There have been some recent changes to the ever-complicated rules governing goodwill, fair value, impairment testing. Previously, an entity which recorded goodwill as part of a transaction was required to test the goodwill for impairment at least annually. The test consists of two parts, the first of which is comparing the current fair value of the reporting unit, in which the goodwill is recorded, to the carrying value of the reporting unit. This step requires the valuation of the reporting unit.
When the fair value of the reporting unit is less than the carrying value, the impairment of goodwill is presumed and the second phase of the impairment test is undertaken. The second phase requires what amounts to a new purchase accounting analysis. The current fair value of the reporting unit is allocated among its assets and liabilities to determine the residual goodwill value. An impairment loss is recognized when the carrying value of goodwill exceeds the newly determined residual goodwill value.
The amendments in the Update allow the consideration of qualitative factors to determine whether the two-step quantitative goodwill impairment test is necessary. Now, an entity will be required to calculate the fair value of a reporting unit only if it determines, based on a qualitative assessment, that it is more likely than not that its fair value is less than its carrying amount. The amendments include a number of events and circumstances to be considered in conducting the qualitative assessment.
Examples of such events and circumstances include the following (there may be others):
- Macroeconomic conditions such as a deterioration in general economic conditions, limitations on accessing capital, fluctuations in foreign exchange rates, or other developments in equity and credit markets;
- Industry and market considerations such as a deterioration in the environment in which an entity operates, an increased competitive environment, a decline in market-dependent multiples or metrics (consider in both absolute terms and relative to peers), a change in the market for an entity’s product or services, or a regulatory or political development;
- Cost factors such as increase in raw materials, labor, or other cost that have a negative effect on earnings and cash flows;
- Overall financial performance such as negative or declining cash flow or a decline in actual or planned revenue or earnings compared with actual and projected results of relevant prior periods;
- Other relevant entity-specific events such as changes in management, key personnel, strategy, or customers; contemplation of bankruptcy; or litigation;
- If applicable, a sustained decrease in share price (consider in both absolute terms and relative to peers).
One of the stated purposes for the Update is to reduce the costs to comply with fair value accounting, as it relates to goodwill impairment. The previous two-step process is costly from a pure dollars cost standpoint, as well as, from a time-invested perspective. Even in the circumstance where only the phase one test is required, the cost and time requirement is great. The addition of the qualitative step into the impairment test should simplify the process of the impairment test.
The qualitative assessment will likely be more cost-effective for reporting units whose fair value was substantially greater than its carrying amount in the prior period. However, the smaller the historical “cushion” in a reporting unit’s Step 1 analysis, the less meaningful this qualitative assessment will be.
The FASB noted that the more time that has elapsed since a recent fair value (Step 1) calculation, the more difficult it may be to support a conclusion based solely on a qualitative assessment. Companies will likely need to prepare documentation supporting these considerations, which may potentially include supporting quantitative information, in order to provide external auditors with sufficient audit evidence of the qualitative factors.
The economic conditions of the past few years have resulted in staggering impairments of goodwill. In addition, considering the continuation of a weak economic climate, many companies may likely trigger one or more of the qualitative factors set forth in the standard, thus requiring the traditional two-step test to be performed.
The FASB acknowledged that a longer-term project to further evaluate the accounting for goodwill may be appropriate, and other alternative approaches, including amortization and direct write off, may replace the current practice as convergence efforts continue.