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Goodwill: hunting for consistency one step at a time.

In the following, Duff & Phelps managing director Greg Franceschi provides new developments in goodwill accounting since FERF and Duff & Phelps conducted their 2010 Goodwill Impairment Study.

Goodwill impairment testing, in particular Step 1, has long been a source of debate between those who think U.S. GAAP calls for an equity level test and others who believe the enterprise premise provides a more substantive economic perspective.

Goodwill is tested for impairment at the reporting-unit level based on a two-step test stipulated in Topic 350: Intangibles-Goodwill and Other. The first step compares the carrying amount of the reporting unit--including goodwill, with its fair value. Current guidance refers to the reporting unit's carrying amount as "net assets," interpreted by some as allowing the test to be performed at either an enterprise level or at the equity level.

In the FERF research study authored by Duff & Phelps, FEI members were asked whether their Step 1 goodwill impairment test was performed by comparing the fair value of the equity or enterprise value to their carrying amounts. Fifty-eight percent of the respondents indicated that enterprise value was used.

This diversity in practice led the Emerging Issues Task Force (EITF) to consider addressing the matter as part of Issue No. 10-A, How the Carrying Amount of a Reporting Unit Should Be Calculated When Performing Step 1 of the Goodwill Impairment Test.

At first EITF considered stipulating an equity level test. However, at its November 2010 meeting, it decided to not be prescriptive, so that both an enterprise and equity premise would be acceptable.

It is practical to have the flexibility of choosing the level of the Step 1 test based on the facts and circumstances. Ultimately, the goodwill impairment test measures the operating performance of the assets in the business, net of operating liabilities.


Companies use a variety of corporate structures with varying amounts and types of debt at the reporting-unit level. An equity-level test requires an estimate of the fair value of debt for each reporting unit, increasing the scope and cost of the impairment analysis, and introduces another step that could be prone to diversity in practice (i.e., fair value of debt in the public market versus the M&A market).

On the other hand, with an enterprise-level test, a fair value of debt analysis would be limited to Step 1 in a market capitalization reconciliation for publicly-traded entities, when one is also utilizing a discounted cash flow analysis, or to derive an enterprise value for a publicly-traded single reporting unit entity.

EITF also addressed the treatment of reporting units with a zero or negative carrying amount in Step 1. A widespread sentiment in the valuation industry is that a reporting unit with a zero or negative carrying amount should not get a "free pass" in Step 1 because of certain accounting interpretations. The final consensus reached at the EITF's November meeting would have such reporting units examined in light of various qualitative factors, and if the indication is that it is more likely than not that a goodwill impairment exists, Step 2 of the goodwill impairment test should be performed.

In Step 2, Topic 350 requires that the implied fair value of goodwill be estimated by subtracting the fair value of the identifiable net assets from the fair value of the reporting unit, and compared to the carrying amount of goodwill.

This may result in certain unintended consequences. Reporting units with a zero or negative carrying amount may be forced to perform a Step 2 test and potentially impair goodwill due to unrecorded intangible assets. Yet, reporting units that have passed Step 1 by only a narrow margin may be able to avoid impairment. A more equitable solution to this issue might have required reporting units with a zero or negative carrying amount to perform an enterprise level test in Step 1 as appropriate, rather than being required to directly consider a Step 2.

This approach is also consistent with allowing flexibility in Step 1 of all impairment tests to apply either an enterprise or equity premise.

One often-overlooked aspect of the goodwill impairment test, and not within the scope of the EITF project, is the treatment of entity-specific synergies related to a prior acquisition. Such synergies were excluded from the initial fair value measurement of the recognized assets in the purchase price allocation but were captured in the residual goodwill calculation.

In subsequent impairment tests, however, these synergies may no longer be considered entity-specific and in fact may be considered a component of fair value to the extent they become "embedded" in the asset group.

To address other application issues and disseminate best practices related to goodwill impairment, an AICPA task force is currently developing a practice aid on goodwill and other asset impairment.

Greg Franceschi is a managing director in the Silicon Valley office of Duff & Phelps in Palo Alto, Calif., where he heads the financial reporting valuation practice. He can be reached at 650.798.5570.
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Title Annotation:Research Forum
Author:Franceschi, Greg
Publication:Financial Executive
Geographic Code:1USA
Date:Jan 1, 2011
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