Goodwill impairment: Two steps back, three steps forward

Any public or private company with goodwill on its balance sheet will be affected if new goodwill impairment guidelines proposed by FASB on April 22, 2011 are enacted. Accounting Standards Update: Intangibles, Goodwill and Other (ASC 350): Testing Goodwill for Impairment would change, among other things, the first step in the two-step goodwill impairment test. Read on to learn how the proposal would impact valuation processes related to goodwill impairment testing. Background Goodwill impairment occurs when the carrying amount of goodwill on the books exceeds its implied fair value. Since goodwill can’t be measured directly, the implied fair value of it must be backed into. Under ASC 350, testing for goodwill impairment is a two-step process that is required to be performed at least on an annual basis, but also in an interim period if there are indications that goodwill is impaired: Step 1: Determine whether the fair value of a reporting unit is less than its carrying amount. If it is, then Step 2 is required. Step 2: Determine the implied fair value of goodwill by assigning the fair value of the reporting unit determined previously in Step 1 to the assets and liabilities of the reporting unit,   and compare that amount with the carrying amount of goodwill to determine the extent of any impairment. Under existing rules, indications that goodwill might be impaired include, but are not limited to, the following (ASC 350-20-35-30):

• A significant adverse change in legal factors or in the business climate
• An adverse action or assessment by a regulator
• Unanticipated competition
• Loss of key personnel
• A more-likely-than-not expectation that a reporting unit, or substantial portion thereof, will be sold or otherwise disposed of

How These Factors Are Being Amended Under the proposed ASU, public and private companies have an option to perform a “Step 0” qualitative assessment. The objective of the qualitative assessment is to determine whether it is more likely than not (generally understood to be more than a 50% chance) that the fair value of the reporting unit is less than its carrying amount. If it is less, companies would go to Step 1. If, however, it’s more likely than not that the fair value of the unit is more than its carrying amount, Step 1 would not be performed. The qualitative assessment is optional in any period for any reporting unit. For example, in a given period, a company may prefer to support its test with a quantitative analysis. Said another way, companies may switch between electing the option and not electing it in any reporting period for any unit and for any reason: it is an option. At first glance, it may seem advantageous to be able to perform a qualitative assessment in order to decide whether Step 1 applies. In fact, simplification was one thing the FASB had in mind in drafting the proposed rule. Keep in mind, however, that companies will need to carefully support their more-likely-than-not assertions regarding fair value if Step 0 is used to forego Step 1. This support will take the form of documentation that reflects the following new qualitative assessment factors:

1. Macroeconomic conditions (i.e., deterioration in general economic conditions, limitations on accessing capital, fluctuations in foreign exchange rates, or other developments in equity and credit markets)
2. Industry and market considerations (i.e., deterioration in the environment in which an entity operates, an increased competitive environment, a decline (both absolute and relative to its peers) in market-dependent multiples or metrics, a change in the market for an entity’s products or services, or a regulatory or political development)
3. Increases in raw materials, labor, or other costs that have a negative effect on earnings
4. Overall financial performance, such as negative or declining cash flows or a decline in actual or planned revenue or earnings
5. Other relevant entity-specific events, such as changes in management, key personnel, strategy or customers; contemplation of bankruptcy, or litigation
6. Events affecting a reporting unit, such as a change in the carrying amount of its net assets, a more-likely-than-not expectation of selling or disposing all or a portion of a reporting unit, the testing for recoverability of a significant asset group within a reporting unit, or recognition of a goodwill impairment loss in the financial statements of a subsidiary that is a component of a reporting unit
7. If applicable, a sustained decrease (both absolute and relative to its peers) in share price.

These are just examples. The magnitude of each factor in relation to the unit should be considered. As companies consider positive and mitigating circumstances, it should be kept in mind that these do not provide a presumption, rebuttable or otherwise, that the company shouldn’t perform Step 1. The Step 0 qualitative assessment factors described above will amend the existing impairment indicators listed above under ASC 350-20-35-30. Under current rules (ASC 350-20-25-29), companies may carry forward reporting unit fair value calculations from one year to the following year if certain conditions are met. The idea behind the carry forward option is to provide some level of relief from having to perform an annual calculation. Most companies, however, don’t use it. The proposed rule removes the carry forward option. Companies in the process of using this option would need to perform a Step 0 or Step 1 test under the proposed rule. Effective Date The rule would be effective for fiscal years beginning after December 15, 2011. Early adoption would be permitted. Comments are due by June 6, 2011. IFRS IFRS does not have a corresponding proposal, so the proposed rule diverges the two GAAPs. Under IAS 36, companies are required to test for goodwill impairment at least annually using a quantitative test. The test compares the fair value of the unit to its carrying amount. Any excess carrying amount over fair value is recorded as an impairment loss. Pluris can assist you in assessing the impact of the proposed change on your organization and help you determine and support whether it is more likely than not that the carrying amount of a reporting unit being tested for goodwill is greater than its fair value. Pluris can also assist you in performing a full