When companies are testing for possible impairment of goodwill in a seemingly troubled reporting entity, the staff of the Securities and Exchange Commission has signaled it won’t be fooled by attempts to spin negative equity into a rationalization that an impairment doesn’t exist.

Evan Sussholz, professional accounting fellow for the SEC, said at the recent national conference of the American Institute of Certified Public Accountants that the staff has heard a number of questions about which valuation approach is required by Accounting Standards Codification Topic 350 Intangibles.

The rules map out a two-step test for determining whether goodwill might be impaired, or whether it may have lost some value since it was last determined and booked. The purpose of the first step, said Sussholz, is to identify potential impairment by comparing the fair value of a reporting unit to its carrying amount, including goodwill.

Fair value, according to accounting rules, is the price that would be received to sell the reporting unit as a whole, but the standard doesn’t specify whether entities should begin the analysis with “enterprise value” or “equity value.” Enterprise value is commonly defined as the sum of the fair value of debt and equity, whereas equity value refers to the sum of all ownership interests in the company, such as through stock, stock options, and other securities convertible to equity.

Sussholz said the SEC staff generally doesn’t expect the selection of the equity or enterprise value will impact the outcome of the goodwill impairment test, but it could be important if debt surpasses equity. He points out that the fair value of a reporting unit cannot be less than zero.

“In a circumstance when the carrying value of equity is negative, a reporting unit would seemingly always ‘pass’ a step-one goodwill impairment test performed on an equity basis, despite the fact that significant goodwill may exist and the underlying operations of that entity may be deteriorating,” he said. “In this example, a step-one test performed on an enterprise basis would likely provide a better indication of whether a potential impairment of goodwill exists and a step-two test should be performed.”

The second step of the impairment test requires companies to measure all assets and liabilities within the reporting unit at fair value to determine exactly what the impairment is—a significant undertaking that companies generally would prefer to avoid. But they shouldn’t try to avoid it by trying to work with a negative equity value, said Sussholz.

“In absence of further authoritative guidance, the SEC staff believes that a reporting entity may want to consider whether utilizing an alternative approach to a step-one test such as enterprise value would be a better economic indicator of goodwill impairment,” he said. The analysis should look at market participant assumptions, the potential structure of a hypothetical sale transaction, and other factors, he said.

If you’re full of ideas about how credit impairments should be determined based on expected cash flows, here’s your chance to pipe up and help shape future accounting rules.

The International Accounting Standards Board and the Financial Accounting Standards Board are looking for candidates to serve on an expert advisory panel to help sort through the operational issues companies might encounter in following an expected cash flow approach to determine credit losses. The panel will help the boards determine what to do as they consider new requirements around the recognition and measurement of financial instruments more broadly.

FASB has already tentatively decided that entities should be required at the end of each period to measure an impairment loss as the present value of management’s current estimate of cash flows that are not expected to be collected. That estimate would take into consideration all available information relating to past events and existing conditions that might suggest a particular item is collectible, such as remaining payment terms, financial condition of the issuer, expected defaults, collateral values, and other environmental factors. It would not, however, take into account possible future scenarios.

The boards are not looking for experts who want to debate what’s been decided, but to explore the operational or implementation challenges that might arise with such an approach and to suggest solutions and guidance that might be necessary to address those. Panel members might also be called on to help with field testing.

FASB and IASB made it clear that they’re not looking for representatives of experts who will act as messengers and attend meetings, nor are they looking for panelists who will be bound by their employers to express specific views. Instead, the boards are looking for panelists with relevant hands-on experience with backgrounds in risk management, systems development or operations, product development, control and audit.

The boards hope to have final standards adopted by the end of 2010.

The 2008 wave of goodwill impairments provides yet another disturbing piece evidence of the value that’s being wrung out of companies as a result of the recession.

Goodwill is an intangible asset that often results from an acquisition; it’s the amount a company pays to acquire another company over and above the fair value of the individual net assets that are acquired. Accounting rules require companies to test or verify the value of goodwill at least annually; it must be written down if it is impaired, or if the value has eroded.

A recent KPMG study of four years worth of financial data for more than 1,600 U.S.-based companies shows goodwill impairment more than doubled in 2008 from 2007. KPMG says that goodwill impairment charges for the companies studied rose to $340 billion in 2008, more than double the $143 billion recorded in 2007 and nearly four times the $87 billion reported in 2006.

Banks, of course, took the biggest hit to goodwill. They accounted for almost 23 percent of the total goodwill impairment charges in the KPMG study, followed by materials, energy, media and technology hardware and equipment, pharmaceuticals, and food and beverages.

Seth Palatnik, a partner in valuation services for KPMG, said companies can thank turmoil in financial markets for the recent hits to goodwill, which cause non-cash charges to earnings and markdowns in the asset and equity sections of the balance sheet. “Goodwill impairment charges increased significantly at the end of 2008, in part, due to the fact that many companies’ December fiscal year-end coincided with their annual goodwill testing procedure,” he said.

The overall market slide that began in the fall of 2008 also had a material impact on the rise in year-end goodwill impairments, Palatnik said. “As part of this process, companies needed to consider whether recent economic events such as stock prices falling below carrying value on the books resulted in goodwill impairments,” he said.

Greg Franceschi, managing director at financial advisory and investment banking firm Duff & Phelps, said companies should expect to face much less impairment testing at the end of 2009. “Mark values have rebounded quite a bit since the lows of last year,” he said. “The economic trends at this point are much more certain than they were in the middle of last year. The general consensus is we’ve probably hit the floor in terms of economic lows. That means values are probably higher than last year.”

The staff of the Securities and Exchange Commission has published a new staff accounting bulletin regarding impairment to make its accounting literature consistent with recent pronouncements on impairment from the Financial Accounting Standards Board.

Staff Accounting Bulletin No. 111 amends an earlier staff accounting bulletin titled “Other Than Temporary Impairment of Certain Investments in Debt and Equity Securities (Topic 5.M).” The effect of the new SAB is to eliminate debt securities from the scope of the earlier SAB, making it consistent with FASB’s recently issued staff position on other-than-temporary impairment of debt securities.

FASB’s staff position provides new and controversial guidance for assessing whether an impairment of a debt security is something other than temporary, giving management some latitude to consider plans to hold a security to recovery in establishing its value and recording related losses. The guidance allows management to split certain debt-security losses into a credit-related loss that would be charged to earnings and a non-credit-related loss that would be charged to other comprehensive income, which does not impact the income statement.

SEC staff notes that the new SAB does not change the staff’s previous views on equity securities. It also points out that for equity securities classified as available for sale, the staff does not believe the phrase “other than temporary” should be interpreted to mean permanent. “The staff believes that FASB consciously chose the phrase ‘other than temporary’ because it did not intend that the test be ‘permanent impairment,’ as has been used elsewhere in accounting practice,” the SAB says.

The staff says the value of investments in available-for-sale equity securities may trail off for any number of reasons, and it’s up to management to consider “all available evidence” to evaluate the prospects for recovery. It should consider factors such as how low market value has sunk below cost and how long it’s been there, how well situated an entity is to carry the loss, and how committed it is to holding the investment to recovery, among other things.

Frustrated by a seizure in judgment and duress from Congress, the Financial Accounting Standards Board is rushing through two new pieces of guidance intended to help grease the wheels of a stalled economy.

The board met in an unusual Monday morning meeting to hash out guidance that will define when markets are inactive, therefore not alone indicative of fair value, and how entities can reflect impairments or declines in fair value in a way that distinguishes between actual losses and other factors not directly impacting earnings.

The first piece will outline the factors entities should consider in determining, in the context of Financial Accounting Statement No. 157, Fair Value Measurement, whether recent transaction prices should be regarded as “distressed” and therefore not an adequate yardstick alone for establishing fair value. The guidance will direct entities to consider factors such as transaction volume, the age of information, variations in price quotes, correlation of indices with recent fair values, liquidity risk premiums, bid-ask spreads, and the visibility of information to the public when determining if a market for a given asset is active.

“The underlying problem here, of course, is a lot of classes of securities have inactive, problem markets,” said FASB Chairman Robert Herz. “There’s no single silver bullet, except get all the information you can and make a judgment. We’re trying to help people through that process.”

Board member Leslie Seidman said the guidance does not alter FAS 157, but provides implementation guidance to help distinguish between distressed transactions and distressed markets. “(FAS) 157 already says right now that a price from a forced sale or distressed transaction does not represent fair value,” she said. “What we’re talking about here is how do I know when I have one of those? And if I do have one of those, what do I do?”

Seidman said the new guidance will not provide an escape from FAS 157’s call for an exit price, or the price an entity would receive in an orderly transaction, in establishing fair value. “It doesn’t mean I’ve identified a distressed transaction and now I can estimate cash flow any way I want to,” she said. “Your objective should not be essentially to derive a fair value that’s based off the transaction price we just said is distressed. Don’t use that data point alone any more. Instead, use other sources of information and estimate fair value that still represents fair value.”

Board member Tom Linsmeier said he was frustrated by the tone of the House subcommittee hearing last week that compelled FASB to rush through the new guidance. During the hearing, Herz faced an agitated panel threatening to alter accounting rules through legislation if FASB didn’t produce new guidance in a hurry.

“The frustration was an assertion that we had done nothing in recognition of these issues over time,” he said. “That’s absolutely not the case.” In October, FASB published guidance that provided instruction on how to reach fair values when markets are inactive, though it didn’t provide detailed guidance on how to define when markets are inactive.

Linsmeier said he believes other factors are at play that inhibit the use of judgment, for example a “check-box mentality, or maybe auditing liability issues—factors in the system that caused people not to do the work … This is consistent with where we were in October. We’re just changing the focus of the evidence and forcing people to think about the orderly transaction price more thoroughly.”

With respect to impairments, the board’s guidance will provide a means for entities to reflect in financial statements where losses stem from credit losses. The intent is to address concerns raised by banks and other financial institutions that it’s difficult to assess the likelihood that a particular security will recover in value and to assert that it plans to hold the investment long enough for it to recover.

David Larsen, managing director at Duff & Phelps and a member of FASB’s Valuation Resource Group, said the two pieces of guidance do not represent significant departure from FASB’s stand on how fair value should be measured or impairments reflected. “With both documents, the concepts therein have been in play and under discussion for a number of months,” he said. “The Congressional hearings may have accelerated the timing, but it did not really add any new content.”

As turmoil persists in financial markets and shakes confidence in the economy, investor advocates are cautioning analysts to be vigilant for signs of aggressive accounting tactics and fraud.

RiskMetrics Group is telling analysts to be especially skeptical about information companies present or dress up as measures of their financial health—“particularly non-GAAP or newly introduced metrics that are emphasized to investors but are not subject to rigorous audit procedures.” In a Webcast this week, RiskMetrics outlined its hot list of accounting issues that are most likely to create tension in varying ways among preparers, auditors, regulators, analysts, and investors.

Among the big concerns, valuation and impairment of financial instruments tops the list. RiskMetrics expects more “fast-tracked rule changes” related to fair value, impairments, and reserves. The Financial Accounting Standards Board has a number of short-term, quick-fix projects on its agenda related to fair value and impairment, sparked by the credit crisis and its mushrooming effects. One in particular would require more interim disclosure around fair value, and one would streamline the model for impairments.

While the reporting problems are especially pertinent for financial institutions, other public companies can run into problems as well, says Jeremy Perler, co-head of an accounting research group at RiskMetrics. Companies reporting their interests in other companies, for example, may assert that depressed values are temporary, he says. “If you own this company, you want to know the potential that that impairment is not just temporary,” he says.

Perler says companies are expected to face a raft of new disclosure requirements, many of them focused on complicated financial instruments, fair value, derivatives, off-balance-sheet entities, pension plans, contingencies, credit derivatives, discontinued operations, and oil and gas reserves. “The standard setters have been pretty active recently in requiring new disclosure,” he says. “This year we expect to see a ton of them in different areas.”

RiskMetrics says analysts and investors should also look cautiously at anything related to off-balance-sheet entities, pension plans, business combinations, convertible debt, and revenue recognition. Longer term, the group says companies should also keep close tabs on developments in the shift to International Financial Reporting Standards and in the movement to develop a new presentation system for financial statements.

Management assertions about whether a company can continue as a going concern in the current economic environment should be “required reading” for investors, according to a Fitch outlook for 2009.

Companies and their auditors are facing off over whether toxic assets without ready buyers should be written down. Exacerbated by a drawn-out standoff in credit markets, the conditions raise big questions about whether companies can secure financing they need to continue operating, says Fitch. “This is a particularly sensitive issue because profitability and regulatory capital adequacy are at stake for many financial institutions,” Fitch wrote in a special report titled “Accounting and Financial Reporting: 2009 Global Outlook.”

“Most of the accounting issues that are out there seem pretty obvious in 2009,” said Olu Sonola, director at Fitch. Those include determinations and disclosures around fair value, impairments, derivatives, credit swaps, off-balance-sheet activity, business combinations, and pensions, to name a few. “It’s the severity that may turn out to be surprising. Going concern is at the top of our list of what to look out for.”

Sonola said the United Kingdom is talking more openly about the going concern question. “In the U.K. people are jumping on it trying to give some early direction as to where there are going concern issues,” he said. “In the U.S. it seems that’s not really the case. It would not come as a surprise to see a lot more going concern opinions in the U.S. than most people anticipate.”

Dina Maher, senior director at Fitch, and Sonola said they are reserving judgment on whether hasty efforts at the Financial Accounting Standards Board to improve impairment accounting will have the desired effect for 2008 financial reporting. They share concerns debated at FASB that the guidance may only delay writedowns. “There’s a lot of talk out there that (delayed writedowns) may turn out to be the result,” said Sonola. “I’m not sure it will be totally helpful.”

Maher said the firm has developed its own loss expectations for entities on a case-by-case basis rather than waiting for entities to announce they have assets that are impaired and can’t recover their value. “Given the nature of accounting today, we need to look at those companies that have significant unrealized losses and make a determination as to whether some of those losses will become realized, and if so what portion.”

An intensive study by the Securities and Exchange Commission has concluded that classic fears of credit quality and banks’ viability caused banks to fail and the financial markets to grind to a halt last year, rather than mark-to-market accounting rules.

The SEC study, mandated by Congress last fall when it passed the Wall Street bailout, recommends that Congress not suspend mark-to-market accounting standards. Rather, the SEC says the market could use some accounting rule changes related to impairments and guidance related to how fair value is measured, especially when markets are inactive and liquidity is a problem. The Financial Accounting Standards Board is already racing the clock to put some impairment changes in place in time for 2008 year-end reporting.

The 211-page study says investors generally believe fair-value accounting results in more transparent financial reporting and allows better investment decision making. The report says banks failed more as a result of credit losses, concerns about asset quality, and in some cases diminished lender and investor confidence, not fair-value accounting. It outlines some specific recommendations that would improve the application of fair-value accounting, according to the SEC, including:

1. Guidance and tools for determining fair value when market information is not available because markets are inactive; addressing how to determine when markets are inactive and therefore transactions are distressed; how a change in credit risk should impact the value of asset or liability; when it’s appropriate to rely on management estimates; and how to confirm assumptions represent the view of the hypothetical market participant, as required in Financial Accounting Standard No. 157, Fair Value Measurement;
2. Enhanced disclosure and presentation requirements regarding the effect of fair value in the financial statements;
3. Examination by FASB on the effect liquidity has in the measurement of fair value, including whether additional application or disclosure guidance might be helpful;
4. Consideration by FASB of whether credit risk should be factored into the measurement of liabilities, including whether current practice provides enough transparency;
5. Educational efforts, including those to reinforce the need for management judgment in the determination of fair-value estimates.

The report says FASB should consider reducing the number of impairment models, allowing management more leeway to tell investors whether declines in value are consistent with underlying credit quality, and allowing impaired assets to reflect recoveries as they regain value. FASB is working on short-term projects now (one looking at streamlining impairment models and one calling for a tabular presentation of measurement attributes in valuing certain debt securities) that address those issues. It is working on guidance related to the remaining issues as well.

Rick Ueltschy, a partner with Crowe Horwath, says the broad findings generally support what his firm has seen in practice. “The study indicates that credit losses have been a much greater contributor to bank weakening and failure than losses on investments recorded because of fair-value accounting,” he says. “While banks have taken some investment related hits, the credit losses have been more significant, except for certain, rare cases where banks had concentrations of investments in particularly troublesome securities.”

Cindy Fornelli, director of the Center for Audit Quality, said in a prepared statement that she’s pleased to see the study calls for improvements to rules, but not a retreat from fair value. “Any changes should be proposed and dealt with through the independent standard-setting process,” she said.