FASB Listens. Really!

By Phillip J. Korb and Thomas E. Vermeer

In Brief

Compromises Driven by Public Comments

Why bother to respond to FASB requests for comments on exposure drafts? Many believe that FASB members have already determined the outcome when the board issues an exposure draft (ED). The authors contrast the September 1999 and February 2001 EDs on business combinations and goodwill accounting to illustrate that FASB will change the content of a proposal significantly on account of what it learns from comment letters. They believe that the differences between the two EDs are significant and are traceable to the opinions from the public expressed through the exposure process. The moral they draw from the analysis is: Make use of the opportunities to comment that are part of the FASB process.

On September 8, 1999, FASB issued an exposure draft (ED) of a proposed statement of financial accounting standard (SFAS), Business Combinations and Intangible Assets. The proposed statement would supersede Accounting Principles Board (APB) Opinion No. 16, “Business Combinations,” and APB Opinion No. 17, “Intangible Assets,” both issued in 1970.

This ED focused on accounting for goodwill and other purchased intangible assets, as well as fundamental issues related to the methods of accounting for business combinations. Its most controversial provision was the elimination of the pooling method for business combinations. FASB members unanimously concluded that the purchase method should be the only method used to account for business combinations because it records values exchanged in a business combination transaction. Not only does the pooling method ignore the exchange values, but it also forces financial statement users to bear the additional costs of comparing the financial statements of companies that have used the pooling method with those that have used the purchase method.

After the ED was issued, significant controversy developed around the elimination of the pooling method. Of the more than 200 comment letters, more than three-quarters addressed the elimination of the pooling method. There was strong disagreement from the high-tech and banking sectors; many respondents believed that the pooling method is critical to the continuation of merger and acquisition activity.

In addition to the business sector’s dislike of the ED, members of the House of Representatives also voiced their opinions of the pooling method. On October 3, 2000, Representative Christopher Cox introduced a bill that would have postponed the implementation of the ED. FASB Chair Edmund L. Jenkins spoke out against the potential legislation, saying, “The proposed bill would directly hamper the FASB’s independence by legislating the timing of the FASB’s proposed improvements.”

The September 1999 ED also contained provisions for accounting for goodwill and other purchased intangible assets. It proposed that goodwill should be amortized on a straight-line basis over its useful life, not to exceed 20 years. A review of goodwill impairment should be performed no later than two years after the acquisition date if certain factors indicate impairment. Goodwill amortization and impairment charges should be displayed on a net-of-tax basis as a separate line item within income from continuing operations. This line item would be preceded by a subtotal such as “income before goodwill charges.” The ED permitted a per-share amount in the income statement for goodwill charges and a per-share subtotal preceding that calculation.

The September 1999 ED proposed that reliably measurable intangible assets should be recognized separately as assets with a presumed useful economic life of 20 years or less, unless the intangible asset is expected to generate clearly identifiable cash flows for more than 20 years and the intangible asset is either exchangeable or its future economic benefits are controlled through contractual or legal rights that extend for more than 20 years. Identifiable intangible assets with indefinite lives and an observable market value would not be subject to amortization but would be reviewed for impairment annually on a fair value basis.

FASB Focus on Revisions

Although most of the mainstream press focused on the elimination of the pooling method, most of the revisions made by FASB occurred in the area of accounting for goodwill and other purchased intangible assets (see the Exhibit for a summary of revisions). In October 2000, FASB decided that an identifiable intangible asset should be separately recognized only if it is separable or if control over its future economic benefit is obtained through contractual or other legal rights. FASB also decided to eliminate the presumption that an identifiable intangible asset has a useful economic life of 20 years or less. Like all long-lived assets, these assets would also be reviewed for impairment under SFAS 121, Accounting for the Impairment of Long-Lived Assets. FASB further noted that an identifiable intangible asset with an indefinite useful life should not be amortized regardless of whether it has an observable market value.

On February 14, 2001, FASB issued a revised ED addressing business combinations and intangible assets. The revised ED primarily reassesses accounting for goodwill without significant changes to the treatment of other intangibles or pooling. In it, FASB tentatively decided that goodwill acquired in business combinations should not be amortized; rather, it should all be reviewed for impairment. Under the impairment-only approach, goodwill would be reviewed for impairment at the lowest reporting level that includes the acquired business. The process of determining whether goodwill has been impaired would involve the following steps:

At date of acquisition—

1) Determine the lowest reporting level that can be distinguished—physically, operationally, and for internal reporting purposes—from the other activities, operations, and assets of the entity. This reporting level should be lower than the reporting segment level described in SFAS 131, Disclosure about Segments of an Enterprise and Related Information.
2) Allocate the goodwill and all other assets and liabilities associated with an acquired business to one or more reporting units determined in the previous step.

At the end of the annual reporting period that follows the reporting period in which the acquisition occurred—

1) Determine the fair value of the reporting unit using the quoted market price of the reporting unit. If quoted market prices are not available, use the estimate of fair value based on valuation models that incorporate the five elements outlined in FASB Concepts Statement No. 7, “Using Cash Flow Information and Present Value in Accounting Measurements.” Option pricing models, matrix pricing models, and option-adjusted spread models are among the valuation techniques consistent with measuring fair value.
2) Determine the fair market value of the recognized net assets, excluding goodwill, using assumptions consistent with those used to determine the fair value of the reporting unit.
3) Determine the fair value of the goodwill by subtracting the fair market value of the recognized assets, excluding goodwill (step 2), from the fair value of the reporting unit (step 1).
4) Goodwill is impaired by the amount that the fair value of the goodwill (step 3) is less than its carrying value. The impairment loss should be presented as a separate line item in the operating section of the income statement unless a goodwill impairment loss is associated with a discontinued operation.
5) No impairment loss is recognized if the fair value of the goodwill is equal to or greater than its carrying value.

After the acquisition period, impairment reviews are only necessary when an event occurs which indicates that the goodwill of the reporting unit might be impaired. These events include a current-period operating or cash flow loss with a history of operating or cash flow losses, and a significant adverse change in one or more of the assumptions used in the most recent determination of the fair value of a reporting unit. These provisions would apply to goodwill arising from acquisitions completed after the issue date of a final statement and to the unamortized balance of goodwill at the date of adoption.

FASB has affirmed its commitment to eliminate the pooling of interest method. First, the board members unanimously concluded in the original ED that the pooling method should be eliminated. Second, on January 24, 2001, FASB reconfirmed the proposal that all business combinations should be accounted for using the purchase method. Third, with the pooling method being employed far less often outside of the United States, FASB demonstrated its commitment to the convergence of global accounting standards. Fourth, the Canadian Institute of Chartered Accountants’ Accounting Standards Board has also issued an ED that prohibits the use of the pooling method. The elimination of the pooling method in both countries would further the goal of convergence. Finally, the arguments in the comment letters for the retention of the pooling method were not conceptually convincing. The respondents’ primary argument was that the elimination of the pooling method would decrease the number of mergers. FASB believes that changes in standards should be primarily guided by the principle of maintaining and enhancing the integrity of financial information, not public policy.

FASB has softened the impact of eliminating pooling by requiring that purchased goodwill be reviewed for impairment rather than be amortized. The elimination of the 20-year maximum amortization period for identifiable intangible assets should also help. After numerous meetings with companies in a variety of industries regarding the goodwill impairment approach and the issuance of the revised ED on February 14, 2001, it appears that FASB is comfortable with this approach.

In the final statement, FASB will also address the dividing line between goodwill and other purchased intangible assets, illustrate examples of events that might give rise to a goodwill impairment review after the initial year, and describe the treatment of negative goodwill.

Despite FASB’s efforts to soften its blow, the new standard is not as attractive as the pooling method to companies concerned about recording a large charge to earnings after a business combination. The pooling method does not require that acquired tangible assets be recorded at fair value and does not require that goodwill from the acquisition be recorded on the books. Although the proposed standard does not require amortization of goodwill, it still requires the recognition of goodwill as an asset. The recognition of goodwill will decrease subsequent rate-of-return measures, because the denominator of these measures would be higher. Furthermore, if goodwill is impaired, subsequent earnings could be dramatically affected, because the numerator of these rate-of-return measures would be higher.

Because the amount of goodwill that is recorded from mergers and acquisitions could be very substantial, FASB will provide detailed guidelines regarding what types of items can qualify as identifiable intangible assets. Legal documents from mergers and acquisitions should be very clear and specific in order to ensure that items intended to qualify as identifiable intangible assets will meet the criteria of the new standard. Furthermore, although it may appear attractive to recognize as much of the purchase price as goodwill as possible because of the impairment-only approach, this strategy may negatively affect future years’ earning because a large amount recorded as goodwill increases the probability of an impairment loss in the future.

Companies should determine the lowest reporting level that can be distinguished from other activities, operations, and assets for goodwill recorded on the books from previous mergers and acquisitions. This step is necessary because the goodwill and intangible asset provisions of the new standard will also apply to the unamortized balance of goodwill and intangible assets at the date of issue of the new standard.

Companies should begin to develop and document the methods they will use to determine the fair value of reporting units. This information would likely have been developed when the merger or acquisition decision was made. This information will determine whether a company will need to record an impairment loss. Companies should not only perform this analysis for the current year but also anticipate whether an impairment loss could occur in future years.

Finally, when determining the impact of the proposed standard on the financial statements, companies should consider the impact of the goodwill impairment-only approach on deferred income taxes. IRC section 197 states that goodwill from acquisitions after October 10, 1993, should be amortized over a 15-year period. If an impairment loss is not recorded in the financial statements, the amortization of goodwill for income tax purposes will create a deferred income tax expense and a long-term deferred tax liability. These items could significantly impact financial ratios that are critical to how a company is evaluated by investors and other users of financial statements.

Trends in Standards Setting

There has been a notable increase in the probability that a final FASB pronouncement will be significantly different from the original ED. Whenever FASB issues an ED, many people focus on the impact of the ED rather than its merits. They fail to recognize that the official positions of the FASB are determined only after extensive due process and deliberations. Besides the significant changes to the business combinations ED noted above, there have been numerous other situations where a final pronouncement was significantly different from the original ED, indicating a developing trend.

For example, when FASB proposed that the fair value of stock options should be reflected in the income statement, many were concerned about the impact this would have on earnings. Numerous articles were published regarding the impact of this proposed statement on earnings and how it would affect U.S. companies’ ability to compete globally. The final pronouncement differed from the ED: It did not require that the fair value of stock options be recorded in the income statement, instead allowing the impact to be reflected in the notes to the financial statements.

In the case of accounting for deferred income taxes, public comments not only significantly changed the original ED but also resulted in the withdrawal of an official pronouncement. SFAS 96 was withdrawn before it was ever implemented, and eventually it was replaced by SFAS 109.

Companies and individuals interested in the standards setting process should remember that the final pronouncement is often very different from the original ED. If you are troubled by an ED, you can influence the result by becoming involved in the process and making your voice heard.