Earlier this month, the Financial Accounting Standards Board proposed two critical changes to the way companies test for impairment of goodwill. Specifically, the board adopted the so-called equity premise to standardize the determination of the carrying amount of a reporting unit. In addition, FASB proposed that when a reporting unit’s carrying amount is zero or a negative amount, the second step of the impairment test must be performed when it is more likely than not that a goodwill impairment exists.
The two changes, issued on October 6 as part of an accounting standards update on Topic 350, are a departure from current practices. As a result, FASB is giving constituents until November 5 to comment on the exposure draft before releasing a final rule. To evaluate the proposal, it is useful to consider the existing rules.
For financial accounting purposes, the intangible asset known as goodwill is not amortized under U.S. generally accepted accounting principles. Instead, goodwill — the amount paid for an acquisition that exceeds its fair value — should be tested for “impairment” at a level of reporting referred to as a reporting unit.
Impairment exists when the carrying amount of goodwill exceeds its implied fair value. As a result, a two-step impairment test is used to identify potential impairment and measure the amount of impairment loss. In essence, the FASB proposal changes the manner in which the impairment test is applied.1
The first step of the proposed impairment test compares the fair value of a reporting unit with its carrying amount. The rules note that the carrying amount of a reporting unit is calculated as the difference between the total assets and total liabilities assigned to the unit. This approach, for which FASB has expressed its preference, is known as “the equity premise.” It says that if the carrying amount of a reporting unit is greater than zero, and its fair value exceeds its carrying amount, goodwill of the unit is not impaired. The proposal also states that in determining the carrying amount, deferred income taxes are included in the carrying amount of the reporting unit.
Then, if the carrying amount of a reporting unit exceeds its fair value, the second step of the impairment test is performed. Moreover, if the carrying amount of a reporting unit is zero or negative, the second step of the impairment test is performed to measure the amount of impairment loss, if any, when it is more likely than not that a goodwill impairment exists.
In considering whether it is more likely than not, a company must evaluate whether there are “adverse qualitative factors.” Apparently, some companies with zero or negative carrying amounts had concluded that Step 1 of the impairment test is automatically satisfied, and therefore Step 2 need not be performed. The proposed ASU dispels this notion.
As before, goodwill of a reporting unit must be tested for impairment on an annual basis, and between annual tests in certain circumstances; for instance, if a change in circumstances would more likely than not reduce the fair value of reporting unit below its carrying amount. In addition, goodwill of a reporting unit with a zero or negative carrying amount must also be tested of it is more likely than not that a goodwill impairment exists. Examples of such events or circumstances include:
- A significant adverse change in legal factors or in the business climate;
- An adverse action or assessment by a regulator;
- Unanticipated competition;
- Loss of key personnel; and
- A more likely than not expectation that a reporting unit, or substantial portion thereof, will be sold or otherwise disposed of.
For public companies, the amendments in the proposed rule would be effective for fiscal years and interim periods within those years, beginning after December 15, 2010. Early adoption would not be permitted. For nonpublic companies, the effective date would be delayed, vis a vis public entities, for one year.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.
1 See Proposed ASU, How the Carrying Amount of a Reporting Unit Should Be Calculated When Performing Step 1 of the Goodwill Impairment Test, October 6, 2010.