Goodwill typically appears on a company's balance sheet as the result of a merger or an acquisition. In a nutshell, it's the difference between the purchase price and the fair value that's allocated to acquired identifiable assets and liabilities assumed.
After recording goodwill from a business combination, subsequent write-offs for impairment may be required under U.S. Generally Accepted Accounting Principles (GAAP). Impairment occurs when the implied fair value of goodwill falls below its carrying value on the balance sheet. Such write-offs typically warn investors and lenders that the company paid too much in a recent deal or the company's financial results have fallen short of expectations.
In 2015, goodwill impairments among public companies more than doubled compared to the year before — rising to the highest level since the market plunged in 2008 — according to a recent study (see box). Here's background on goodwill impairment and details of financial reporting changes that the Financial Accounting Standards Board (FASB) approved in November 2016.
FASB Accounting Standards Codification Topic 805, Business Combinations, requires an acquiring entity to allocate the purchase price of an acquired company among its assets and liabilities. This allocation is made according to the "fair value" of acquired tangible assets (such as receivables and inventory), acquired identifiable intangible assets (such as patents, brands and customer lists) and liabilities assumed. Any leftover purchase price that isn't allocated to specific assets and liabilities is assigned to a catchall category called "goodwill."
FASB defines fair value as, "The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date." Typically, companies hire outside valuation professionals to compute fair value and allocate it to an acquired entity's assets (including goodwill) and liabilities.
After a deal closes, FASB Accounting Standards Codification Topic 350, Intangible Assets — Goodwill and Other, kicks in. This rule generally requires companies to test acquired goodwill and other intangibles at least annually for impairment.
Testing goodwill for impairment is a complex process under existing GAAP that requires the following two-step process:
- Calculate the fair value of the reporting unit and compare it with its carrying amount, including goodwill. If the carrying amount exceeds fair value, no impairment has occurred and testing stops. If the fair value exceeds the carrying amount, continue to the second step.
- Calculate and compare the implied fair value of the reporting unit's goodwill with its carrying amount. To compute the implied fair value of goodwill, a business must determine the fair value at the impairment testing date of its identifiable assets and liabilities. This procedure is similar to what would be required in a purchase price allocation for an acquired business.
The test for impairment has evolved over the years. In 2012, the FASB introduced step zero, an optional qualitative assessment in which management evaluates whether it's "more likely than not" that the carrying value of the reporting unit exceeds its fair value. If that threshold is met, a company needn't perform the two-step impairment test.
In 2014, the FASB provided a simplified alternative for private companies. Rather than test for impairment, private companies may elect to amortize goodwill straight-line, generally over 10 years. Companies electing this alternative must continue to test for impairment when certain triggering events occur, such as the loss of a key person or an unexpected increase in competition.
The FASB recently voted to finalize Proposed Accounting Standards Update (ASU) No. 2016-230, Intangibles — Goodwill and Other (Topic 350): Simplifying the Accounting for Goodwill Impairment. In a nutshell, the FASB plans to eliminate the second step of the goodwill impairment test.
Instead, a business would perform its annual goodwill impairment test by simply comparing the fair value of a reporting unit with its carrying amount. The impairment charge would equal the difference between the carrying amount and its fair value. This means no assessment of the implied value of goodwill will be required under the update.
Although the new rules will simplify the reporting requirements, most companies still need to hire valuation professionals to estimate fair value, especially if their financial statements are audited by outside CPA firms. FASB research has shown that analysts and investors care more about the existence of goodwill impairment than a precise calculation of what the impairment amount is attributable to.
Simplifying the Requirements
Approximately 82% of the respondents to the 2016 U.S. Goodwill Impairment Study favor the recently approved changes to the goodwill impairment test. These rules are scheduled to go into effect for fiscal periods starting after December 15, 2019, for public companies and for fiscal periods starting after December 15, 2020, for private businesses that don't elect to amortize goodwill.
However, many organizations are expected to implement the FASB's simplification measures ahead of the effective date to save time and money. If you need help implementing the new guidance or estimating fair value for financial reporting purposes, contact a business valuation professional.
Goodwill Impairment Trends
The recently published 2016 U.S. Goodwill Impairment Study found, among other results, that public companies added a total of $458 billion of goodwill to their balance sheets in 2015. That was the highest annual increase since the Financial Executives Research Foundation (FERF) began tracking this information in 2008.
Now in its eighth year of publication, the latest report examines general and industry goodwill impairment trends of more than 8,500 U.S. publicly-traded companies from January 2015 through December 2015.
Other key findings from the study include:
- Deal activity in 2015 surged by two-thirds relative to 2014.
- The total goodwill impairment recorded by U.S. public companies more than doubled from $26 billion in 2014 to $57 billion of in 2015. This is the highest write-off volume reported since 2008 at the peak of the financial crisis.
- The number of companies that incurred impairment losses increased only slightly, from 341 in 2014 to 350 in 2015. But the average write-off more than doubled, from $75 million in 2014 to $163 million in 2015.
Certain industries tend to be more vulnerable to write-offs than others. More than 80% of the total goodwill impairment reported in 2015 can be attributed to these four industries:
- Energy ($18.2 billion in impairment losses),
- Information technology ($12.9 billion in impairment losses),
- Industrials ($7.7 billion in impairment losses), and
- Consumer discretionary ($7.6 billion in impairment losses).
The energy sector has experienced significant write-offs, accounting for nearly one-third of the total goodwill impairment U.S. public companies reported in 2015. According to the 2016 study, 17% of energy companies reported goodwill — and more than half of those companies reported goodwill impairment — in 2015.
LOUIS J. CERCONE, JR., CPA, CFE, CFF, ABV, ASA, CVA
Lou is the Managing Director of Brisbane Consulting Group in charge of business valuations, forensic accounting, and litigation support services. He has extensive valuation experience and has served as a financial consultant and expert to attorneys in the economic aspects of matrimonial dissolution. He has been engaged in several forensic accounting cases and has served the judiciary as a court appointed expert and receiver for financially troubled companies. He has testified as an expert witness in State Supreme Court and Federal Court. Lou has also been engaged in the quantification of lost income in determining business interruption claims for insurance adjusters.