SFAS Nos. 141 and 142 Implications for Goodwill Acquired by M&A
SFAS No. 141 and 142 affect all financial statements (i.e., balance sheet, income statement and cash-flow statement) of a corporation involved in an M&A transaction. Companies exiting bankruptcy protection and preparing fresh-start accounting financial statements in compliance with American Institute of Certified Public Accountants (AICPA) Statement of Position (SOP) 90-7 have to comply with these two FASB statements. Also, valuation analysts often rely on these GAAP business financial statements as a starting point in the valuation of the corporate entity in the bankruptcy state. This reliance upon financial statements is relevant for the valuation of collateral claims, the credit analysis of DIP financing, the assessment of proposed plans of reorganization, the preparation of “fresh-start accounting” (SOP 90-7) financial statements and many other reasons. However, many valuation analysts who perform bankruptcy analyses are not sufficiently familiar with the valuation and accounting implications of SFAS Nos. 141 and 142. Therefore, this discussion summarizes the provisions of SFAS Nos. 141 and 142. In particular, this discussion focuses on the financial accounting and valuation issues related to goodwill acquired in an M&A transaction. This discussion also presents a simplified goodwill valuation example within the context of SFAS Nos. 141 and 142.
Three Components of Goodwill
In the valuation of a collective bundle of operating assets, appraisers generally consider three components of business goodwill. Analysts typically consider these three components in the context of either (1) the factors that create business goodwill or (2) the reasons why goodwill exists within certain businesses.
The first goodwill component is the existence of operating business assets in place and ready to use. This goodwill component is sometimes referred to as going-concern value. The fact that all elements of the company are physically and functionally assembled creates intangible value. These elements of the company may include (1) capital (e.g., equipment), (2) labor (e.g., employees) and (3) coordination (e.g., management). Some of the going-concern value may enhance the value of the individual company assets. For example, the value of the company business equipment is typically greater when the equipment is appraised on a value in continued use (or going-concern) basis as compared to a value in exchange (or piecemeal, liquidation) basis. Some of the going-concern value may also attach to any discrete intangible assets. For example, the value of a patent, copyright or trademark is typically greater when that intellectual property is appraised on a value in continued use (going-concern) basis as compared to a value in exchange (or piecemeal, liquidation) basis. Finally, some of the going-concern value may inure to the company goodwill.
The second goodwill component is the existence of excess economic income. Excess income is the level of income generated by company operations that is greater than the amount that is considered a fair rate of return on all of the tangible assets and discrete intangible assets. This excess economic income component relates to the concept of goodwill as the value of the business enterprise that cannot be separately assigned to any of the tangible assets or identified intangible assets.
The third goodwill component is the expectation of future events that are not directly related to the current operations of the subject business. For example, goodwill may be created by investors’ expectations of future capital expenditures, future mergers and acquisitions, future products or services, and future customers or clients. This future expectations component exemplifies the concept of goodwill as the current value of future assets (tangible or intangible) that do not yet exist as of the valuation date. Investors (and owners) assign a goodwill value to a business if they expect that the net present value of the income associated with future events is positive. Of course, the positive net present value of the expected future income associated with assets currently in place (e.g., capital assets, product lines, customers) are appropriately assigned to the respective tangible and intangible assets.
Accounting Interpretation of Goodwill
Under GAAP, the goodwill that a company develops in the normal course of business operations is rarely recorded on the company financial statements. This accounting recognition of internally created goodwill is different than the accounting recognition for purchased goodwill. Purchased goodwill is recorded on the acquirer’s balance sheet as soon as the purchase transaction is completed. There are a few instances when internally created goodwill is recorded on a company’s financial statements, such as under the push-down accounting rules related to corporate reorganization. But the instances in which a company’s internally developed goodwill (as opposed to its purchased goodwill) is recognized for accounting purposes are rare.
In accounting, there is a broad definition for intangible value in the nature of goodwill. This accounting interpretation of goodwill is the residual value that is calculated by subtracting the fair market value of all the tangible assets and identified intangible assets from the total acquisition purchase price. Often, this accounting definition of goodwill quantifies all of the intangible value of the acquired company. This is the case when the purchased intangible assets are not separately identified and appraised. Therefore, this accounting broad definition of intangible value in the nature of goodwill often captures the total intangible value of the acquired business (with little consideration to the individual intangible assets).
Economic Interpretation of Goodwill
In economics, the interpretation of intangible value in the nature of goodwill is less broad than in accounting. As a result, the economic interpretation of goodwill may be more useful to analysts interested in the valuation of the specific goodwill intangible asset—as opposed to the valuation of the company total intangible value.
Typically, the economist first quantifies all of the economic income of the subject business. Second, the economist allocates (or assigns) some portion of the business income to each asset category (both tangible and intangible) that contribute to that income. These individual asset categories typically include (1) net working capital, (2) tangible personal property, (3) real estate and (4) identified intangible assets and intellectual properties (e.g., patents, trademarks, copyrights, contracts, licenses, etc.). Third, the economist quantifies the portion of the business income that cannot be associated with any specific tangible or intangible asset. That residual economic income is often called “excess income” or “excess earnings.” This excess income is then assigned to the taxpayer company goodwill. The economic value of goodwill equals the business enterprise value (BEV) less the values of each of the identified tangible and intangible assets.
Goodwill and Financial Accounting Purchase Price Allocations
Effective for business combinations completed after June 30, 2001, SFAS 141 provides for consistent financial accounting for all business combinations and presents guidelines to identify and value all tangible and intangible assets of an acquired company. SFAS No. 141 paragraphs 9 and 10 define which M&A transactions are considered business combinations:
9. For purposes of applying this Statement, a business combination occurs when an entity acquires net assets that constitute a business or acquires equity interests of one or more other entities and obtains control over that entity or entities. This Statement does not address transactions in which control is obtained through means other than an acquisition of net assets or equity interests. For purposes of this Statement, the formation of a joint venture is not a business combination.
10. This Statement applies to combinations involving either incorporated or unincorporated entities. The provisions of this Statement apply equally to a business combination in which (a) one or more entities are merged or become subsidiaries, (b) one entity transfers net assets or its owners transfer their equity interest to another, or (c) all entities transfer net assets or the owners of those entities transfer their equity interests to a newly formed entity (some of which are referred to as roll-up or put-together transactions). All those transactions are business combinations regardless of whether the form of consideration given is cash, other assets, a business or a subsidiary of the entity, debt, common or preferred shares or other equity interests, or a combination of those forms and regardless of whether the former owners of one of the combining entities as a group retain or receive a majority of the voting rights of the combined entity. An exchange of a business for a business also is a business combination.1
Companies that complete a business combination after June 30, 2001, are required to comply with the SFAS No. 141 provisions to allocate the purchase price to the acquired assets (both tangible and intangible) and to the assumed liabilities. Accordingly, this purchase-price allocation involves a separate valuation of each individual class of acquired asset and liability.
Intangible assets are defined in SFAS No. 141 paragraph 39 as follows:
An intangible asset shall be recognized as an asset apart from goodwill if it arises from contractual or other legal rights (regardless of whether those rights are transferable or separable from the acquired entity or from other rights and obligations). If an intangible asset does not arise from contractual or other legal rights, it shall be recognized as an asset apart from goodwill only if it is separable—that is, it is capable of being separated or divided from the acquired entity and sold, transferred, licensed, rented or exchanged (regardless of whether there is an intent to do so). For purposes of this Statement, however, an intangible asset that cannot be sold, transferred, licensed, rented or exchanged individually is considered separable if it can be sold, transferred, licensed, rented or exchanged in combination with a related contract, asset or liability. For purposes of this Statement, an assembled workforce shall not be recognized as an intangible asset apart from goodwill. Appendix A provides additional guidance relating to the recognition of acquired intangible assets apart from goodwill, including an illustrative list of intangible assets that meet the recognition criteria in this paragraph.2
Effect of SFAS No. 141 on Financial Accounting
The excess of the total transaction purchase price over the sum of all identified tangible assets and intangible assets is goodwill. Included in goodwill are acquired intangible assets that do not meet the SFAS No. 141, paragraph 39 asset-recognition criteria.
When the total transaction purchase price is less than the value of the identified tangible and intangible assets, there is negative goodwill. However, negative goodwill is not recorded on the company’s balance sheet. Rather, the values of other acquired assets are reduced until the sum of the values of the acquired assets equals the transaction purchase price. Negative goodwill is first allocated to the acquired intangible assets. If there is still negative goodwill, then the values of the tangible assets are reduced until all negative goodwill is eliminated.
SFAS No. 141 states that independent appraisals and actuarial or other valuations may be used to measure the fair values of the acquired assets and assumed liabilities in a business combination. SFAS No. 141 requires that numerous disclosures be made in the financial statements footnotes, including:
1. description of the business combination
2. a list of intangible assets acquired
3. the amount allocated to goodwill.
The footnote disclosure requirements subsequent to the purchase transaction are described in SFAS No. 142.
How Purchased Goodwill Is Valued
In an acquisition purchase-price allocation, goodwill value is based on the residual-from-purchase-price method, which measures goodwill by subtracting the value of the financial assets, tangible assets and identifiable intangible assets from the transaction purchase price. Accordingly, the purchased goodwill value is calculated as:
Total transaction purchase price
Less: Fair value of financial assets
Less: Fair value of tangible assets
Less: Fair value of identified intan-gible assets
Equals: Fair value of purchased good-will
Exhibit 1 presents a simplified example of the valuation of goodwill acquired in the Alpha Corporation business combination.
SFAS No. 142 and Purchased Goodwill
In a reorganized business operation, intangible value in the nature of goodwill may comprise a significant portion of the company’s asset value. Prior to SFAS No. 142, purchased goodwill was amortized in equal installments over a period not to exceed 40 years. This meant that periodic goodwill amortization reduced (1) the amount of purchased goodwill recorded on the acquirer balance sheet and (2) the acquirer-reported annual net income.
SFAS No. 142 does not assume that purchased goodwill is a wasting asset. In addition, SFAS No. 142 does not provide for the annual amortization of purchased goodwill. Instead, purchased goodwill is tested for impairment annually. Only the decrease in the purchased goodwill value is recognized as an expense on the company financial statements. When there is no impairment in the purchased goodwill value, there is no impact on the company financial statements. As a result, the periodic recognition of goodwill expense may be more volatile, but it will be more consistent with actual changes in the value of the purchased goodwill. Though purchased goodwill is expensed over time based on these periodic impairments, SFAS No. 142 does not allow for the recognition of increases in purchased goodwill value.
What Is the Appropriate Standard of Value for SFAS No. 142?
The appropriate standard of value for SFAS No. 142 purposes is fair value. This standard of value is generally recognized to represent a marketable, controlling ownership interest level of value. As defined in SFAS No. 142 paragraph 23, fair value is “the amount at which the asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced sale or liquidation.”3 This standard of value is generally consistent with the fair-market-value standard of value.
What Is a Reporting Unit?
SFAS No. 142 requires that acquirers periodically test for goodwill impairment at the “reporting unit” level. A reporting unit may or may not be equal to the total corporation. A reporting unit is an operating segment that operates on a stand-alone basis.
A reporting unit is defined in SFAS No. 142 paragraph 30 as follows:
A reporting unit is an operating segment or one level below an operating segment (referred to as a component). A component of an operating segment is a reporting unit if the component constitutes a business for which discrete financial information is available and segment management regularly reviews the operating results of that component. However, two or more components of an operating segment shall be aggregated and deemed a single reporting unit if the components have similar economic characteristics. An operating segment shall be deemed to be a reporting unit if all of its components are similar, if none of its components is a reporting unit or if it comprises only a single component. The relevant provisions of Statement 131 and related interpretive literature shall be used to determine the reporting units of an entity.4
A reporting unit is often the target entity in the business combination. The concept of the reporting unit is intended (1) to separately identify the different layers of goodwill within the corporation and (2) to distinguish between the different layers of goodwill purchased in various M&A transactions.
The best evidence of fair value for publicly traded companies is the current market price of the company. However, the market price of an individual security may not be a reliable indication of fair value for a reporting unit. This is because the reporting unit may only be one part of a larger business enterprise. Accordingly, independent appraisals are often necessary to determine (1) whether goodwill impairment has occurred and (2) the amount of the goodwill impairment.
Financial Accounting Effect of SFAS No. 142
SFAS No. 142 requires financial statement disclosures of (1) the company’s investment in goodwill and (2) the subsequent financial performance of the acquired intangible assets. The total carrying amount of purchased goodwill, as well as the carrying amount of each intangible asset class not subject to amortization, is disclosed in each year that there is no impairment.
The disclosure requirements are more detailed when an intangible asset impairment loss is recognized. The following financial statement disclosures are required when there is goodwill impairment:
• a description of the facts and circumstances that resulted in the goodwill
• the amount of the impairment loss and the method for measuring fair value of the appropriate reporting unit (e.g., the quoted stock market price or the business valuation approach used)
• if the goodwill impairment is an estimate that is not final, the reason for the estimate; in subsequent periods, the nature and amount of any significant adjustments made to the initial estimate of the goodwill impairment.
How Goodwill Is Valued for SFAS No. 142
SFAS No. 142 provides specific guidance related to the ongoing valuation of purchased goodwill. Goodwill recorded on the balance sheet is tested for impairment at least annually in a two-step process. In the first step, recorded good-will is tested for potential impairment. The second step determines how the impairment amount should be allocated to the acquirer’s assets. The second step is only necessary if goodwill impairment is indicated in step one.
The first step in the impairment test is to determine whether the fair value of the company equity (on a marketable, controlling-ownership-interest basis) exceeds the recorded amount of the company’s equity. If the fair value of the reporting-unit equity exceeds the book value of the reporting-unit equity, then no goodwill impairment exists. Any generally accepted business valuation approach can be used to measure the fair value of the reporting unit equity. The applicable business valuation approaches are based on the specific facts and circumstances of each goodwill impairment analysis.
SFAS No. 142 does not assume that purchased goodwill is a wasting asset... Instead, purchased goodwill is tested for impairment annually.
If goodwill impairment exists, the recorded goodwill is written off (or expensed) in an amount equal to the impairment. If goodwill impairment exceeds the reported amount of the purchased goodwill, the impairment is allocated to the company’s other assets until the total impairment is recognized. In this impairment allocation procedure, less-liquid assets are generally written off first. Accordingly, the intangible assets are written off (or expensed) before the tangible assets or financial assets.
Exhibits 2, 3 and 4 illustrate the two-step test for goodwill impairment under two scenarios. In Exhibit 2, Beta Company recognizes no goodwill impairment. In Exhibits 3 and 4, Gamma Company recognizes goodwill impairment.
Summary and Conclusion
Valuation analysts often rely on financial statements as the starting point in the appraisal of a company operating under bankruptcy protection. For companies that complete an M&A transaction after June 30, 2001 (or that implement fresh start accounting under SOP 90-7), these financial statements are subject to the accounting and the valuation implications of SFAS Nos. 141 and 142. For companies that reported purchased intangible assets prior to June 30, 2001, these financial statements are also subject to the accounting and valuation implications of SFAS No. 142.
Accordingly, analysts who perform valuations of the operating assets or equities of companies included in the bankruptcy estate should be familiar with the accounting and valuation requirements of SFAS Nos. 141 and 142. This is particularly true for analysts who perform SOP 90-7 “fresh-start accounting” valuations of companies that are exiting bankruptcy protection.
1 “Statement of Financial Accounting Standards No. 141: Business Combinations”
(Norwalk, Conn.: Financial Accounting Standards Board of the Financial Accounting
Foundation, June 2001), pp. 3-4.
2 Ibid., p. 12.
3 “Statement of Financial Accounting Standards No. 142: Goodwill and Other Intangible Assets” (Norwalk, Conn.: Financial Accounting Standards Board of the Financial Accounting Foundation, June 2001), p. 8.
4 Ibid. p. 11.