How are Goodwill Impairment Losses Recognized? | Accounting

The following article will guide you about how are goodwill impairment losses recognized.

SFAS 142 – Goodwill and Intangible Assets:

In SFAS 142, “Goodwill and Other Intangible Assets,” July 2001, the FASB approved significant changes in the way income is determined for combined business entities. The most prominent of these changes is that goodwill is no longer amortized systematically over time. Instead, goodwill is now subject to an annual test for impairment.

This non-amortization approach is applied to both previously recognized and newly acquired goodwill. For consolidations of par­ent and subsidiary companies, goodwill amortization expense no longer appears on the com­bined income statement. The consolidated balance sheet frequently carries acquisition-related goodwill at its original assigned value. Only upon the recognition of an impairment loss (or par­tial sale of a subsidiary) will goodwill decline from one period to the next.

SFAS 141R, “Business Combinations,” suggests several categories of intangible assets for pos­sible recognition when one business acquires another. Examples include noncompetition agree­ments, customer lists, patents, subscriber databases, trademarks, lease agreements, licenses, and many others.

If fair values can be measured reliably for the identified intangibles in a business combina­tion, they are separately recognized and subsequently amortized if appropriate. If a separate fair-value estimation is unavailable or unreliable for a particular intangible, then any remaining unallocated acquisition-date excess fair value is simply recognized as goodwill.

SFAS 142, “Goodwill and Other Intangible Assets,” requires that all identified intangible assets be amortized over their economic useful life unless such life is considered indefinite. The term indefinite life is defined as a life that extends beyond the foreseeable future. A rec­ognized intangible asset with an indefinite life should not be amortized unless and until its life is determined to be finite. Importantly, indefinite does not mean “infinite”. Also, the use­ful life of an intangible asset should not be considered indefinite because a precise finite life is not known.

For those intangible assets with finite lives, the amortization method should reflect the pat­tern of decline in the economic usefulness of the asset. If no such pattern is apparent, the straight-line method of amortization should be used. The amount to be amortized should be the value assigned to the intangible asset less any residual value.

In most cases, the residual value is presumed to be zero. However, that presumption can be overcome if the acquiring enterprise has a commitment from a third party to purchase the intangible at the end of its useful life or an observable market exists for the intangible asset that provides a basis for estimating a terminal value.

The length of the amortization period for identifiable intangibles (i.e., those not included in goodwill) depends primarily on the assumed economic life of the asset.

Factors that should be considered in determining the useful life of an intangible asset include:

i. Legal, regulatory, or contractual provisions.

ii. The effects of obsolescence, demand, competition, industry stability, rate of technological change, and expected changes in distribution channels.

iii. The enterprise’s expected use of the intangible asset.

iv. The level of maintenance expenditure required to obtain the asset’s expected future benefits.

Any recognized intangible assets considered to possess indefinite lives are not amortized but instead are tested for impairment on an annual basis. To test for impairment, the carrying amount of the intangible asset is compared to its fair value. If the fair value is less than the car­rying amount, then the intangible asset is considered impaired and an impairment loss is rec­ognized. The asset’s carrying value is reduced accordingly.

SFAS 142—Goodwill Impairment:

SFAS 142 requires an annual test for goodwill impairment. The FASB reasoned that although goodwill can decrease over time, it does not do so in the “rational and systematic” manner that periodic amortization suggests. Thus, amortization was not viewed as representationally faithful of the pattern of goodwill decline and the FASB decided that goodwill would no longer be subject to amortization. Moreover, because SFAS 141 provides more guidelines for recognizing identifiable intangibles, it was argued that future amounts included in goodwill were more likely to be non-wasting.

Ultimately, the FASB decided to record a decline in the value of goodwill only when:

i. It is apparent that goodwill becomes impaired—that is, when the carrying amount of good­will exceeds its implied fair value and an impairment loss is recognized equal to that excess.

ii. The operating unit where goodwill resides is partially or completely sold.

Importantly, goodwill impairment testing is performed at the reporting unit level. All assets (including goodwill) acquired and liabilities assumed in a business combina­tion must be assigned across reporting units within a consolidated enterprise.  

The goodwill residing in each reporting unit is then separately subjected to periodic impairment testing. Recent evidence shows that goodwill impairment losses can be substantial. Exhibit 3.15 provides examples of goodwill impairment losses recognized under SFAS 142 reporting rules.

Testing Goodwill for Impairment:

The notion of an indefinite life for goodwill allows firms to report over time the original amount of goodwill acquired in a business combination at its assigned acquisition-date value. However, such goodwill can, at some point in time, become impaired, requiring loss recogni­tion and a reduction in the amount reported in the consolidated balance sheet. Unlike amorti­zation, which periodically reduces goodwill, impairment must first be revealed before a write-down is justified. To detect when impairment has occurred, a two-step testing procedure is utilized.

Step 1—Goodwill Impairment Test- Is the Fair Value of a Reporting Unit Less than its Carrying Value?

In the first step of impairment testing, fair values of the consolidated entity’s reporting units with allocated goodwill are compared with their carrying values (including goodwill). If an individual reporting unit’s total fair value exceeds its carrying value, its goodwill is not consid­ered impaired, and the second step in testing is not performed. Goodwill remains at the amount assigned at the date of the business combination.

However, if the fair value of a reporting unit has fallen below its carrying value, a potential for goodwill impairment exists. In this case, a second step must be performed to determine whether goodwill has been impaired.

Step 2—Goodwill Impairment Test- Is Goodwill’s Implied Value Less than its Carrying Value?

If Step 1 indicates a potential goodwill impairment for a reporting unit, goodwill’s implied and carrying values are compared for that reporting unit. The second test requires determin­ing the fair value of the related goodwill. If goodwill’s fair value has declined below its car­rying value, an impairment loss is recognized for the excess carrying value over fair value.

However, determining fair values for reporting units and goodwill can be complex, making implementation of the necessary comparisons costly.

These complexities are described in terms of three key attributes that govern the process of testing goodwill for impairment:

1. The assignment of acquisition values to reporting units.

2. The periodic determination of the fair values of reporting units.

3. The determination of goodwill implied fair value.

1. Assigning Values to Reporting Units:

In deciding to forgo amortization in favor of impairment testing for goodwill, the FASB noted that goodwill is primarily associated with individual reporting units within the consolidated entity. Such goodwill is often considered “synergistic” because it arises from the interaction of the assets of the acquired company with those of the acquirer in specific ways. To better assess potential declines in value for goodwill (in place of amortization), the most specific business level at which goodwill is evident is deemed the appropriate level for impairment testing.

This specific business level is referred to as the reporting unit. The FASB also noted that, in practice, goodwill is often assigned to reporting units either at the level of a reporting segment—as described in SFAS 131, “Disclosures about Segments of an Enterprise and Related Information”—or at a lower level within a segment of a combined enterprise. Conse­quently, the reporting unit is the designated enterprise component for tests of goodwill impair­ment.

Reporting units may thus include the following:

i. A component of an operating segment at a level below the operating segment. Segment man­agement should review and assess performance at this level. Also, the component should be a business in which discrete financial information is available and should differ economi­cally from other components of the operating segment.

ii. The segments of an enterprise.

iii. The entire enterprise.

For example, in its 2005 financial statements, Meade Instruments Corporation notes that the company’s reporting units for purposes of applying the provisions of SFAS 142 are Meade Europe, Simmons, and Coronado. The latter two reporting units represent Meade Instruments’ business acquisitions of Simmons Outdoor (2002) and Coronado Technology Group (2004).

The number of reporting units identified by companies varies widely. In its respective 2004 annual reports, Berkshire Hathaway, Inc., revealed that it employs 40 reporting units while Iomega Corporation noted that its goodwill resided in only one reporting unit related to its Zip product line.

In implementing impairment tests, it is essential first to identify the reporting units resulting from the acquisition. The assets and liabilities (including goodwill) acquired in a business com­bination are then assigned to these identified reporting units. The assignment should consider where the acquired assets and liabilities will be employed and whether they will be included in determining the reporting unit’s fair value.

The goodwill should be assigned to those reporting units that are expected to benefit from the synergies of the combination. Overall, the objective of the assignment of acquired assets and liabilities to reporting units is to facilitate the required fair value/carrying value comparisons for periodic impairment testing.

2. Determining Fair Values of Reporting Units Periodically:

The necessary comparisons to determine whether goodwill is impaired depend first on the fair- value computation of the reporting unit and then, if necessary, the fair-value computation for goodwill—but how are such values computed? How can fair values be known if the subsidiary is wholly owned and thus not traded publicly?

Several alternative methods exist for determining the fair values of the reporting units that compose a consolidated entity. First, any quoted market prices that exist can provide a basis for assessing fair value—particularly for subsidiaries with actively traded non-controlling interests. Second, comparable businesses may exist that can help indicate market values. Third, a variety of present value techniques assesses the fair value of an identifiable set of future cash flow streams or profit projections discounted for the riskiness of the future flows. Clearly, portions of consoli­dated entities are frequently bought and sold. In these transactions, parties do derive fair values. However, the required periodic assessment of fair value is costly when applied to many firms.

However, once a detailed determination of the fair value of a reporting unit is made, that fair value may be used in subsequent periods if all of the following criteria are met (SFAS 142):

i. The assets and liabilities that compose the reporting unit have not changed significantly since the most recent fair-value determination. (A recent acquisition or a reorganization of an entity’s segment reporting structure are examples of events that might significantly change the composition of a reporting unit.)

ii. The most recent fair-value determination resulted in an amount that exceeded the carrying amount of the reporting unit by a substantial margin.

iii. Based on an analysis of events that have occurred and circumstances that have changed since the most recent fair-value determination, it is remote that a current fair-value determination would be less than the reporting unit’s current carrying amount.

If any of these criteria are not met, an updated determination of the reporting unit’s fair value is required.

3. Determining Goodwill’s Implied Fair Value:

If the fair value of a reporting unit, once determined, falls below its carrying value, the second step of the impairment test focuses on the possibility that goodwill could be impaired. Then the fair value of goodwill must be determined in order to make the relevant comparison to its carrying value. Because, by definition, goodwill is not separable from other assets, it is not possible to directly observe its market value. Therefore, an implied value for goodwill is calculated in a simi­lar manner to the determination of goodwill in a business combination.

The fair value of the reporting unit is treated as an acquisition-date fair value as if the reporting unit were being acquired in a business combination. Then this amount is allocated to all of the reporting unit’s iden­tifiable assets and liabilities with any remaining excess considered as the fair value of goodwill. This procedure is used only for assessing the fair value of goodwill. None of the other values allo­cated to assets and liabilities in the testing comparison are used to adjust their reported amounts.

Example—Accounting and Reporting for a Goodwill Impairment Loss:

To illustrate the procedure for recognizing goodwill impairment, assume that on January 1, 2009, Newcall Corporation was formed to consolidate the telecommunications operations of DSM, Inc., Rocketel Company, and Visiontalk Company in a deal valued at $2.9 billion. Each of the three for­mer firms is considered an operating segment, and each will be maintained as a subsidiary of Newcall.

Additionally, DSM comprises two divisions—DSM Wired and DSM Wireless—that along with Rocketel and Visiontalk are treated as independent reporting units for internal perfor­mance evaluation and management reviews. Following SFAS 141R, “Business Combinations,” Newcall recognized $221 million as goodwill at the merger date and allocated this entire/amount to its reporting units.

That information and each unit’s acquisition fair value were as follows:

In December 2009, Newcall tested each of its four reporting units for goodwill impairment. Accordingly, Newcall compared the fair value of its reporting units to its carrying value. The comparisons revealed that the fair value of each reporting unit exceeded its carrying value except for DSM Wireless, whose market value had fallen to $600 million, well below its cur­rent carrying value. The decline in value was attributed to a failure to realize expected cost-saving synergies with Rocketel.

As indicated by SFAS 142, Newcall then compared the implied fair value of the DSM Wire­less goodwill to its carrying value.

Newcall derived the implied fair value of goodwill through the following allocation of the fair value of DSM Wireless:

Thus, $151,000,000 is reported as a separate line item in the operating section of Newcall’s con­solidated income statement as a goodwill impairment loss. Additional disclosures are required describing- (1) the facts and circumstances leading to the impairment and (2) the method of determining the fair value of the associated reporting unit (e.g., market prices, comparable busi­ness, present value technique).

Although the amount reported for goodwill changes, the amounts for the other assets and liabilities of DSM Wireless do not change. The reported values for all of DSM Wireless’s remaining assets and liabilities continue to be based on amounts assigned at the business combination date.