New Treatment of Goodwill and Intangibles
Goodwill and intangible assets often represent a considerable portion of an enterprise’s net worth, and Financial Accounting Standards Board (FASB) rules for treating goodwill and intangibles may have an important effect on the valuation of some companies. The implications for past, pending and future mergers, acquisitions and other deals are significant, so it is important that business owners be familiar with these rules, Accounting Standards Codification (ASC) 805 (formerly Statements of Accounting Standards (“SFAS”) 141 (R)), Business Combinations, and ASC 350 (formerly SFAS 142), Goodwill and Intangible Assets. SFAS 141 (R), issued December, 2007 and effective for fiscal years beginning after December 15, 2008, modified certain aspects of the original SFAS 141 issued in June 2001.
By way of background, ASC 805 requires all business combinations to be evaluated using the purchase method of accounting, and it specifically prohibits use of the pooling-of-interests method. It also provides recognition criteria for intangible assets other than goodwill, along with general guidelines for assigning values to assets acquired and liabilities assumed. ASC 805 defines an identifiable intangible asset apart from goodwill as:
- An asset arising from a contractual or legal right, such as a patent, trademark or copyright; or
- An asset other than contractual that can be sold, transferred, licensed, rented or exchanged individually or in combination with a related contract, asset or liability.
Under ASC 805, parties to a business combination are required to estimate the fair value of acquired intangible assets in the following manner. First, intangible assets must be categorized by type, such as customer lists, trademarks, patents, software, intellectual property, etc. Second, intangible assets with an identifiable remaining useful life must be separated from those with an indefinite useful life. The latter are then classified with goodwill, which is subject to a two-step test for impairment under ASC 350 (formerly SFAS 142).
ASC 805 requires an acquirer to recognize all of the assets acquired and all of the liabilities assumed, as well as any minority (that is, noncontrolling) interest (in acquisitions of less than 100 percent of the target company’s stock), at their respective fair values at the acquisition date. This supersedes SFAS 141’s cost allocation process, which required the cost of an acquisition to be allocated to the individual assets acquired and liabilities assumed based on their estimated fair values. This approach resulted in not recognizing certain assets and liabilities at the acquisition date, as well as measuring certain assets and liabilities at amounts other than fair value. For example, SFAS 141 required acquisition related costs (for example, legal, investment banking, and accounting fees) to be capitalized and included in the total consideration to be allocated to the acquired assets and assumed liabilities. In contrast, ASC 805 requires such costs to be accounted for separately from the acquisition, and expensed as incurred.
ASC 805 also requires that contingent consideration, for example, earn-out amounts that are dependent on the future financial performance of the acquired business, be recorded at fair value at the acquisition date. In contrast, under SFAS 141, such contingencies were only recorded when determinable.
ASC 805 also changes the accounting treatment for in-process research and development activities (“IPR&D”). Under SFAS 141, IPR&D, if determined to have no alternative future use, was included as an asset in the purchase price allocation and then immediately expensed. In contrast, ASC 805 requires IPR&D, regardless of whether an alternative future use exists, to be capitalized like other acquired intangible assets, and considered as an indefinite-lived asset until the completion or abandonment of the associated R&D activities. Once the R&D activities have been completed or abandoned, the useful life of the IPR&D is to be determined pursuant to the provisions of ASC 350 and amortized accordingly.
Another significant change under ASC 805 deals with so-called bargain purchases, that is, acquisitions where the sum of the fair values of the identifiable assets acquired exceeds the consideration paid. These so-called “negative goodwill” situations arise where goodwill, which under ASC 805 is measured on a residual basis as the excess of the consideration paid over the fair values of the identifiable net assets acquired, is negative. Whereas SFAS 141 dictated a pro rata reduction in the carrying values of certain non-current assets so as to equate the aggregate fair value of all acquired assets to the consideration paid, under ASC 805 there will be no adjustment to the fair values of the assets. Instead, the difference between the aggregate fair value of the assets acquired and the consideration paid is to be recorded as an extraordinary gain on the income statement.
ASC 805 also changes the accounting for acquisitions where less than a 100 percent equity interest is acquired. Under SFAS 141, minority interests in the acquired entity were recorded on a historical cost basis, which did not provide an indication of the minority interest’s proportional share of the acquired entity’s net assets. In contrast, ASC 805 requires that the minority interest be measured at fair value, which will result in the recognition of the minority interest’s portion of the total goodwill of the acquired entity, as well as its share of the total fair value of the entity’s identifiable assets and liabilities. This change is intended to improve the meaningfulness of the resultant purchase price accounting by employing purely fair value accounting, rather than a blend of fair value and historical cost accounting.
Under ASC 350 (formerly SFAS 142), amortization of goodwill is no longer permitted, although it still is recognized as an asset. Instead, goodwill and other indefinite-lived intangibles are subject to an annual test for impairment of value. (Prior to the enactment of SFAS 142, which became effective January 1, 2002, goodwill had been amortized over its useful life, up to a period not to exceed 40 years.)
Instead of amortizing goodwill, companies must test goodwill impairment at least once a year. Businesses must perform goodwill impairment testing in new reporting units, develop valuation methodologies for those units and subjectively value identifiable intangible assets. ASC 350 requires businesses to perform a Transitional Impairment Test on all goodwill within six months. The calculated amounts should be measured as of the first of the year. If this first step indicates that goodwill is impaired, any goodwill impairment loss should be calculated and recorded as soon as possible prior to year-end.
After the initial Transitional Impairment Test is conducted, businesses must perform the Goodwill Impairment Test on an annual basis (with certain exceptions) under ASC 350. This process must be conducted at the reporting unit level, defined as the lowest level of an entity, i.e., business units, subsidiaries, operating units, divisions, etc. There are two steps to the process:
1.) Identify potential impairments by comparing the fair value of a reporting unit to its carrying amount, including goodwill. Goodwill is not considered impaired as long as the fair value of the unit is greater than its carrying value. The second step is only required if an impairment to goodwill is identified in step one.
2.) Compare the implied fair value of goodwill to its carrying amount, where the implied fair value of goodwill is computed on a residual basis, that is, by subtracting the sum of the fair values of the individual asset categories (tangible and intangible) from the indicated fair value of the reporting unit as determined under step one. If the carrying amount of goodwill exceeds its implied fair value, an impairment loss is recognized. That loss is equal to the carrying amount of goodwill that is in excess of its implied fair value, and it must be presented as a separate line item on financial statements.