s of June 30, 2001, FASB changed the rules for the mergers and acquisitions game. Companies no longer may use the pooling-of-interests accounting method for business combinations. Nor will they account for mergers on their financial statements under the traditional purchase method, which required them to amortize goodwill assets over a specific time period. Instead purchased goodwill will remain on the balance sheet as an asset subject to impairment reviews. FASB’s new standards, Statement no. 141, Accounting for Business Combinations, and Statement no. 142, Accounting for Goodwill and Intangible Assets, are a radical change, and now management accountants, auditors and financial executives must understand and work with a very different accounting process.
Some believe FASB eliminated amortization to make purchase accounting techniques more appealing to corporate America. Traditional purchase accounting required companies to amortize “purchased” goodwill on a periodic basis, for as long as 40 years. Now companies will be able to make acquisitions without being forced to take large periodic earnings write-downs, which some corporate executives view as an unnecessary drag on earnings.
“The elimination of pooling is one of the most significant and drastic modifications in accounting methodology in many years,” says CPA Norman N. Strauss, national director of accounting standards at Ernst & Young, LLP, and a member of FASB’s emerging issues task force. “Business combinations are important, and so is how they are treated in financial statements. Analysts will have to understand the impact of the two new FASB standards, and companies and their auditors will have to learn how to implement them.”
The changes in accounting methodology are, indeed, momentous, but what impact will these standards have on future deals? CPA James Bean, director of accounting policy at Golden State Bank in San Francisco, discussed the new standards with managers at other commercial banks and thrifts and says the implementation of Statement no. 141 will not have a significant effect on the pace of mergers and acquisitions in the financial industry. “There were relatively few mergers in the past that could be justified only if they were treated on a pooling-of-interests basis,” says Bean. “Most bankers and M&A specialists have been planning for the inevitability of this standard for the last few years. Companies knew there was a time limit on doing a business combination based on the pooling-of-interests method.”
The knowledge that pooling was coming to an end did not make companies rush to merge. Bean says there were two reasons why the pace of mergers slowed dramatically. “First, despite current myths, the ability to utilize the pooling method did not drive the business justification for a merger. Second, the economic downturn in the last half of 2000 and the first half of 2001 had an affect on such strategic business decisions.”
Some companies, of course, routinely handle significant amounts of goodwill on their books. “Wells Fargo, the largest West Coast bank, pioneered the concept of ‘earnings per share before amortization of goodwill’ in its earnings releases,” Bean says. “Other banks followed this lead. As a result, most banking analysts have been deducting the amount of goodwill amortization to arrive at a bank’s core earnings.”
Bean’s company has already begun meeting with its auditors to resolve how to comply with goodwill impairment testing Statement no. 142 now requires. One of the primary issues of discussion is determining the reporting unit level on which goodwill is to be tested. Next in importance for the bank’s financial statement preparers is deciding what specific methodology to use to calculate the fair value of the reporting unit—will it be derived from an independent third party valuation, an earnings model, a multiple of book value, or some other model?
Goodwill is the difference between what a company paid for an acquisition and the book value of the net assets of the acquired company. Until now, analysts, creditors and shareholders found it difficult to know precisely how much goodwill a company had on its balance sheet because companies called it different things and often lumped it together with other identifiable intangible assets. With the new standards, FASB mandates a purchase accounting method for business combinations that requires companies to conduct an annual goodwill impairment test based on the fair value of the reporting unit. Since companies can apply only the purchase method, they must recognize goodwill as an asset on financial statements and present it as a separate line item on the balance sheet. However, the goodwill asset will not be amortized.
CPA Patricia McConnell, senior managing director at Bear, Stearns & Company, Inc., and head of its accounting and taxation equity research group, believes impairment testing of goodwill will provide more transparency. “If properly applied and enforced it will give users of financial statements more insight than the current system of arbitrary amortization, which tells little or nothing,” McConnell says. “A goodwill impairment charge may be an important signal of a decline in a business for reasons not obvious to financial statement users.”
The final standards differ greatly from what FASB originally proposed in its 1999 ED, which offered a hybrid purchase accounting method and allowed amortization of goodwill over its economic life, not to exceed 20 years (see “Everyone Out of the Pool,” JofA, May00, page 49 ). “Once FASB decided amortization had to go, it wanted to establish the best possible accounting method for business combinations,” notes Strauss.
The relevance of purchase accounting is demonstrated as follows: Assume that a company purchases a building for $1 million that the seller carried on its books at a depreciated cost of $100,000. Proponents of the purchase method argue that the building should be capitalized for $1 million. However, if the building were the entire asset base of a company acquired in a pooling, the same building would, in fact, be recorded at $100,000.
WILL MARKETS REACT?
Throughout the process to develop and finalize the standards, one of the major problems companies had with FASB’s decision to eliminate goodwill amortization post merger was concern over the inevitable market reaction to identified earnings losses. Companies generally do not want a goodwill write-off to distort income and cause a negative earnings hit. Did analysts pay attention to goodwill amortization in their company evaluations in the past? “We have found many equity research analysts, particularly those covering industrial companies, continue to look at reported earnings per share; thus, acquisitions that could dilute earnings per share often were scrapped even if there was a strong strategic rationale for the deal,” says Lawrence Hamdan, the managing director and co-head, industrial mergers and acquisitions, at Credit Suisse First Boston Corp. He believes future acquisitions that could have qualified for pooling will look less attractive from an earnings per share standpoint because of the increased depreciation of the written-up assets.
“Some companies are concerned about taking a large impairment charge if an acquisition does not turn out as expected. Although this is a risk, the market is likely to already sense an acquirer has overpaid for a business even before such a write-off is recorded,” notes Hamdan. So what impact will the new FASB standards have on future deals? Hamdan feels the new rules should prove a marginal positive for acquisitions. “Strategic rationale and the CEO’s confidence will still remain the decisive factors in M&A activity,” he says.
Pooling transactions sometimes allowed companies to hide the purchase price of the acquired business while the purchase method did not. Some empirical evidence suggests companies paid a premium to pool to avoid goodwill amortization. However, the economics of the business combination are the same regardless which accounting treatment companies applied. If the markets in fact valued pooling companies higher, that worked to the advantage of such businesses at the expense of the companies that applied purchase accounting. FASB considered that outcome detrimental to the purchase accounting businesses and, more important, to the capital markets as a whole. (The FASB project summary, standards and exposure drafts are available at www.fasb.org . CPAs can obtain additional information on the standards from the AICPA’s CPE course supplement to “Accounting and Auditing—Recent Developments.”)
WHEN IS GOODWILL IMPAIRED?
Under Statement no.142, companies will test for goodwill impairment using a two-step approach.
Step 1: Financial statement preparers will compare the fair value of the reporting unit to its carrying amount, including goodwill. If the reporting unit’s fair value is greater than its carrying amount, goodwill is not impaired and the company doesn’t have to do anything else. Impairment occurs when the implied fair value (meaning the fair value of the goodwill asset is implied by the fair value of the reporting unit as a whole) of a reporting unit’s goodwill is less than its recorded value. In this case, the second step follows.
Step 2: Financial statement preparers will compare the fair value of goodwill to its carrying amount. If the fair value is less than its carrying amount, goodwill is considered impaired and the company must recognize a loss on the balance sheet.
The implied fair value is the amount by which the fair value of the reporting unit exceeds that of its identifiable net assets; implied fair value is determined by subtracting the value of the recognized net assets (excluding goodwill) from the reporting unit’s fair value (see “New Rules Illustrated,” below). Statement no. 141 defines a reporting unit as an operating segment or one level below it (see also Statement no. 131, Disclosures about Segments of an Enterprise and Related Information ). A reporting unit is the level at which management reviews and assesses the operating segment’s performance—in other words, units that can be discrete business lines or grouped by geography and can produce stand-alone financial statements (for example, four operating divisions reporting to the corporate parent). A company can use a reporting unit one level below the operating segment for impairment testing if components of an operating segment engage in business activities for which discrete financial information is available, have economic characteristics different from the other components of the operating segments and are at the level at which goodwill benefits are realized. (Nonpublic companies that do not report segment information in accordance with Statement no. 131 must test for goodwill impairment at the reporting unit level.)
To illustrate, consider an insurance company that has three principal lines of business and presents them in financial statements: life insurance, homeowners insurance and automobile insurance. The company splits the segments into eastern and western regions (one level below the operating segments). It recently purchased another entity that underwrote homeowners insurance in New York State. Thus, conceptually, the eastern region of the homeowners insurance segment of the business stands to profit from the acquisition. Accordingly, the company would assess the goodwill at the level of the eastern region of the homeowners insurance segment.
FAIR VALUE MEASUREMENTS
Businesses don’t like the reporting unit requirement because of the difficulty they have determining the fair value of the segment. Many finance managers believe that the current price at which their company stock trades does not reflect its fair value. Instead, the stock is either undervalued or occasionally overvalued. Thus, the current stock price may not be a perfect proxy for the value of their company. However, for accounting purposes, stock price represents an ideal estimate for fair value because it is objective and verifiable; people don’t have to make assumptions. For conducting an impairment test, CPAs will welcome using stock price as a measure of fair value. When the reporting unit is the company as a whole, the current stock price will represent the company’s fair value.
In the insurance company example noted above, the stock value of the entire company is available in the financial press. However, what is the value of the eastern region homeowners insurance business? Companies will use valuation models such as the discounted cash flow model or the residual income model to find out. Fair value measurements can be difficult and costly and CFOs may need to hire valuation experts to perform them.
Companies are not required to perform the annual impairment test at the close of the fiscal year, but they must perform the initial step of the impairment test within the first six months after the beginning of their fiscal year. Additionally, they can perform the fair value measurement for each reporting unit at any time as long as they use one measurement date consistently from year to year. Companies may choose different measurement dates for various reporting units. The standard also provides for interim testing of goodwill impairment between annual tests when circumstances might reduce the fair value of the reporting unit below its carrying value. Examples are a market decline, regulatory action, new competition or a loss of key personnel. Financial statement preparers will do the following for interim testing:
Identify the reporting units affected by the acquisition and recognition of goodwill.
Identify the goodwill and other net assets associated with the reporting unit as well as the model and key assumptions to be used to measure the fair value of that reporting unit.
Refrain from recalculating the fair value of the reporting unit each year if its components have not changed since the previous fair value calculation, the previous fair value amount was substantially greater than the unit carrying amount and no evidence exists that the current fair value of the reporting unit may be less than the current carrying amount.
Finally, interim testing will be necessary when a company expects to sell or dispose of a reporting unit or a significant portion of one. A significant asset group in the reporting unit is tested for recoverability under Statement no. 121, Accounting for the Impairment of Long-lived Assets and for Long-lived Assets to be Disposed of. (Statements no. 141 and 142 rescind prior FASB guidance, APB Opinion no. 16, Business Combinations, and APB Opinion no. 17, Intangible Assets. )
Companies will not have to test existing goodwill for impairment immediately on adoption unless an indicator of impairment, such as a significant market decline in equity, exists. However, they must conduct a benchmark goodwill assessment within six months of adoption for all significant prior acquisitions, which will be the first determination of current goodwill value. Because companies must conduct goodwill impairment tests annually, the standard does not require them to benchmark assessments after an acquisition or internal reorganization that changes their reporting structure. But to perform the next annual impairment test of a reporting unit created or modified by an acquisition or reorganization, financial statement preparers must identify goodwill and other net assets associated with the reporting unit, including the model and key assumptions used to measure the unit’s fair value.
Companies will report pro forma income before extraordinary items and pro forma net income until they report goodwill in all periods shown on financial statements under the new regulations. The pro forma amounts will exclude amortization of goodwill and companies can report them either on the face of the income statement or in the notes to the financial statements. The company should provide a reconciliation of reported earnings to pro forma earnings in the notes, and should also report pro forma earnings per share either on the face of the income statement or in the notes.
To those who argued companies should retain the option to amortize goodwill, CPA Mike Mathieson, former vice-president and controller of Fortune Brands, Inc., says it is not useful to have alternative accounting methods to record goodwill. “The accounting model should be consistent for all companies and reflect current circumstances,” he says. “If the goodwill is decreasing in value, the impairment test should reflect that. Also, a good impairment test promotes transparency because the trigger is a change in underlying economic or business conditions, not an arbitrary time period. As a result, the reporting will be based on current events affecting the business.”
Another reason not to amortize goodwill, according to FASB, is that it is not a wasting asset. Mathieson and McConnell disagree on whether it is, but both favor impairment testing. “If properly managed, goodwill is an appreciating asset, and if not, the impairment test will recognize the reduction in value,” Mathieson says. McConnell believes goodwill is a wasting asset because it has a definite life. “However, it does not decline in value over a straight line for an observable period,” she says. “Its value will be stable or increase for long periods, then an event or series of events will cause it to decline. That’s why I believe capitalization with no amortization, but with a rigorous impairment test, will provide more transparent and useful information.”
How will a company assess the impact of a potential acquisition on its balance sheet in light of the new FASB standards? When company auditors asked CPA Arthur V. Neis, vice-president, treasurer and CFO of Life Care Services LLC, a privately held company in Des Moines, Iowa, whether it was wise to proceed with a potential acquisition, he focused on the projected cash flows and returns to the shareholders, concluding that the company should make the acquisition regardless of the impact on financial statements. “Any acquisition must be based upon both sound strategy and economics,” says Neis. “Fundamental economics expressed as current and projected cash flows, and long-term strategic plans, are far more important than financial reporting of the noncash, goodwill amortization as a reduction of net income.” Where cash flow is the primary measure of a company’s value, it may or may not depend upon a large, hard asset base. Neis adds, “Recognition in the balance sheet of the value of intangible assets and service commitments/future value is tainted because of the use of the term ‘goodwill,’ which implies the buyer overpaid, or gave money away without getting value in return.”
The new rules have important implications for financial reporting. Combining companies will no longer worry about structuring a deal to comply with pooling requirements. In many instances, companies and auditors may struggle to value existing goodwill. Analysts no longer will need to factor in accounting differences between companies that applied purchase rather than pooling accounting to past acquisitions. But analysts will face the challenge of recognizing when the goodwill asset is wasting and being replaced by internally generated goodwill compared to instances in which value remains related to past business acquisitions.
Just because it’s difficult to measure an intangible asset doesn’t mean it can’t be done. As companies undertake their future business combinations subject to the new requirements, auditors, finance professionals, regulators, analysts and investors will judge the difficulty and effect of implementing a very different accounting methodology.