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Transaction structures matter in goodwill impairment testing: corporate finance departments need to consider hypothetical transaction structures for each reporting unit early in the process, since they can affect whether goodwill is impaired and the extent to which it is.

Goodwill impairment has become an all too common phenomenon recently, as one in five S&P 500 companies recorded an impairment charge during calendar year 2009, according to data from Capital IQ, a quantitative analysis and research provider. Accounting Standards Codification 350 (ASC 350, formerly Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets), states that companies are required to test for possible goodwill impairment at the reporting unit level at least annually, following a two-step process.

Step 1 is used to identify potential impairment and Step 2 measures the amount, if any, of the impairment charge. During the past year, ASC 350-20-35 (formerly "EITF Issue No. 02-13, Deferred Income Tax Considerations in Applying the Goodwill Impairment Test in FASB Statement No. 142"), emerged as an important and sometimes critical consideration in the goodwill impairment testing process.

As a result, corporate finance departments found themselves immersed in discussions of hypothetical transaction structures, deferred taxes and "step-ups" in asset values, For many companies, consideration of ASC 350-20-35 will impact whether goodwill is impaired and the extent of any impairment.

Goodwill impairment tests are performed either as part of the annual requirement under ASC 350 or upon the occurrence of what is known as a "triggering event"--a change in circumstances for the reporting unit that could create a situation where the fair value of the unit is below its carrying value.

For example, triggering events can result from adverse regulatory decisions or a sudden drop in revenue. In 2008 and 2009, many companies experienced triggering events merely as a result of the broad stock market decline and equity valuations dropping with the decline of the global economy.

The Process

The goodwill impairment testing process begins by identifying whether a possible impairment exists. This is accomplished by comparing the fair value of the net assets of a reporting unit to the carrying value of its net assets. Note that the accounting standards are not clear as to the definition of "net assets," and an AICPA Impairment Task Force is currently discussing the issue of whether Step 1 should be performed on an equity or enterprise value basis.

To determine the fair value of the net assets of the reporting unit, traditional income or market-based valuation methods are utilized, depending on the specific facts and circumstances of the entity being valued. Typically, these valuation methods include discounted cash flow analysis, comparable company or transaction approaches or some weighting of these approaches.

Once fair value is estimated, it is then compared to the carrying value of the reporting unit. For public companies with multiple reporting units, a reconciliation of the aggregate fair value of all reporting units to the overall capitalization of the company is performed in order to assess the reasonableness of the fair value estimates. If the carrying value of the net assets of a reporting unit exceeds fair value, its goodwill is potentially impaired and Step 2 is required.

In estimating the fair value of the reporting unit, per ASC 350-20-35, one also needs to consider the impact of the transaction structure. For instance, would a sale of the reporting unit be structured as a taxable sale transaction (or asset deal) or a nontaxable transaction (or stock deal)?

To determine the appropriate transaction structure, ASC 350-20-35 lays out three criteria:

1. Whether market participants would structure a hypothetical transaction as a taxable or a nontaxable transaction;

2. The feasibility of a taxable or nontaxable transaction; and

3. The type of structure that yields the highest economic value to the seller after adjusting for tax implications.

In practice, if the first two criteria do not provide a conclusive determination, the transaction structure that yields the highest post-tax proceeds (highest economic value) is the assumed transaction structure, consistent with the premise of "highest and best use." For example, in certain industries where buyers are reluctant to take over the environmental liabilities of the seller, almost all transactions are structured as taxable transactions so the seller retains all such liabilities.

In such instances, even though a nontaxable transaction may yield the highest net proceeds to the seller, the fair value of the reporting unit is estimated assuming a taxable transaction structure because market participants would not likely structure a deal any other way.

In practice, management evaluates a likely transaction structure for the hypothetical sale of a reporting unit by considering current facts and circumstances, including:

* The structure of the Reporting Unit: Is it a legal entity with saleable equity or an operating division with intercompany accounts?

* The form of the transaction in which the stock or assets were initially acquired. If the original transaction was nontaxable, there is a rebuttable presumption that the hypothetical sale would also be nontaxable.

If the assets of a unit were originally acquired in a taxable transaction or in separate transactions where some were taxable and some were nontaxable, the rebuttable presumption is that the hypothetical transaction would be taxable, as the assumptions reflecting a taxable transaction generally yield a higher enterprise value.

* Whether a taxable transaction structure would actually result in a step-up or step-down in tax basis. For instance, if there is a step-down in the tax basis of the assets a potential buyer may optimize taxes by structuring the transaction as a stock transaction.

Based on the result of this evaluation, ASC 350-20-35 requires that the estimated fair value of the reporting unit under Step 1 reflect the specifics of a hypothetical asset or stock deal as appropriate. In an asset deal, the price paid becomes the taxable basis of the assets acquired. In most cases, the fair value of the assets acquired is in excess of their current carrying value.

For example, an internally developed trade name will typically have a carrying value of zero, but when acquired, its value is then stepped-up to its estimated fair value. For tax reporting the acquirer typically amortizes acquired intangible assets, including residual goodwill, over the appropriate statutory period. In the United States, most intangible assets purchased as part of a business are amortized for tax purposes over a 15-year period.

The amortization expense creates a tax shield for the acquirer, enhancing the cash flow and value of the reporting unit. In a stock deal, the acquirer assumes the current tax attributes of the acquired entity. As such, the acquirer is not able to step-up the values of the acquired assets for tax purposes, and the amortization expense follows the pre-acquisition tax schedule. For this reason, the value of the unit under an asset sale is generally higher than under a stock sale due to the ability to realize a larger amortization tax shield.

Hence, a question that often arises is, "To avoid impairment, shouldn't we always want to support the presumption of an asset sale?" After all, increasing fair value increases the chance of exceeding the entity's carrying value, possibly eliminating the need for Step 2.

The answer is "no," for two reasons. First, consistent with ASC 350-20-35, the appropriate transaction structure is to be determined based on the criteria outlined above and is not a matter of preference. Second, while an asset sale typically results in higher value of the net assets of the reporting unit, it may not result in the highest after-tax proceeds. As illustrated in Table 1 (above left), in certain instances, the highest after-tax proceeds are realized in a stock sale, even if fair value is higher under an asset sale.
Table 1

                                  Asset Sale  Stock Sale

Fair Value of Reporting Unit [A]   $ 120,000   $ 102,000

Tax Basis [B]                       $ 25,000    $ 75,000

Taxable Gain/Loss [A-B]             $ 95,000    $ 27,000

Tax [C] (1)                         $ 36,100    $ 10,260

After-tax Proceeds [A-C]            $ 83,900    $ 91,740

(1) Assumed a tax rate of 38%

After fair value is determined considering the appropriate transaction structure, the Step 1 test is performed by comparing fair value of the reporting unit to the carrying value of net assets of the reporting unit (per ASC 350-20-35, deferred income taxed are included in the carrying value of the net assets of the reporting units, regardless of the transaction structure.).

If fair value exceeds the carrying value, there is no impairment and the testing is complete. However, if the carrying value exceeds the fair value, then Step 2 is required.

Step 2 of the goodwill impairment test is used to estimate the residual goodwill. As noted in ASC 350, goodwill cannot be measured directly, as it is a residual amount estimated by deducting the fair values of the acquired assets from the fair value of the reporting unit, after business combination accounting adjustments.

Therefore, in order to determine the fair value of goodwill, management must determine the fair value of all acquired assets and assumed liabilities, including assets and liabilities that were not recognized on the balance sheet.

As such, Step 2 is essentially a business combination exercise based on the hypothetical purchase price from Step 1. To ensure consistency in the assumptions across Step 1 and Step 2, the hypothetical business combination assumes the same transaction structure as used to estimate the fair value of the reporting unit in Step 1.

Estimating Fair Value

As in typical business combination accounting, the fair values of tangible and intangible assets are estimated. The fair value of the identifiable net assets is deducted from the consideration (or fair value of the reporting unit used in goodwill impairment test), and any excess after accounting adjustments (e.g. deferred taxes) reflects the implied fair value of goodwill.

Management then compares the implied fair value of goodwill to its carrying amount. An impairment loss is measured as the excess of the carrying amount of goodwill over its implied fair value.

The diagram in Chart 1 on page 57 reflects the business combination accounting under an asset sale transaction structure.
Chart 1--Business Combination Accounting Under an Asset Sale
Transaction Structure

Fair Value of Tangible Assets    Long and Short Tern Operating

Fair Value of Intangible Assets  Fair Value of Reporting Unit

Implied Goodwill

As discussed earlier, for a stock sale the acquirer assumes the tax attributes of the acquired entity. Therefore, for tax reporting there is no step-up in the taxable basis of the assets. However, for financial reporting consistent with ASC 805, the assets are recorded at fair value typically resulting in a step-up in the assets.

This book and tax difference results in a difference between book and tax depreciation and amortization over time. This, in turn, creates a deferred tax liability, which reflects the "consequences attributable to taxable temporary differences." (Note: definition of deferred tax liability from Master Glossary of FASB Accounting Standards Codification.) This deferred tax liability increases the hypothetical consideration and, correspondingly, the implied fair value of goodwill as an accounting adjustment, potentially reducing the amount of the impairment charge.

The diagram in Chart 2 on the left, reflects business combination accounting under a stock sale transaction structure, specifically highlighting the deferred tax liability. However, there may be other accounting adjustments.
Chart 2--Business Combination Accounting Under a Stock Sale Transaction

Fair Value of Tangible Assets    Long and Short Term Liabilities

Fair Value of Intangible Assets  Fair Value of Reporting Unit
                                 ("Purchase Price")

Implied Goodwill                 Deferred Tax Liability

In certain instances, a portion of the carrying amount of a reporting unit's goodwill may have been created due to a deferred tax liability recorded at the time of an acquisition. To the extent that the hypothetical transaction would create a new deferred tax liability, this can continue to shield the goodwill from impairment.

However, if the hypothetical transaction involving the reporting unit would not result in a deferred tax liability, this is no longer available to shield goodwill from impairment.

Companies need to carefully consider the hypothetical transaction structure for each reporting unit early in the goodwill impairment testing process, as the transaction structure may, in certain instances, impact whether goodwill is impaired and the extent to which it is impaired.

MICHAEL LYNCH ( is a managing director and Shital Gandhi ( is a director, both with Duff & Phelps in Boston. Duff & Phelps is a global independent provider of financial advisory and investment banking services that delivers advice principally in the areas of valuation, transactions, financial restructuring, dispute and taxation.
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Title Annotation:ACCOUNTING
Author:Lynch, Michael; Gandhi, Shital
Publication:Financial Executive
Geographic Code:1USA
Date:Sep 1, 2010
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