FASB looks to cut out that ‘second step’ of goodwill accounting

The accounting for goodwill on corporate balance sheets could get a lot easier in the future if public companies speak up and let accounting rulemakers know they support change.

Goodwill is an intangible asset that makes its way onto corporate balance sheets as a result of a merger or acquisition. When one company buys another, the price paid to buy the business typically exceeds the value of its individual assets and liabilities. That’s goodwill.

It represents the “expected synergy,” as it is defined in accounting rules. Investors like to watch that number because they regard it as an indicator of whether they got their money’s worth in a particular acquisition.

Getting goodwill on the balance sheet is typically not a big concern for most companies. Accounting for it in subsequent periods, however, has been a headache, especially during market downturns or periods of disappointing performance.

Under accounting rules adopted in 2001, companies are required to “test” the goodwill values on balance sheets to determine if they are “impaired,” or simply not holding up over time, and therefore should be marked down. The Financial Accounting Standards Board developed a two-step test for determining whether goodwill should be written down and, if so, by how much.

The first step involves comparing the fair value of the reporting unit to the carrying value on the books. If it is at least greater than the carrying value, goodwill is considered sound, so remains on the books as recorded. If it is lower, however, that triggers step two.

“Under the model as it stands today, if you get to step two, you have to identify the fair value of all the assets and liabilities just as you would if you were acquiring the business,” says Mark Winiarski, shareholder at audit firm Mayer Hoffman McCann. “That process is so costly and complex.”

“Under the model as it stands today, if you get to step two, you have to identify the fair value of all the assets and liabilities just as you would if you were acquiring the business. That process is so costly and complex.”

Mark Winiarski, Shareholder, Mayer Hoffman McCann

In 2011, FASB tried to make goodwill impairment testing a little less onerous by introducing what became known as “step zero,” which allows companies to perform a qualitative assessment of goodwill before performing a fair-value measurement. If qualitative indicators suggest goodwill is holding up, no further testing is required.

That’s perhaps simpler when performance and market indicators are strong in supporting goodwill values, but it does nothing to simplify the subsequent steps if goodwill is not holding its own. Now FASB is tackling that challenge as well with a proposal that would simply drop the second step of the current impairment test. That would mean no more fair-value measurement of individual assets and liabilities to arrive at a current residual value for goodwill.

“You could still decide to do the qualitative assessment,” says Winiarski. “If it’s more likely than not that goodwill is impaired, you would proceed to the quantitative test, looking at the carrying value compared to the fair value of the reporting unit. If the carrying value is greater than the fair value, you’d have an impairment loss based on just that measurement alone.”

QUESTIONS FOR RESPONDENTS

Below is a list of questions from FASB to help companies comment on the board’s proposal for goodwill impairment. FASB is accepting comments on its current proposal through July 11.
Question 1: Do you agree with the proposed amendments to eliminate Step 2 from the goodwill impairment test? Why or why not?
Question 2: Should the requirement to perform Step 2 of the current goodwill impairment test be retained as an option? Why or why not? If the use of Step 2 is optional, should an entity be allowed to apply that option by reporting unit or should it be a policy election at the entity level applicable to all reporting units?
Question 3: Do you agree with the proposed amendments to require all entities to apply the same one-step impairment test to all reporting units, including those with zero or negative carrying amounts? Why or why not? If not, what would be the suggested goodwill impairment test for reporting units with zero or negative carrying amounts?
Question 4: Should entities with reporting units with zero or negative carrying amounts be required to disclose the existence of those reporting units and the amount of goodwill allocated to them? Why or why not? Are there additional disclosures that would provide useful information to users of financial statements?
Question 5: Should the guidance on deferred income tax considerations when determining the fair value of a reporting unit outlined in paragraphs 350-20-35-25 through 35-27 and illustrated in Example 1 and Example 2 be retained, or should this Subtopic rely on the fair value guidance in Topic 820, Fair Value Measurement? If the guidance on the tax structure is retained, what, if any, amendments are necessary to address the potential difference in the impairment charge calculated under the proposed amendments, depending on which tax structure is used in calculating the fair value of the reporting unit?
Question 6: Do you agree that the proposed guidance to remove Step 2 from the goodwill impairment test should be applied prospectively? Should there be specific transition guidance for companies that previously adopted the goodwill accounting alternative for private companies in current GAAP but decide to adopt this proposed guidance after it becomes effective?
Question 7: How much time would be necessary to adopt the amendments in this proposed Update? Should early adoption be permitted? Would the amount of time needed to apply the proposed amendments by entities other than public business entities be different from the amount of time needed by public business entities?
Question 8: Would the proposed amendments meet the Board’s objective of reducing the cost of the subsequent accounting for goodwill while maintaining the usefulness of the information provided to users of financial statements? Why or why not?
Question 9: Are there additional changes that should be made to the subsequent accounting for goodwill to meet this objective, including changes that might be considered in Phase 2 of the Board’s project?
Question 10: Are there any unintended consequences resulting from the improvements to the Overview and Background Sections of the Subtopics (discussed in Part II of the proposed amendments)?
Source: FASB

Brian Marshall, a partner at audit firm RSM, says he expects preparers generally to support doing away with the second step of the impairment test. “Preparers will definitely like this proposal from a simplicity standpoint,” he says. “Step two can be pretty complex and time-consuming.”

While eliminating the second step would certainly simplify the measurement of any possible goodwill impairment, it might also raise a concern in the view of some accounting experts that companies will want to consider as they decide whether they support the proposal. “If you eliminate step two, often times there will be a difference in what you get from the step-one shortfall and the actual impairment recorded under step two,” says Marshall.

Scott Lehman, a partner at Crowe Horwath, says the second step of the impairment test today provides a more specific number if goodwill must be written down because it measures the intangible asset following a more precise process. “What you might end up with is a less exact number,” he says. “But we hear constituents say they are probably more concerned with whether there’s an impairment than having the dollar amount that precise.”

Doug Reynolds, a partner with Grant Thornton, says he doesn’t see it as a less precise measure for goodwill, but an alternative measure that would be applied more simply and consistently across all companies. “Some might argue step two as we have it today is conceptually purer than having one step,” he says. “It’s just a different way where all companies would view these things in the same way.”

The key difference in the mathematical equation between the first step and the second step of the current goodwill impairment test is the effect of intangible assets, experts say. Companies do not separately identify and value their intangible assets for accounting purposes, so that would not factor into the first step of the impairment test. However, intangible assets are valued and reflected under accounting for business combinations, so those are included in the second step that FASB now proposes to eliminate.

While it is a difference, it is not likely to be a significant difference, says Chris Wright, managing director for Protiviti. He expects preparers to support the simplicity of dropping the second step because it will enable them to use data they already gather for other purposes to also comply with goodwill impairment requirements. “In instances where the data matters, it is likely already being collected, analyzed, and reported for other purposes,” he says, such as segment reporting.

While that provides some streamlining benefits, says Wright, it doesn’t mean companies will be able to be any less rigorous in complying with the remaining goodwill testing requirements. “It won’t allow them to be any less accurate around producing data,” he says. “The controls will still be just as important.”

With the current proposed simplification, FASB also indicates it plans to continue studying other ways to simplify the accounting for goodwill. The board approved an alternative method for private companies that allows them to simply amortize, or mark down over time, the value of goodwill. That’s still a possibility for public companies, FASB says. While the current proposal would affect time, cost, and disclosures, says Wright, a move to amortization would have far more effect on the actual reported results.

FASB is accepting comments on its current proposal through July 11.