The dreaded “step two” of the goodwill impairment test is dead. The Financial Accounting Standards Board issued a final update to accounting standards eliminating the requirement for companies to complete the grueling fair value exercise when there’s evidence that goodwill on the balance sheet might need a haircut.
Goodwill is an intangible asset on the balance sheet that arises when one company buys another and integrates it to financial statements. After the individual assets and liabilities of the acquired company are added to the balance sheet, goodwill represents the premium the buying company paid to get a complete business and not just a collection of assets and liabilities.
Investors like to watch goodwill numbers as a way of assessing whether an acquisition is delivering value over time. Companies have long been required under GAAP to test the value of goodwill on the balance sheet to see if it is holding up or is impaired and needs a markdown.
The first step of the goodwill impairment test is to measure the fair value of a reporting unit and compare it to the carrying value for the unit in the company’s books. If the fair value exceeds the carrying value, goodwill is sound. If it doesn’t, goodwill might be impaired or overstated.
The second step took companies through a full fair-value measurement of all the assets and liabilities of a reporting unit to arrive at a better number for goodwill. It’s that second step, however, that companies have long criticized as overly burdensome and complex for the information it produces.
FASB first rolled back the second step of the impairment test when the board’s Private Company Council recommended it as an appropriate accounting accommodation for private companies, which do not issues financial statements for the sake of arm’s length investors in capital markets. That prompted a push for FASB to consider the same curtailment of burdensome accounting for public companies as well.
With the second step eliminated, now companies will rely on the information they get out of the remaining initial step of the goodwill impairment test. If the fair value of a reporting unit is less than the carrying value on the books, then that number represents the markdown that must be taken.
Companies will still have the “step zero” test FASB added in 2011, which allows companies to perform a qualitative assessment of goodwill before even proceeding to the arithmetic in the first step. If qualitative indicators suggest goodwill is holding up and auditors agree, companies are not required to conduct the quantitative analysis.
Accounting Standards Update No. 2017-04, which officially eliminates step two from GAAP, takes effect for public companies in 2020, but FASB also permits early adoption beginning in 2017 for interim and annual goodwill impairment testing.