Impairment Test Offers Clearer Picture of Goodwill.

In July, the Financial Accounting Standards Board completed its 5-year project on business combinations and intangible assets with the issuance of two separate statements, FASB Statement No. 141, Business Combinations, and FASB Statement No. 142, Goodwill and Other Intangible Assets.

One of the fundamental changes made by Statement 142 is the accounting for goodwill subsequent to an acquisition. As a result of Statement 142, all existing and newly acquired goodwill will no longer be amortized but will be tested for impairment annually and written down only when impaired.

TESTING GOODWILL

Before understanding how the impairment test works, one must first understand that goodwill is not to be tested on an acquisition-by-acquisition basis or at the enterprise level, as it is tested in current practice. Rather, goodwill is to be tested in the aggregate, at a reporting level, referred to as the reporting unit.

The reasoning behind the change is that most of the assets and liabilities of an acquisition, including goodwill, become so integrated with the acquiring company that they are indistinguishable from the company's other assets and liabilities. Thus, goodwill is no longer only associated with the net assets it was acquired with, rather it is associated with a larger part of the acquired company, known as the reporting unit.

THE REPORTING UNIT

A reporting unit is an operating segment or one level below an operating segment (as that term is used in FASB Statement No. 131, Disclosures about Segments of an Enterprise and Related Information). Existing goodwill and newly acquired goodwill must be assigned to a reporting unit along with other assets and liabilities.

THE FAIR VALUE OF GOODWILL

In general terms, impairment is defined as the condition that exists when the carrying amount of an asset exceeds its fair value. However, because goodwill cannot be sold by itself and does not produce its own cash flows, determining the fair value of goodwill for impairment purposes created a challenge for FASB.

Goodwill is what makes the company as a whole worth more than the sum of its individual parts and is initially measured as a residual. That is, it is the difference between the fair value of the acquired company (the amount paid for the company) and the amounts assigned to the acquired company's assets and liabilities during the purchase price allocation process. In developing the impairment test, FASB concluded that a method similar to the purchase price allocation process could be used to measure the value of goodwill subsequent to its acquisition. That subsequent measure is referred to as the implied fair value of goodwill.

THE WHOLE OF ITS PARTS

To determine the implied fair value of goodwill, the fair value of a reporting unit, which is the amount at which the unit as a whole could be bought or sold, is measured first. If available, quoted market prices in active markets are the best evidence of fair value and should be used in most cases. Otherwise, the fair value of a reporting unit could be measured using prices of comparable businesses or valuation techniques, such as the present-value technique.

The fair value of a reporting unit is treated as if it were the purchase price of an acquired business and is allocated to the assets and liabilities of the reporting unit (whether recognized or unrecognized), similar to the way the purchase price of an acquired business is allocated to the acquired net assets. The excess fair value over the amount allocated to the assets and liabilities of a reporting unit is the implied fair value of goodwill.

THE IMPAIRMENT TEST

Once FASB had a method to estimate the implied fair value of goodwill, a two-step impairment test was implemented. The first step of the impairment test acts as a screen to identify a potential impairment so that the implied fair value of goodwill only need be estimated when a potential impairment exists.

The first step of the goodwill impairment test is a comparison of the fair value of a reporting unit with its carrying amount. If the fair value of a reporting unit exceeds its carrying amount, goodwill is not considered impaired. If the carrying amount of a reporting unit exceeds its fair value, the second step of the impairment test is performed to measure the amount of the impairment loss, if any.

The second step of the impairment test is a comparison of the implied fair value of a reporting unit's goodwill with the carrying amount of that goodwill. If the carrying amount exceeds the implied fair value, an impairment loss must be recognized in the amount of that excess.

The goodwill impairment test must be performed annually. However, a detailed determination of the fair value of a reporting unit may be carried forward from one year to the next if certain criteria are met. In addition, the goodwill impairment test must be performed between annual tests if certain events occur indicating that goodwill may be impaired.

Statement 142 is effective for fiscal years beginning after Dec. 15, 2001, so calendar-year companies will adopt the statement Jan. 1, 2002. Early adoption is permitted for companies with fiscal years beginning after March 15, 2001, if their first quarter financial statements have not been issued. If goodwill is acquired between July 1, 2001, and the date a company adopts the statement in its entirety, that goodwill should not be amortized. The goodwill impairment provisions do not apply until adoption of the entire statement.

FASB acknowledges that there are costs associated with the new goodwill impairment test but believes the benefits of writing down goodwill when impaired instead of on an arbitrary, systematic basis exceed those costs. FASB also believes that investors will be provided with greater transparency regarding the economic value of goodwill and the amount and timing of its impact on earnings.

Stephanie Harper is the postgraduate technical assistant for the Financial Accounting Standards Board.