Add unscheduled goodwill impairment testing to the long list of tasks CFOs have to complete amid the credit crunch.
As the recession drives stock prices down, the value of intangible assets will sink with them, likely triggering a goodwill impairment test under U.S. accounting rules, posits Greg Franceschi, managing director and global leader of the financial reporting valuation group at Duff & Phelps.
Under the accounting rule known as FAS 142, companies are required to perform an annual goodwill impairment test regardless of whether there is a triggering event. However, if an event somehow depresses the value of goodwill assets, companies are required to reexamine the asset value before their annual test.
The current liquidity crisis, and the related tumbling of stock prices, is sure to be a triggering event, forcing companies to test earlier and more frequently, asserts Franceschi. “Where there is smoke, there is fire,” reckons Franceschi, who says plummeting stock prices is one indicator that goodwill testing is necessary.
Goodwill is an intangible asset acquired in a merger, and is usually defined as the excess amount, above book value, that one company pays for another in an acquisition. The goodwill premium often is attributed to a strong brand name or a company’s reputation for being a good place to work, for example. Goodwill becomes permanently impaired, and therefore requires a company to reduce the value of the asset, when the value posted on the balance sheet is higher than what the asset is really worth in the marketplace.
But Franceschi emphasizes that being forced to test whether intangible assets have lost their market value does not necessarily mean a write-down is imminent, although it could lead to that. Indeed, a company may have paid $3 million for a business five years ago, boosted its value to $5 million as of last year, and seen the value decrease to $3.5 million this year. That drop may trigger an impairment test, but it does not trigger a write-down because the asset is still worth $500,000 more than the company paid for it in 2003, maintains Franceschi.
But he points out that the testing process itself is onerous and can be thorny, as it includes running several valuation models, examining and reworking internal forecasts, gathering and digesting analysts’ price targets, reviewing historical pricing, and crunching industry data. Yet as the economy and stock prices sag, the addition testing seems unavoidable.
A goodwill write-down is required when the impairment is deemed permanent — or not “recoverable within a reasonable amount of time,” explains Franceschi. In accounting terms, if the stock price stays below carrying value for 60 days it generally means a triggering event. “We are in that kind of situation now, in which many companies are experiencing depressed pricing for longer than 60 days, and not seeing much volatility on the upside,” says the Duff & Phelps executive.
He also points out that along with sinking stock prices, a significant revision of an internal forecast — which in some industries is happening every quarter — can also trigger an impairment test because it may indicate waning company value. “Certainly for the foreseeable future, we will see continual demand for interim impairment testing because there won’t be a significant upswing in general pricing for many companies,” contends Franceschi.
Companies with a fiscal year that begins after December 15, 2008, will have to conduct their testing in accordance with the new fair-value rules. Specifically, the business-combination rule, FAS 141(R), provides new measurement dates for calculating assets and liabilities obtained in an acquisition and provides guidance on when and how to estimate contingent assets and liabilities of a target company that is involved in lawsuits. In addition, FAS 157, which went into effect at the beginning of the year, requires companies to measure assets and liabilities using a three-level, risk-based hierarchy that prescribes what types of inputs should be used to arrive at the answer.
There will be a wide variety of companies, in terms of size and industry, that will be forced to test for goodwill impairment this coming year, concludes Franceschi, noting that “no industry is immune to declines in market value.”