A relatively new goodwill accounting rule got its first real test drive last year when the ripple effect from the 2008 recession hit company balance sheets. More than two-thirds (68%) of public companies in the United States recognized a goodwill impairment under the rule known as Topic 350 (formerly FAS 142), writing down an aggregate $260 billion, according to a report issued by financial advisory firm Duff & Phelps and the Financial Executives Research Foundation. The report examined nearly 6,000 publicly held companies.
Now, as 2009 results are filed, there is anecdotal evidence that goodwill write-downs have declined, says Greg Franceschi, who heads up the global financial reporting practice for Duff & Phelps. He notes that during the past 18 months there has been an increase in company values, so by default there are fewer goodwill write-offs.
Nevertheless, a new accounting wrinkle has surfaced related to goodwill impairments. At issue is whether companies should determine the fair value of a reporting unit — and thereby the value of the related goodwill — based on either the unit’s equity value or its enterprise value. (In general, enterprise value is the sum of the fair value of debt and equity.)
The question was sparked by a December speech given by Evan Sussholz, an accounting fellow in the Office of the Chief Accountant at the Securities and Exchange Commission. In his speech, Sussholz suggested that in certain situations, using an enterprise-value measurement may provide a more economically accurate picture of the reporting unit. His suggestion left preparers and auditors clamoring for a clarification, as companies have historically applied the equity-value approach to impairment testing, says PricewaterhouseCoopers partner Larry Dodyk.
In response, the Financial Accounting Standards Board and the American Institute of Certified Public Accountants have launched efforts to figure out whether additional guidance on the subject is needed. FASB’s emerging issues task force is slated to start discussing potential guidance during the second half of the year, while the AICPA is currently working on completing a practice aid, which is a sort of unofficial manual that discusses best practices and concepts that auditors and preparers may want to apply.
Topic 350 requires companies to perform a goodwill impairment test at least once a year to determine if the current value of an acquired reporting unit is worth more or less than its original price. The test is a two-step process in which the company must first compare the fair value of a reporting unit with its original price — the amount the company carries on its books. If the book value exceeds the fair value, then the asset is impaired and a second step is required to measure the amount of the impairment. If the book value is lower than the unit’s fair value, then the asset passes the test and nothing more is required.
The confusion over whether to use equity value or enterprise value stems from the seemingly straightforward first step of the test, because the accounting rule is unclear. Sussholz said that originally, the SEC didn’t believe the selection of one approach over the other would affect the test outcome. However, since taking a closer look at the practical implications, SEC staffers have acknowledged one unanticipated situation that is a potential problem: when the book value of a reporting unit measured at the equity level is negative.
Intuitively, it might seem that a negative book value would mean a reporting unit is on the verge of bankruptcy, but that may not be the case. Dodyk explains that a single reporting-unit company, for example, may have negative shareholders’ equity as a result of unrecognized assets (such as intangibles) that have significant value but don’t figure into the equity equation. Heavy borrowing for a leveraged buyout could also send shareholders’ equity into negative territory.
Consider what happens in an equity-value impairment test when a reporting unit’s book value is negative. By definition, the fair value of common equity cannot be less than zero, because the equity is essentially a call on the company’s operations. That means the fair value of a reporting unit measured at the equity level would always be greater than a negative book value, and therefore always pass step one of the impairment test. That would be the case even if significant goodwill exists and the underlying operations of the reporting unit “may be deteriorating,” asserted Sussholz.
On the other hand, says Franceschi, testing for impairment at the enterprise level would include the reporting unit’s debt burden, providing what Sussholz claimed was a more accurate picture of the company’s financial health. To be sure, his speech opened up the possibility that another testing approach may be permitted or required.
Franceschi doesn’t believe the additional guidance will cause a significant increase or decrease in goodwill write-offs. But it may require companies to rethink valuation models and approaches, especially if the guidance recommends that companies use more judgment when determining a reporting unit’s fair value. “For valuation issues, you can never have something that says, ‘This is the way to do it, and the only way to do it,'” he says. “There may be multiple approaches one needs to consider.”
Another concern with tinkering with Topic 350 is that it may spark other changes. “Once you open the rules to the goodwill impairment test, you never know where it is going to go,” says Dodyk.