Goodwill Convergence

By Robert N. Waxman

In Brief

New Stance in an Old Debate

Accounting for goodwill in the U.S. took a significant step in a new direction with the adoption of SFAS 142 in July 2001. After revising previous exposure drafts to reflect the lessons of 14 field visits and hundreds of comment letters, FASB decided to treat goodwill as a nonwasting asset that would periodically be tested for impairment. Goodwill has generated debate for decades, and standards setters in other nations and at the IASB have addressed how to account for purchased goodwill. The author compares and contrasts the new U.S. standard with standards from the United Kingdom and the IASB and speculates about the potential for convergence of these standards in the near future. In a future article, Waxman will analyze in depth the implications of SFAS 141 and 142 on accounting for goodwill and other intangibles.

International harmonization of accounting standards began as an initiative to promote a common financial reporting framework and facilitate cross-border financings. Now, the convergence of national accounting standards within a global framework, coupled with their consistent application, is the goal. Convergence—the act of moving toward union or conformity—has become an important part of the agendas of accounting standards setters in the United States and abroad.

The U.K.’s Accounting Standards Board (ASB) recently sponsored a publication (The Convergence Handbook) in response to the European Commission’s proposal that consolidated accounts of listed companies should comply with International Accounting Standards (IAS) by 2005. The Handbook details the differences between ASB and IAS requirements as a point of departure for the ASB to either adopt the IAS standards or to persuade the IASB to conform to ASB standards.

Although FASB is committed to global convergence, its treatment of goodwill accounting could pose hurdles: U.S., U.K., and international principles for goodwill accounting currently differ in significant ways that affect the reporting of goodwill arising from business combinations.

U.S. GAAP

Before the effective date of SFAS 142, Goodwill and Other Intangible Assets, goodwill was capitalized and amortized over an estimated period of benefit, up to a maximum of 40 years. Negative goodwill was recorded as a deferred credit after reducing proportionately to zero the values of assets that would have otherwise been assigned to noncurrent assets (except long-term investments in marketable securities).

Under SFAS 121, goodwill related to long-lived assets intangibles to be held and used was assessed for impairment; while goodwill not identified with impaired assets (enterprise goodwill) was reviewed for impairment following the guidance in APB 17.

Now, under SFAS 142, goodwill is no longer amortized but is tested for impairment; SFAS 121 no longer applies to goodwill and APB 17 is superseded. In addition, goodwill embedded in an equity method investment would not be amortized, but the investment as a whole would be reviewed for impairment under APB 18. Under the new standard, negative goodwill is recorded as an extraordinary gain to the extent that it exceeds allocations to certain assets.

Annual and trigger-based impairment tests. Goodwill of a reporting unit must be tested for impairment annually, and be tested between annual tests depending on events or circumstances. The annual impairment test may be performed any time during the year, but it must be performed at the same time every year, and different reporting units may be tested for impairment at different times. Step One of the test is as follows:

• Compare the fair value of the reporting unit with its carrying amount (book value), including goodwill.
• If the fair value of the reporting unit exceeds its carrying amount, goodwill of the reporting unit is not impaired and no further work is needed. If the carrying amount of the reporting unit exceeds its fair value, go to Step Two.

Step Two comprises the following procedures:

• Compare the “implied fair value of goodwill” to its carrying amount.
• If the carrying amount of reporting unit goodwill exceeds the implied fair value of goodwill, record an impairment loss equal to the excess. After a goodwill impairment loss is recorded, the adjusted carrying amount of goodwill is its new accounting basis and the impairment loss cannot be reversed.
• If Step Two is not finished before the financial statements are issued, and a goodwill impairment loss is probable and can be reasonably estimated, record the best estimate of that loss following SFAS 5.

Events or circumstances. If an event occurs or circumstances change that would more likely than not (a likelihood of more than 50%) reduce the fair value of a reporting unit below its carrying amount, then the two-step impairment test is performed. Examples of events or circumstances include the following:

• A significant adverse change in legal factors or the business climate
• An adverse action or assessment by a regulator
• Unanticipated competition
• A loss of key personnel
• A more-likely-than-not expectation that a reporting unit, or a significant part of a reporting unit, will be sold or otherwise disposed of. When only a portion of goodwill is allocated to a business to be disposed of, the remaining goodwill in the reporting unit must be tested for impairment using its adjusted carrying amount.
• The testing for recoverability under SFAS 121 of a significant “asset group” within a reporting unit
• Recording a goodwill impairment loss by a subsidiary that is a component of a reporting unit.

Negative goodwill. Under SFAS 141, negative goodwill is allocated as a pro rata reduction of the amounts that otherwise would be assigned to all of the acquired assets except (a) financial assets [other than investments accounted for by the equity method], (b) assets to be sold, (c) deferred tax assets, (d) prepaid assets relating to pension or other postretirement benefit plans, and (e) any other current assets.

Any excess remaining after these assets are reduced to zero is recorded as an extraordinary gain in the period in which the business combination is completed, unless the combination involves contingent consideration, which would be recorded as an additional cost of the acquired entity. If an extraordinary gain is recorded before the end of the period, any later adjustments resulting from changes to the purchase price allocation would be recorded as an extraordinary item.

U.K. GAAP

Before 1998, under SSAP (Statement of Standard Accounting Practice) 22, goodwill in the United Kingdom was either written off against reserves (retained earnings) or it was capitalized and amortized over an “appropriate” period. U.K. GAAP also required that, upon a later disposal of previously acquired assets or a later closure of a previously acquired business, any goodwill previously charged directly to shareholders’ equity should be charged in the income statement against the income or loss on the disposal or closure.

Effective January 1, 1998, Financial Reporting Standard (FRS) 10, “Goodwill and Intangible Assets,” changed goodwill treatment. Goodwill must now be capitalized, and, as in the United States, internally generated goodwill cannot be recorded as an asset.

Amortization and impairment. Goodwill is amortized under a rebuttable presumption that it has a useful economic life of 20 years or less. This presumption may be overcome, however, if its estimated useful life is more than 20 years, or even indefinite, and the goodwill is capable of continued measurement in the future such that an annual impairment review can be performed. If goodwill is not amortized, or is amortized over a period of more than 20 years, then an impairment review must be performed each year. In addition, an indication of impairment requires an impairment review without regard to the amortization period.

Where goodwill is amortized over 20 (or fewer) years, impairment reviews must be performed only at the end of the first full year after initial recognition and at other times if circumstances indicate that its carrying value may not be fully recoverable.

With regard to an indefinite life for goodwill, FRS 10 states, “non-amortisation of goodwill constitutes a departure from the specific requirement of companies legislation to depreciate the value attributed to goodwill over a limited period that does not exceed its useful life. ... the Board has limited the circumstances in which ... goodwill is not amortised to those circumstances where systematic amortisation would not provide a true and fair view.”

Reversal of writedowns. When goodwill has a readily determinable market value or there is an unexpected reversal of the external event that caused the impairment, then a writedown may be reversed.

Negative goodwill. If negative goodwill is created in an acquisition, the fair values of the assets must be tested for impairment and the liabilities examined for understatement or omission. Negative goodwill is not allocated proportionately to reduce the values assigned to noncurrent assets. Negative goodwill is separately classified just below the goodwill caption on the balance sheet and a subtotal shows the net positive and negative goodwill. Negative goodwill, up to the fair values of the acquired nonmonetary assets, is recognized in the income statement in the periods when the nonmonetary assets are recovered, whether through depreciation or sale. Any remaining negative goodwill is recorded in the income statement over the future periods of expected benefit.

Is goodwill an asset? Unlike U.S. GAAP, U.K. GAAP under FRS 10 considers goodwill to be a link, and “neither an asset like other assets nor an immediate loss in value. Rather, it forms a bridge between the cost of an investment shown as an asset in the acquirer’s own financial statements and the value attributed to the acquired assets and liabilities in the consolidated financial statements.”

International GAAP

Current international GAAP regarding goodwill was established by the IASB in IAS 22, “Business Combinations.” The original standard, issued in 1983 and revised in 1998, requires that goodwill be capitalized and completely amortized. IAS 22 says: “The amortisation period should reflect the best estimate of the period during which future economic benefits are expected to flow to the enterprise. There is a rebuttable presumption that the useful life of goodwill will not exceed twenty years from initial recognition.” Furthermore, internally generated goodwill cannot be recorded and the standard does not permit an entity to assign an infinite useful life to goodwill.

Nonetheless, goodwill can be subject to an annual impairment test under IAS 36, “Impairment of Assets,” if its useful life is demonstrated to be more than 20 years and the reasoning behind this determination is disclosed. IAS 36 explains how an entity reviews the carrying amount of its assets, how it determines the recoverable amount of an asset, and when it recognizes or reverses an impairment loss.

In addition, IAS 22 requires annual calculations of the recoverable amount of goodwill if its useful life exceeds 20 years from the initial date of recording. Also, if the useful life was initially less than 20 years but is later extended to exceed 20 years, the entity must perform an annual impairment test.

Paragraph 47 of IAS 22 provides the rationale for amortization:
With the passage of time, goodwill diminishes, reflecting the fact that its service potential is decreasing. In some cases, the value of goodwill may appear not to decrease over time. This is because the potential for economic benefits that was purchased initially is being progressively replaced by the potential for economic benefits resulting from subsequent enhancements of goodwill. In other words, the goodwill that was purchased is being replaced by internally generated goodwill. IAS 38, “Intangible Assets,” prohibits the recognition of internally generated goodwill as an asset. Therefore, it is appropriate that goodwill is amortised on a systematic basis over the best estimate of its useful life.

Paragraph 49 continues:
Because goodwill represents, among other things, future economic benefits from synergy or assets that cannot be recognized separately, it is difficult to estimate its useful life. Estimates of its useful life become less reliable as the length of the useful life increases. The presumption in this Standard is that goodwill does not normally have a useful life in excess of twenty years from initial recognition.

Negative goodwill. Negative goodwill is always measured and initially recorded as the acquirer’s interest in the fair value of the identifiable assets and liabilities acquired, minus the cost of the acquisition. Allocating the negative goodwill to reduce the fair values of the assets acquired is not permitted. The portion of negative goodwill that relates to reliably measured, identifiable future losses and expenses, but are not liabilities at the acquisition date, is deferred and recorded in the income statement as those future losses or expenses occur.

On the other hand, negative goodwill that is not related to reliably measured, identifiable expected future losses and expenses at the date of acquisition should be recorded as income as follows: The amount of negative goodwill not exceeding the fair value of acquired identifiable nonmonetary assets is recognized as income on a systematic basis over the remaining weighted average useful life of the identifiable acquired depreciable or amortizable assets. The amount of negative goodwill exceeding the fair value of acquired identifiable nonmonetary assets is recorded as income immediately. Negative goodwill is disclosed in the balance sheet as a deduction from assets, in the same section as positive goodwill.

Is goodwill an asset? In contrast to FRS 10, IAS 22 says, “Any excess of the cost of the acquisition over the acquirer’s interest in the fair value of the identifiable assets and liabilities acquired as at the date of the exchange transaction should be described as goodwill and recognized as an asset … Goodwill arising on acquisition represents a payment made by the acquirer in anticipation of future economic benefits. The future economic benefits may result from synergy between the identifiable assets acquired or from assets that, individually, do not qualify for recognition in the financial statements but for which the acquirer is prepared to make a payment in the acquisition” (paragraphs 41, 42).

Current developments. Currently, the IASB has on its agenda a project on business combinations, whose objective is to develop a single standard in order to converge the alternative methods permitted by other standards-setting bodies. This project would either amend IAS 22 or result in a new International Financial Reporting Standard (IFRS) with guidance to supplement IAS 22. In addition to all of the issues involved with business combinations, this project will reexamine the measurement and recognition of acquired intangible assets and goodwill, and the amortization and impairment approaches.

The Search for High-Quality Accounting

Accounting for goodwill has been an intractable problem; all prior theories are provisional and subject to change. FASB’s latest approach has come full circle to reflect elements of ARB 43 (Ch. 5, Par. 2), issued 48 years ago, which separated intangibles into two categories:

(a) Those having a term of existence limited by law, regulation, or agreement, or by their nature (such as patents, copyrights, leases, licenses, franchises for a fixed term, and goodwill as to which there is evidence of limited duration).

(b) Those having no such limited term of existence and as to which there is, at the time of acquisition, no indication of limited life (such as goodwill generally, going value, trade names, secret processes, subscription lists, perpetual franchises, and organization costs). [Emphasis added] ARB 43 required that if the term of existence of a type (b) intangible became limited, its cost would be amortized over its remaining useful life. Furthermore, if a type (b) intangible did not continue to have value during the entire life of the enterprise, it would be amortized, even though there were no indications of limited existence, there was no loss of value, and expenditures were being made to maintain its value. The cost of a type (b) intangible would be written off when it became reasonably evident that it had become worthless.

APB Opinion 17, which was issued 31 years ago (over some significant dissent within the board), reversed ARB 43 and required amortization without exception and grandfathered all prior nonamortizing goodwill.

Leveling the playing field. For many years, goodwill was charged to equity in the United Kingdom and elsewhere, and many U.S. businesses (especially those involved in mergers and acquisitions) complained that the playing field was not level. Now, with the ASB and IASB generally requiring goodwill to be amortized over 20 years, and FASB adopting an impairment method, the tilt is in the opposite direction.

Qualitative characteristics. Before issuing its exposure draft on goodwill, FASB indicated that its survey of 14 public companies motivated them “to develop an approach that would produce information that was more useful to investors and management in making their decisions.” (See Viewpoints, “Why Did the Board Change Its Mind on Goodwill Amortization?”.) It also said that although “the economic life of goodwill might be finite, predicting with any degree of accuracy what that life will be is virtually impossible” and therefore “amortization is not representationally faithful of the pattern of decline.” In addition, because identified intangibles would be separated from goodwill, “what is included in goodwill is more likely to be nonwasting.” Therefore, distinguishing that which is wasting from that which is not would not be necessary.

Analysis. In sum, FASB justified its decision by asserting that the impairment model meets the tests of information that has relevance (i.e., it is more useful) and is representationally faithful (i.e., it has more substance and reliability).

FASB members learned in their 14 field visits that some analysts and some in management ignore goodwill amortization; consequently, FASB accepted the idea that “amortization expense in many cases [is] not considered by users of financial statements.” Note that, in SFAS 142, “some” was changed to “many.” Are 14 field visits sufficient to conclude that users of financial statements wholly ignored goodwill amortization?

Most of the controversy about goodwill over the last four decades has centered on the earnings drag was of amortization rather than on its usefulness. This earnings drag was highly visible and largely responsible in many minds for the popularity of the pooling-of-interests method. Moreover, the author’s experience with analysts and investment bankers indicates that they paid an inordinate amount of attention to goodwill and its amortization. The comment letters to FASB also show that many accountants disagree that nonamortization will result in statements that are more useful and representationally faithul, particularly when goodwill may in fact be a wasting asset and decline in value.

Contrary to FASB’s argument that “what is included in goodwill is more likely to be nonwasting” is the exposure draft’s rationalization in paragraph 69:

Board members concluded that it is appropriate to assume that acquired goodwill is being replaced by internally generated goodwill provided an entity is able to maintain the overall value of goodwill (for example, by expending resources on advertising and customer service).

The exposure draft also says (paragraph 83), “the Board concluded in the 1999 exposure draft that amortizing goodwill was a more appropriate method of accounting for goodwill than not amortizing goodwill and testing it for impairment or writing it off immediately. ... goodwill may be a nonwasting asset in part and ... measures of its amortization and impairment may be less precise than other measures of income items.”

FASB claims that its goodwill nonamortization policy may be supported wholly, or in part, by newly created, internally generated goodwill. GAAP, however, requires that all costs related to internally developed intangibles be charged to expense; under no circumstances should they be capitalized. The concept that expenses to “maintain the value of goodwill” justifies the impairment model simply seems weak. Old goodwill cannot be replaced on the balance sheet by newly created, internally developed goodwill unless the entire goodwill concept, which is predicated on its occurrence at an acquisition, is revised.

A compromise. Many accountants believe that the original value of purchased goodwill decreases over time and that it should be systematically and rationally amortized against income. The period and the method of goodwill amortization, however, have posed serious problems.

SFAS 142 concludes that a present value technique might be the best available method to measure the fair value of a reporting unit, absent a quoted market value. Simply put, goodwill amortization could be recorded over the period of the cash flows used in the present value calculation and in proportion to their gross amounts.

The amortization period using this approach will likely be short, change with the cash flow assumptions, and the method may not be straight-line. It will be as externally verifiable as an expected future cash flow model. Nonetheless, it provides a rational and systematic basis for amortizing goodwill.

Advantages of the impairment model. Many commentators strongly favor the nonamortization and impairment model because it will increase earnings and earnings per share. In addition, it appears at first to be conceptually pure.

Nevertheless, the decision of when there is a “more likely than not” trigger event, combined with the determination of the fair value of the reporting unit and the detailed measurement of the implied fair value of goodwill, may be so subjective that the timing and amount of write-downs may not always be independently verifiable.

Conflicting international appro- aches. According to AU 380.11 (SAS 90, “Audit Committee Communications”): “[I]n connection with each SEC engagement, the auditor should discuss with the audit committee the auditor’s judgments about the quality, not just the acceptability, of the entity’s accounting principles as applied in its financial reporting. ... Objective criteria have not been developed to aid in the consistent evaluation of the quality of an entity’s accounting principles as applied in its financial statements.”

Consider the following case: A U.S. parent company owns 60% of an U.K. subsidiary and 80% of a French subsidiary. These subsidiaries, which are audited by the U.S. auditor’s London and Paris offices, amortize goodwill over 20 years in accordance with FRS 10 and IAS 22, and issue audited financial statements in their home countries. Upon consolidation, the U.S. company, using the impairment model, reverses the goodwill amortization taken by these subsidiaries and reverses any impairment losses; the U.S. auditor reports on the consolidated financial statements.

Given the various conflicting accounting standards followed by the same entity audited in three different countries, how does the U.S. auditor decide and justify that the accounting followed by the U.S. parent is of higher quality than that used by the U.K. and French subsidiaries? Is it enough to say that, because it is U.S. GAAP and because FASB asserts that it is representationally faithful and of high quality, it is better both conceptually and theoretically?

Negative goodwill. U.S. accounting for negative goodwill differs substantially from U.K. and international accounting. Many accountants are not persuaded that purchase accounting ever creates an income event. Why is a bargain purchase considered income? Although FASB says they took a practical approach, another practical approach would have been to defer and to amortize the bargain purchase. FASB offers no conceptual basis for treating negative goodwill as income other than to say the deferred credit does not meet the definition of a liability. Yet under SFAS 141, if negative goodwill arises in a business combination with contingent consideration, part or all of the negative goodwill will be recorded as if it were a liability, notwithstanding it does not meet the definition of a liability.

SEC’s concept statement. In response to the SEC’s Concept Release “International Accounting Standards,” many commentators supported the increased use of IAS by foreign registrants in the United States to promote its use globally and to improve the quality of accounting standards. A review of the differences in accounting for goodwill (see above and the Exhibit) raises doubts about the possibility of achieving complete accord about high-quality financial reporting any time soon.

Nevertheless, if there is to be an efficient global economy, financial statements must be comparable across national boundaries. Similar accounting events and transactions must be comparable, and the only solution to the challenge is convergence.