Users’ Comments on SFAS 141 and 142 on Business Combinations and Goodwill

By Eric E. Lewis, Jeffrey W. Lippitt, and Nicholas J. Mastracchio, Jr.

In Brief

Implementing the User Perspective

Edmund L. Jenkins brought a perspective on financial reporting to the FASB that places a premium on the needs of financial report users: analysts, investment bankers, lenders, and investors. The authors have analyzed the comment letters from financial report users on the FASB’s exposure drafts on business combinations and goodwill and found links between users’ comments and the changes incorporated in the final standards. Greater engagement with financial report users and attention to their concerns, rather than to those of preparers and auditors, could be the next step in the evolution of accounting standards setting.

Accunting for business combinations has become a particularly important topic for financial report users in the financial services industry. FASB has recently addressed the issue through SFAS 141, Business Combinations, and SFAS 142, Business Combinations and Intangible Assets: Accounting for Goodwill. Analysts, brokers, investment bankers, and insurance and banking executives are the ones that will have to decide how the new rules affect their judgments of future mergers. The financial services industry will largely determine how markets interpret and use any new information in the disclosures and calculations required by SFAS 141 and 142.

Over 200 letters were received by the FASB in response to the February 14, 2001, modified exposure draft. Forty-two financial institutions and related entities responded, representing over 20% of total responses. Their concerns, as expressed in the response letters and discussion with FASB, shed light on how the financial services industry will analyze goodwill and related items under the new rules.

FASB responded to many of the issues raised by the financial services respondents in its latest pronouncements, although it was silent on some concerns. Users’ concerns were generally similar to those of preparers and auditors, but their emphasis reflected their user orientation.

Users’ Concerns

International convergence. International financial institutions said that the non-amortization rule for goodwill would push U.S. GAAP further away from International Accounting Standards (IAS). IAS allows some forms of pooling of interest accounting but favors the amortization of goodwill. FASB has stepped beyond goodwill in SFAS 142 by opening the door to the non-amortization of other identified intangibles with indefinite lifespans. In fact, many respondents identified other intangible assets that share characteristics with goodwill and could also be treated by the non-amortization rule, such as acquired brands, purchased credit card relationships, and excess reorganization values for bankrupt entities. FASB included intangibles created during bankruptcy reorganizations as an intangible to be treated under the same rules as goodwill. The others, which can be found in Appendix A of SFAS 142, may be eligible for non-amortization under SFAS 142’s provision for intangibles with indefinite lives.

Negative goodwill. Many financial user respondents suggested that negative goodwill be recorded as an intangible liability and amortized to non-interest income over some reasonable period. They favored this treatment over the extraordinary gain provision for non-apportioned negative goodwill ultimately prescribed in the pronouncement.

Reporting units. In all phases of the exposure draft modifications, FASB attempted to define the reporting unit for goodwill. Although FASB sought to identify these reporting units in various ways, most user respondents agreed with other respondents that FASB’s definitions were not appropriate. Many felt that it would be too burdensome for companies to track information for units different from those already required for segment reporting under SFAS 131. This recommendation was ultimately adopted, allowing SFAS 131 reporting units to be used for goodwill impairment testing.

The testing method. Although almost all user respondents agreed that goodwill is probably a nonwasting asset (some disagreed, and others argued that only some goodwill is nonwasting), many were seriously concerned with the reliability of the proposed impairment testing method. They criticized the testing method from several angles, and shed light on what is probably the most serious weakness of SFAS 142.

A common concern was that a measurement using the present value of cash flow computations would be subject to capitalization rate fluctuations that could cause unintended results. Interest rate changes could reduce the value of goodwill even when the underlying cash flows are relatively stable. Under the rules, write-downs are not reversible, meaning that a temporary fluctuation of interest rates could cause a permanent impairment of goodwill. Valuation experts will have to choose between being generous with rates for impairment calculations or determining that a change in prevailing rates represents only a temporary impairment of goodwill. Inconsistencies will be inevitable.

Another concern was that the fair market value of other identifiable intangible assets could not be measured with sufficient reliability to isolate the value of the goodwill residual amount. Even with the reporting unit valued as a whole, the apportionment of that value to the assets and liabilities assigned to the reporting unit can be problematic. The market values of patents, trademarks, and brands can be difficult to determine. SFAS 142 requires, however, that the fair market value of the reporting unit be assigned to these and all other assets in order to determine the residual value of the unit’s goodwill. Some fear that this technique will lead to the manipulation of reporting units in efforts to protect goodwill—bad news for those expecting FASB to meet its stated primary goal for the business combination initiative to “improve the transparency of the accounting for business combinations.”

Accounting change treatment for impairments from initial review. There were numerous requests from respondents that any impairment measured at the initial impairment review be treated as a change in accounting principle under APB 20, Accounting Changes. The initial adjustments would result from a different impairment standard from that in SFAS 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of. FASB will allow impairments resulting from initial reviews to receive APB 20 treatment, rather than inclusion in operating income as the new pronouncement requires for all subsequent write-downs.

Feared Abuses

The FASB proposal calls for the goodwill acquired in a business combination to be allocated to those reporting units of the combined entity that will benefit. Reporting units that receive goodwill allocations will be subject to goodwill impairment reviews. The temptation to allocate goodwill based upon a reporting unit’s ability to support the future, unimpaired valuation of goodwill may give rise to artificial goodwill support divisions to receive and maintain the goodwill acquired in corporate mergers. By design, such reporting units would enjoy healthy present and expected future cash flows relative to their existing tangible and identified intangible assets.

In addition, because only identified assets are included in the asset base for apportioning the fair market value of a reporting unit assigned to goodwill. Any unidentified assets that contribute to market value will be captured as a portion of the value ascribed to goodwill. Examples of such assets include advertising, research and development, gain contingencies, and others assets whose capitalization is prohibited. Because their income streams are homogenized in the overall performance of the reporting unit, it will be very difficult to distinguish the separate value of acquired goodwill from this collection of assets, and impossible to separate its value from internally developed goodwill. Companies may be tempted to place acquired goodwill into reporting units that have significant unrecorded goodwill rather than reporting units most likely to benefit. Thus, unrecognized goodwill would protect acquired goodwill from accounting impairment, because it would increase the expected present value of future cash flows without increasing the market value of recorded assets. Additionally, transfer pricing mechanisms and corporate reorganizations could be managed to enhance goodwill havens in corporations of significant size and complexity.

Inconsistent impairment standards. All respondents were puzzled by the differences between SFAS 121 and SFAS 142. SFAS 142 establishes a different standard for testing goodwill impairment than for any collection of assets tested under SFAS 121. The SFAS 121 threshold for impairment is much easier for a collection of assets to meet, because it uses undiscounted future cash flows as a gross measure of whether impairment has occurred. Under SFAS 142, present values are used to make a similar measurement. While this might result in goodwill being written down more often than other assets (a conservative result), the obvious question is why not, if the new standard is better, extend the new rule to other assets, superceding SFAS 121? Instead, there are now different impairment standards for different assets. A SFAS 121 review is one of the remaining triggers for an intraperiod goodwill impairment review. There could be goodwill write-downs caused exclusively by SFAS 121 reviews, although other assets might not be written down because of its permissive impairment test.

Deferred taxes. SFAS 142 does not deal with the deferred tax issue that results from not amortizing tax-deductible goodwill. Some users commented that if goodwill has an indefinite life, rather than just different amortization schedules for book and tax purposes, then permanent difference treatment would be appropriate.

Cost vs. benefit. A survey conducted by The American Business Conference, Grant Thornton, LLP, and the NASDAQ Stock Market, Inc., asked CFOs about how they would handle the valuation provisions of SFAS 142. Fifty-seven percent of CFOs said that they’d be likely or almost certain to use “outside assistance” when attempting to value a reporting unit and its assets and liabilities, and 71% would use outside assistance when performing the impairment test.

One large valuation firm, responding to the changes in the exposure draft, offered the strongest support for the new pronouncements. It argued that the implementation issues are minor, and the cost of performing annual reviews and, if necessary, impairment tests will be minimal with respect to the dollar value of the assets and liabilities that valuation firms will be asked to examine. This view was not shared by most respondents. Both users and preparers worried that another fee, for valuation services, would significantly increase annual review costs while yielding benefits that are nominal at best. FASB has allowed shortcut calculations if the goodwill in a reporting unit has overwhelmingly exceeded the impairment threshold in the previous year and not much has changed regarding the collection of net assets in the the current year.

Users Are Also Merging

Regulatory concerns. An issue of concern exclusively to banking institutions was SFAS 141 and 142’s impact on compliance with the capital requirements for banks established under Title 12 of the U.S. Code. These institutions must perform periodic checks of their mandatory minimum capital while complying with FASB standards for reporting their financial position and performance. Since goodwill is treated as a special item in the USC calculations, a change in accounting for goodwill that keeps it on the books indefinitely could adversely affect the calculation of minimum capital and cause banks to change their capital management strategies. If the only reason for such changes is simultaneous compliance with the SFAS and the USC, some banks think this will result in less than optimal management decisions regarding capital maintenance.

Not-for-profit exclusion. Many credit unions and mutual banks thought that, as not-for-profit entities, they should not be subject to the new pronouncements. Often, when these entities merge, no consideration is exchanged. In mutual bank and credit union mergers, the prohibition against pooling, coupled with the new negative goodwill rules, will result in the elimination of all of the assets and equity of at least one of the mutual entities involved in a merger. Because there is no purchase price, and really no acquiring entity in many of these combinations, one entity must simply be chosen as the survivor, and the other’s net assets must be given negative goodwill treatment at their entire market value, an outcome counter to FASB’s transparency objective. FASB, while insisting that the new pronouncements will apply to mutual enterprises, has suspended implementation of the new rules for them until it is able to provide more guidance. This gives mutual banks and credit unions a temporary reprieve and provides incentive to consummate any planned mergers before FASB folds them into the new standards.

A Paradox

FASB’s deliberations, its changes to the exposure drafts, and the accompanying responses from a wide range of interested groups make it clear that FASB has attempted to tackle an issue that isn’t easily approached within the current reporting and measurement framework. SFAS 142 attempts to measure the fair market value of an intangible residual with more precision than is required for more identifiable assets.

The pronouncement requires that the market values of all of a reporting unit’s identifiable assets be established in order to adjust the value of its goodwill residual. GAAP, however does not permit the restatement of these other, tangible, identifiable assets to their market values, ostensibly because of the unreliability and subjectivity of such restatements. Is it not striking that valuations which fail for other, more conventional GAAP purposes have been accepted to establish a value by inference for a residual debit on the balance sheet? Goodwill has claimed center stage for the moment, but with questionable benefit to the financial service users and potential high cost to the reporting entities.