New Rules for Business Combinations Intangibles and Goodwill Accounting
June 30, 2001—New accounting rules require that goodwill acquired after this date will no longer be subject to amortization. Companies will also cease amortizing goodwill acquired before June 30, 2001, upon adopting the new rules.
What a difference 30 years makes.
This summer, the Financial Accounting Standards Board (FASB) released two new Statements of Financial Accounting Standards (SFAS) dealing with valuing and accounting for businesses and their intangible assets. SFAS 141, Business Combinations, replaces Accounting Principles Board Opinion 16 of the same title (APB 16). SFAS 142, Goodwill and Other Intangible Assets, replaces Accounting Principles Board Opinion 17, Intangible Assets (APB 17). Both of these new standards will have an enormous impact on companies' financial statements and on how we read, interpret and set financial covenants on those statements.
The two standards are long and complex. This article will give the reader an overview of some of the more substantive changes required by SFAS 141 and SFAS 142.
Application to Reorganizations and Fresh-start Accounting
American Institute of Certified Public Accountants Statement of Position 90-7, Financial Reporting by Entities in Reorganization Under the Bankruptcy Code (SOP 90-7), required that so called "fresh-start" accounting applied to a qualifying company emerging from bankruptcy should be applied in conformity with the requirements of APB 16 and APB 17. With SFAS 141 and SFAS 142 superceding APB 16 and APB 17, the application of fresh-start accounting must conform to these new statements. One provision of SOP 90-7 specifically addressed in SFAS 142 relates to the rather bulky term, "reorganization value in excess of amounts allocable to identifiable assets." As specified in SFAS 142, "reorganization value in excess of amounts allocable to identifiable assets" will be captioned "goodwill" on the reorganized company's balance sheet.
SFAS 141, Business Combinations
In many respects, accounting for business combinations and acquisitions of minority interests following the rules specified in SFAS 141 will be no different than the accounting under APB 16. Where the rules differ, however, the differences are significant.
Perhaps the most significant of the changes is the elimination of "pooling." Recording a business combination under the pooling rules essentially entailed adding together the balance sheets of the acquiree and the acquiror at their historical cost bases. Under SFAS 141, the only acceptable method of accounting for a business combination is the purchase method. The purchase method sets the cost basis of the acquired enterprise at the more evident of the value of the consideration given or consideration received plus transaction costs.
More Guidance for Identifying the Acquirer, Intangibles, etc.
In an exchange of equity interests or in roll-up transactions, SFAS 141 still uses a judgmental determination for identifying the acquirer. Applying APB 16 usually resulted in treating the largest forming company or the entity with whose stockholders owned the larger portion of voting rights as the acquirer. SFAS 141 requires consideration of all facts and circumstances, not just the relative size of the combining companies or the survival of majority voting rights.
Under SFAS 141, the purchase price allocation to identifiable intangible assets is subject to a higher standard of identification. Under APB 16, if an asset could be identified and named, value could be assigned to it. Now, value will only be assigned to an intangible asset if the asset is obtained through a legal or contractual right or is separable from the entity's assets.
Negative Goodwill Eliminated
Under APB 16, if an entity was acquired for less than the value of its current assets, the remaining residual credit after writing the non-current assets down to zero was recorded on the balance sheet as "negative goodwill." Negative goodwill was amortized into income over a reasonable period of time. There have been a number of bankruptcy cases over the last 10 years where the reorganization value in comparison to the assets and liabilities of the reorganized entity has resulted in negative goodwill. Ames I (filed 1990) and Zales (filed 1992) are two such cases that come to mind. Under FSAS 141, once non-current assets (with a few exceptions) are reduced to zero, the remaining residual credit is recognized in income immediately as an extraordinary gain.
SFAS 142, Goodwill and Other Intangible Assets
Unlike the relationship between SFAS 141 and APB 16, SFAS 142 and APB 17 have very little in common. Perhaps the single consistent accounting treatment between the two statements relates to the accounting for internally generated intangible assets. Both APB 17 and SFAS 142 require companies to expense incurred costs related to internally generated intangible assets.
Amortization vs. Impairment
Goodwill has been amortized over periods not to exceed 40 years since Richard Nixon was in the White House (and Arthur Burns was chairman of the Fed.) The chosen period for amortizing the goodwill and the very presence of amortization expense in a company's income statement have been controversial ever since. Among other controversies, the Securities and Exchange Commission has regularly challenged registrants' use of the full 40-year amortization period, and company management and stock analysts have regularly complained that investors don't understand the profitability of companies because they don't understand goodwill amortization.
SFAS 142 replaces the concept that goodwill is a depleting asset that should be amortized with the recognition that some intangible assets, including goodwill, have indefinite useful lives and should not be amortized against income, but should instead be periodically tested for impairment. As a result, SFAS 142 replaces the requirement to amortize goodwill with specific guidance on annually evaluating goodwill for impairment.
Although the accounting model has long recognized the concept of asset impairment, APB 17 did not specifically articulate the requirement that goodwill, although subject to amortization, should also be evaluated for impairment. As a result of the lack of guidance in this area, the recognition of excess carrying value of goodwill is not often reported because the general standard against which to evaluate impairment was not specifically tied to value. As an example of the looseness in the rules under APB 16 and APB 17, one large construction-related company acquired another complementary operation a few years ago. At the time of the acquisition, the acquiror forecast that it would record approximately $45 million of goodwill on the purchase price of approximately $200 million. Within the one-year adjustment period following the acquisition, the acquiror discovered unrecorded contract losses that took the net identifiable assets acquired from approximately $155 million to approximately -$75 million. (The acquiror ended up purchasing no net assets; rather it assumed net liabilities of approximately $75 million.) The $230 million of contract loss accruals resulted in the acquiror recording total goodwill of approximately $275 million on the transaction. As the acquiror filed for bankruptcy approximately two years later, at least partly as a result of the acquisition, it continued to carry the amount of the acquisition goodwill, net of subsequent amortization, on its balance sheet. Under SFAS 142, the acquiror would likely have been required to charge off the excess goodwill that essentially represented a capitalization of contract losses.
Until SFAS 142, a one-step undiscounted cash flow test would have been performed at the acquired business level to assess the impairment of goodwill. Under SFAS 142, a two-step fair value impairment test at the reporting unit level is required at least annually and on an interim basis if conditions or events indicate that an interim evaluation is warranted. Under the new rules, the acquiror must allocate the goodwill from the acquisition to its appropriate reporting unit level. A company's reporting units are based on the company's organizational structure. The reporting unit to which the goodwill is assigned depends on how the acquired company is integrated into the acquiror. The first step of the goodwill impairment test compares the fair value of the reporting unit with its carrying value, including goodwill, on the company's financial statements. If the carrying value exceeds the fair value of the reporting unit, the second step, comparing the implied fair value of the reporting unit goodwill with the carrying amount of that goodwill, is performed. If the implied value of the reporting unit goodwill is less than the carrying value of that goodwill, impairment exists, and an impairment loss must be recognized as a charge against income. The charge should be presented as a separate line item before the subtotal "income from continuing operations" or similar caption, unless the impairment loss is associated with a discontinued operation.
More Guidance Related to Other Intangible Assets, Disposal of Businesses
SFAS 142 provides more guidance than APB17 related to accounting for the effect on goodwill of disposing of all or a portion of a business. Additionally, SFAS 142 specifically addresses other types of intangible assets that may have indefinite useful lives and the appropriate accounting for these assets.
SFAS 141 and SFAS 142 expand on the necessary disclosure related to business combinations and intangible assets, including goodwill. Particularly those disclosures required by SFAS 142 should expand the financial statement reader's understanding of the company's assessment of the value of its businesses and the circumstances and events that affect that assessment of value. Among the information a company must disclose are changes in goodwill-carrying amounts by reportable segment, the events and circumstances leading to any impairment, the amount of the impairment loss, the method used to determine the fair value of the associated reporting unit, and whether the loss recognized is based on an estimate rather than a full valuation and the reasons why.
Impact on Other Reporting
Concepts such as EBITDA must also be re-evaluated with the effective date of SFAS 142. A substantial portion of the "A" is being replaced by what is expected to be irregularly occurring charges against income for impairment losses. Being based on current fair value assessments, such charges do not have the same character as amortization expense. While management may seek to have such charges excluded from covenant calculations, lenders must re-evaluate the purpose of those covenants and determine whether such charges should be excludable from covenant reporting or whether such charges will serve as a leading indicator of emerging problems for the company.