end financial statements, you will most likely need to assess if any goodwill is impaired. If your Company does not have the appropriate resources and expertise internally to prepare a goodwill impairment analysis, you may need to consider accounting services consulting or use of a valuation specialist. In preparation for a goodwill impairment analysis some of the key items necessary include: proper identification of reporting unit(s) and carrying amounts; preparation of projections and discounted cash flow models, with support for key assumptions; and identification of market comparables at the company and industry levels.