Goodwill impairment testing post-financial crisis: even with the financial crisis largely behind us, goodwill impairment continues to grab headlines. Here's an examination of the issues preparers should consider, given the FASB's updated guidance in ASU 2011-08 and regulatory concerns.
According to the 2012 Goodwill Impairment Study conducted and recently released by Financial Executives Research Foundation and Duff & Phelps, corporate America has impaired almost $330 billion in goodwill in the five years since the onset of the financial crisis (data from 2007 to 2011).
And despite a significantly lower and a relatively stable level of annual goodwill impairments since the peak year of the study, goodwill impairment remains significant ($188 billion in 2008, $26-$30 billion in each of 2009 through 2011, and some substantial impairments have been reported in 2012).
What is Goodwill and Do Investors Pay Attention on its Impairment?
Goodwill represents the premium paid by a buyer over the fair value of the net assets acquired in a transaction. Its impairment, then, is a reflection on management's ability (or inability) to appropriately price a transaction and/or to effectively integrate that business to realize the anticipated synergies. Not surprisingly, there are two opposing views.
In simplifying its guidance on goodwill impairment testing recently, the Financial Accounting Standards Board (FASB) acknowledged in paragraph BC 10 of Accounting Standards Update 2011-08 that "many users of both nonpublic entity and public entity financial statements generally exclude goodwill impairment losses from their quantitative analyses" and the revisions were designed with the expressed objective of reducing the costs and complexity associated with performing the annual impairment test.
That's a long way of saying that goodwill and the impairment of goodwill is a nonevent to financial statement users or investors.
The FERF/Duff & Phelps study, however, offers an alternative perspective. Data shows companies that recorded goodwill impairment charges to have underperformed the S&P 500 Index for the 12 months prior to and subsequent to the month in which the impairment is publicly announced. The study examined returns in four six-month intervals (two before and two after) where the median level of underperformance ranged from 0.8 percent to 4.9 percent.
Further, the level of underperformance is at its worst in the seven-to 12-month period leading up to the announcement and progressively improving to a 0.8 percent underperformance in the seven-to-12-month period subsequent to the announcement. The results suggest investors are aware of the issues that may lead to a subsequent impairment long before it is publicly disclosed, but that goodwill impairment is not entirely irrelevant to the market.
Regulators certainly believe information related to goodwill impairment is important to investors. Staff at the U.S. Securities and Exchange Commission's (SEC) Division of Corporation Finance is responsible for reviewing the periodic filings by registrants and routinely issue comment letters seeking additional information and clarifications. While each registrant represents a unique set of facts and circumstances, there are some common valuation issues that the SEC staff seeks to understand how they are addressed in the registrant's goodwill impairment test.
Three of those issues are listed below, as well as a discussion following on how best to dispose of each concern.
* The applicability/relevance of the registrant's quoted market price;
* In instances where multiple valuation techniques are relied upon, the appropriateness of the weights assigned to the resultant indicators of fair value; and
* The reasonableness of the discount rate as applied in any income approach analysis.
The Applicability/Relevance Of the Registrant's Quoted Market Price
The accounting guidance is clear in the requirement to maximize the use of observable inputs, whether as a percept of fair value under FASB Accounting Standards. Codification (ASC) Topic 820 or the more specific guidance on goodwill impairment testing in FASB ASC Subtopic 350-20. A company with publicly traded equity securities would then be expected to use the quoted market price in determining its fair value if that price is representative of the price that would be received to sell an asset or paid to transfer a liability (in this case, the reporting unit) in an orderly transaction between market participants at the measurement date.
So when registrants ignore market information and instead choose to rely on the indications of fair value derived from the application of other valuation methodologies (principally, the income and/or market approaches), the SEC staff is compelled to comment, particularly in the case of registrants with a single reporting unit. These single reporting unit companies will typically cite the presence of an inactive market as justification for not considering its own stock price in its goodwill impairment test.
Further probing by SEC staff, however, would often reveal that registrants give very little thought and analysis as to whether the transactions themselves were orderly or not orderly, as required by FASB ASC Topic 820. By providing less than satisfactory responses, registrants reinforce the skepticism of the SEC staff as to whether U.S. GAAP [generally accepted accounting principles] is being applied appropriately.
For the majority of companies that operate with multiple reporting units, SEC staff accepts that it may not be possible to rely on the quoted market price of the registrant's equity to determine the fair value of a particular reporting unit and that one or more valuation methodologies would need to be used to determine their fair values. The comments for this subset of registrants are thus focused on how the aggregate fair value of the entity's reporting units compares to its market capitalization.
Though not a requirement under U.S. GAAP, such a comparison is widely accepted as a best practice to assess the reasonableness of the concluded fair values of the reporting units. Here companies are faced with ensuring appropriate, sufficient evidence exists to justify the differences between the sum of the parts and the whole. That argument is typically rooted in the presence of a control premium, as the reconciliation normally results in an aggregate fair value of the reporting units that exceeds the market capitalization.
So what is a control premium and what must a company do to support the premium implied by its goodwill impairment test? FASB ASC 350-20-35-23 describes it as the "value in the ability to take advantage of synergies and other benefits that flow from control over another entity." It goes on to state that the "control premium may cause the fair value of a reporting unit to exceed its market capitalization."
Regardless of the techniques and data sources that companies and their valuation specialist choose to employ and analyze (and for which there are several) in support of the implied control premium, it is important to keep in perspective the expectations of the SEC as set forth in a 2008 speech by a staff member from the Office of the Chief Accountant. The salient points from his speech are as follows:
* The control premium needs to be premised on a reasonable and supportable basis;
* At a minimum, there should be an evaluation of control premium identifiable in comparable transactions or the cash flows associated with obtaining control of a reporting unit; and
* The amount of evidence supporting such judgment would likely be expected to increase as any control premium increases.
Failure to adequately address the points above is a recipe for a protracted comment and response process with SEC staff.
The Appropriateness of the Weights Assigned to Multiple Indicators of Fair Value
In the absence of fair value measurements categorized within Level 1 of the fair value hierarchy (i.e., the use of the quoted market price for its own stock), SEC staff is interested in how registrants weigh the indications of value derived from methodologies that produce fair value measurements categorized within Levels 2 and 3 of the fair value hierarchy.
Too frequently, SEC staff learns that registrants have applied an equal weighting to all indications of value, arguing there is no discernible difference between the different methodologies or have significantly changed the weights from one reporting period to another, seemingly to achieve a desired outcome.
It is especially important for registrants to be able to demonstrate to SEC staff that they have given thoughtful consideration as to the quality of the evidence on fair value. As such, a company may wish to evaluate:
* Its ability to meet financial projections;
* Trends in macro factors (economic, regulatory and industry) that could affect the level of (un) certainty in its operations;
* The degree of comparability of the peer companies to the reporting unit(s) included in the market approach; and
* Other pertinent factors that could influence the weightings assigned.
The Reasonableness of the Discount Rate as Applied in Any Income Approach Analysis
It is almost without exception that a registrant will apply the income approach in its goodwill impairment test. The income approach is a valuation technique that converts a reporting unit's expected future cash flows into its present value equivalent by discounting it at an appropriate rate of return. Though an SEC staff person may ask questions around the formulation of the projections for the reporting units, a vigorous challenge would be quite rare. Management is presumed to be in the best position to make those judgments based on its intimate knowledge of the operations.
So that leaves the SEC staff to focus on the discount rate and for a very good reason. It is the importance of matching the discount rate to the nature or characteristics of the cash flow projections.
When performing an income approach, one must be consistent in matching the basis of the projections to the technique applied. The discount rate adjustment technique requires a discount rate to be adjusted to capture the risks inherent in a set of conditional cash flows that represent a single, most likely case scenario.
On the other hand, the expected present value technique matches expected (or probability weighted) cash flows to an expected rate of return, which would not contain an incremental risk adjustment so as to avoid double counting the risks that are already reflected in the expected cash flows.
This nuanced aspect of the income approach can materially affect the conclusions of the goodwill impairment test. As if to validate the SEC staff's efforts in this area, the FERF/Duff & Phelps study reports that approximately 40 percent of companies were not properly matching the basis of projections to the technique applied.
The objective here was to highlight the issues that should be top of mind when performing a company's goodwill impairment test. There are two efforts currently underway that should be helpful to companies in a number of these areas: The Appraisal Foundation is assembling a monograph on market participation acquisition premiums and the American Institute of Certified Public Accountants is preparing a comprehensive guide on goodwill impairment testing.
Grasping those issues early on can minimize audit risks and regulatory scrutiny, which can lead to better communication with investors and stakeholders-constituents with whom having "goodwill" is always valuable.
This month's feature article is the required-reading for FERFPros Sidestepping the Goodwill 'Two-Step.'What It Means for You [segment #1 of FMN-December 2012]
Greg Franceschi is a managing director at Duff & Phelps who is co-chair of the AICPA's Impairment Task Force and Jouky Chang, a managing director at Duff & Phelps, is a former SEC Accounting Fellow
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|Title Annotation:||Valuation; Financial Accounting Standards Board; Accounting Standards. Codification|
|Author:||Franceschi, Greg; Chang, Jouky|
|Date:||Dec 1, 2012|
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