The CPA Journal

Goodwill Valuation Under SFAS 142

By Z. Christopher Mercer, Matthew R. Crow, and Kenneth W. Patton

In Brief

SFAS 142 Charts New Territory for Business Appraisers

SFAS 142 raises many issues for business valuation experts, auditors, and managers. The authors unravel the complex and confusing threads of SFAS 142's requirement to assess whether goodwill has been impaired and to revalue it if necessary. They analyze FASB's fair value concept in the context of mainstream business valuation literature and draw preliminary conclusions about the appropriate approaches and models for SFAS 142 goodwill valuations (in businesses that have recorded goodwill). The valuation guidance in this article and the advice on choosing an expert should be of great interest to everyone responsible for financial reporting.

SFAS 142, Goodwill and Other Intangible Assets, represents a significant expansion of business valuation into the financial reporting framework. It will be implemented in conjunction with SFAS 141, Business Combinations. Because of SFAS 142, finance and accounting professionals in reporting companies, and non-reporting companies that adopt the standard, must understand many of the principles, methods, and techniques of business valuation.

Even for professionals with significant experience in business valuation and intangible asset valuation, valuing reporting units for compliance with the pronouncement is a new frontier. It is not enough for an expert to be skilled in valuation, although that is critical. Rather, it is important to understand the valuation implications of SFAS 141/142, and to recognize when valuation decisions and judgments are being made that may materially affect a reporting unit's reported financial performance. Appraisers, auditors, and management will have to develop a common understanding of the valuation implications of SFAS 142. Moreover, the SEC will be reviewing SFAS 142 compliance with respect to public disclosure. Further interpretation of SFAS 142 from a valuation perspective will undoubtedly be required as FASB provides additional guidance and as everyone involved gains experience in the application of the statement.

Brief Summary of SFAS 142

SFAS 141 and SFAS 142 are designed to improve reporting and disclosure with respect to goodwill and other acquired intangible assets. SFAS 141 eliminated the pooling of interests method as an accounting option for business combinations, while SFAS 142 modified the purchase method of accounting by eliminating the amortization of goodwill and substituting the impairment test.

The emphasis on asset valuation, as opposed to expense recognition, reflected FASB's growing emphasis on fair value measurements of assets and liabilities. As FASB noted, goodwill could be both replenished and increased; therefore, amortization of the goodwill asset does not necessarily reflect the economic change of an investment's value. A nonamortization approach resolves these inherent deficiencies. Instead of amortization, the new standard prescribes an impairment review to assess the fair value of goodwill and appropriately adjust the reported asset balance.

SFAS 142 is a one-way street. Assets deemed impaired must be written down to their fair values. There is no provision in SFAS 142 for a subsequent recovery of the impairment writedown under more favorable operating or market conditions.

Goodwill and Reporting Units

SFAS 142 prescribes an impairment review at the reporting unit level, defined as an operating segment or one level below an operating segment (component). SFAS 131, Disclosures About Segments of an Enterprise and Related Information, defines an operating segment as a component of a business that earns revenue and incurs expenses, whose operating results are regularly reviewed by the chief operating decision maker to assess performance and allocate resources, and for which discrete financial information is available. Subject to certain quantitative thresholds, an operating segment becomes a reportable segment.

A component of an operating segment (one level below the operating segment level) meets SFAS 142's requirement for a reporting unit if the assets composing that unit constitute a business as defined in EITF 98-3 and if it meets the preceding requirements used in determining an operating segment. If all the components of an operating segment are economically similar, or if no discrete component level financial information exists, then the reporting unit is considered to be the operating segment. FASB's intent, as in SFAS 131, was not to create new internal reporting structures but rather to view the entity from management's perspective.

Goodwill Impairment Reviews

Conducting goodwill impairment reviews consists of two steps:

Step one. The first step consists of a carrying amount comparison, which compares the fair value (as defined in the pronouncement) of the reporting unit to its carrying value (stated shareholders' equity, including goodwill). If fair value exceeds carrying value, then no further testing is required. FASB noted that this initial comparison can provide a significant cushion in determining whether goodwill may be impaired, if tangible or identifiable intangible assets have fair values significantly in excess of their carrying values.If the carrying value of a reporting unit exceeds its fair value, then a second step is required to determine the implied fair value of goodwill.

Step two. Step two measures the implied fair value of goodwill.FASB noted that goodwill cannot be measured directly; it is a residual amount. The approach follows the purchase price allocation under the purchase method. To determine the implied fair value of goodwill, the fair value of net assets (fair value of all assets other than goodwill, minus the fair value of liabilities) is subtracted from the fair value of the reporting unit.

Step two testing is considerably more complex than step one testing. If step one testing indicates that recorded goodwill may be impaired, then all assets of the reporting unit, both tangible and identifiable intangible assets, must be valued to determine the implied fair value of goodwill. If the implied fair value of goodwill is less than its carrying amount, then reported goodwill is impaired.

An entity must recognize an impairment loss as a component of income from continuing operations, except that impairment losses arising from initial applications of SFAS 142 may be recorded as changes in accounting principle.

Considerations in Step One Impairment Testing

Identify the asset. One of the essential requirements of any valuation assignment is the definition of the property to be valued. A valuation of a reporting unit is no different. In many cases, the definition of the reporting unit may predetermine whether or not goodwill is impaired. For example, if a small, poorly performing business unit can be subsumed into a larger, more successful unit, then no goodwill impairment may exist. Furthermore, the definition of the reporting unit has both an immediate impact and a lasting impact as the business changes over time.

The valuation analyst will frequently work with management to define the reporting units at the outset of impairment testing engagements. However, auditors must approve the reporting unit definitions and changes to the definitions over time. Management and auditors could easily view reporting units from different perspectives as shown in the following example:

Standard of value. SFAS 142 requires that reporting units be valued using the standard of fair value. Fair value is defined in Appendix F of SFAS 142 as: "The amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale."

A point of potential confusion needs clarification. Valuation terms sometimes have multiple meanings in different contexts. When corporations engage in transactions that give rise to the right to dissent under state statutes, shareholders are generally entitled to the fair value of their shares. This fair value, however, has a different meaning than the term within the context of SFAS 142.

Fair value for goodwill impairment purposes can be compared to the better-known standard of fair market value (see Exhibit 1). Fair market value participants to a transaction are hypothetical parties. Their status is not explicitly defined under SFAS 142, but it can be inferred that the parties are identifiable. Both definitions assume a hypothetical transaction, ground the valuation determination in time (either currently, or as of a specified date), and deal in present value terms.

Two other standards of value, investment value and intrinsic value, also bear consideration. Investment value is commonly defined as value to a specific or prospective owner, and can include synergies, efficiencies, and other enhancing factors arising from a merger or acquisition. In other words, the benefits of ownership to a particular purchaser, which may include enhancements to the previously existing business, influence investment value. The investment value of a business, therefore, may be substantially greater than fair market value. Intrinsic value is commonly defined as the value of a company or an asset based on a belief about underlying value. Management's perception that its stock is undervalued is often based on an intrinsic value considered greater than market value. Intrinsic value is usually calculated based upon a theory or model, such as fundamental anyalysis. Whereas investment value implies that an owner will have an active role, intrinsic value implies passive investment.

Fair market value assumes that both parties to a hypothetical transaction have reasonable knowledge of relevant facts. SFAS 142 is silent on this point, but the context of the fair value definition implies greater than reasonable knowledge. A strategic transaction occurs only after disclosure of highly sensitive information that might not be available to a hypothetical buyer in a fair market value context. Thus, the knowledge level of the parties in an investment value context could be meaningfully greater than in a fair market value context. Interpretations of fair market value suggest that both parties must have the financial capacity to engage in a transaction. Fair value, by focusing on real buyers and sellers, implies similar financial capacity.

The fair value definition excludes consideration of forced or liquidation scenarios (negative compulsion), whereas the definition of fair market value also excludes any sort of compulsion (including positive compulsion to buy). This difference is important, because other guidance in SFAS 142 refers to potential synergies in the allocation of goodwill. In the traditional fair market value framework, synergy potential is often considered to be beyond fair market value, even at the controlling interest level. Therefore, fair value under SFAS 142 appears comparable to investment value to the current owners.

Levels of value. The following discussion of levels of value can only address the major issues bearing on goodwill impairment analysis; an in-depth analysis of all the theoretical issues involved is outside the scope of this discussion.

The traditional levels of value chart included three premises or levels of value. Accepted valuation theory has begun to recognize the difference between financial and strategic buyers with the addition of a fourth level, the synergistic or strategic control value, as seen in Exhibit 2.

Within this framework, the controlling interest value is greater than the marketable minority interest value because the controlling shareholder can improve the enterprise's cash flow. The controlling interest value does not, however, presume that the control buyer has the opportunity to take advantage of the synergies associated with the buyer at the strategic control level. The control buyer in this context is a financial, not strategic, buyer (even though appraisers have long used acquisition premium data to estimate the value of financial control). Financial buyers may be able to extract one level of efficiencies or synergies in a given business through improvements in operations. In addition, a strategic buyer may be able to create further efficiencies or synergies by combining a business with another or running it very differently. The implied assumption is that a strategic buyer may expect greater cash flows than the financial buyer.

It is useful at this point to introduce the distinction between internal and external synergies. Internal synergies are those opportunities for cash flow enhancement available to the existing owner from combination with the owner's other businesses.External synergies, on the other hand, are those opportunities for cash flow enhancement available to a potential acquirer as a result of the integration of the business with the potential acquirer's other existing businesses.

Impairment testing compares the expected future benefits of an asset to its book value. As a result, it appears that only internal synergies, that is, synergies that could accrue to the current holder, should be considered. Although greater synergies could be available to another company were it to hold the reporting unit, it appears that these external synergies should not be considered. Therefore, fair value would seem to equal the investment value to the holder.

The application guidance in Appendix B of SFAS 142 indicates that cash flows used in deriving fair value "should be consistent with the most recent budgets and plans approved by management." This is consistent with the notion that management is representative of a control buyer capable of realizing only internal synergies. Consequently, a discounted cash flow analysis and the single- period income capitalization method will likely result in strategic control values. This implies that if the market's consensus forecast of the company's cash flow is consistent with management's, the "as if freely traded" or marketable minority interest value (i.e., the public company's market capitalization) will be very close to the company's strategic control value inclusive of internal synergies.

The topic of control premiums has been controversial in the business valuation profession for at least a decade. If the value of public companies on a controlling interest basis were materially greater than the price of freely traded shares, one would expect considerably more mergers and acquisitions as arbitrageurs took advantage of value differentials.

Although generally thought to be outside the purview of fair market value (unless the consensus buyers of a property are strategic buyers), the synergistic or strategic control value appears to be consistent with fair value as defined by FASB. Although SFAS 142 leaves much open to interpretation and judgment, Appendix B, Paragraph 154, notes: "The ability of a controlling shareholder to benefit from synergies and other intangible assets that arise from control might cause the fair value of a reporting unit as a whole to exceed its market capitalization." This guidance clearly endorses, in substance if not by name, a strategic control level of value.

Business valuation analysts traditionally assume that guideline company analysis ultimately yields valuations at the marketable minority interest level, because the derived values are based on comparison with freely traded securities. When determining fair value under SFAS 142, however, the appraiser must consider the nature of the capitalized cash flows in order to assess the level of value represented by the valuation conclusion. To the extent that guideline company multiples are applied to cash flows forecasted by management (including all internal synergies), the resulting valuation is likely to be at the strategic control level. In such cases, it would be inappropriate to apply a control premium to the indicated value.

If a company's (or reporting unit's) fair value is based on the application of a control premium available only through external synergies from another buyer, the shareholders might be best served by selling the company (or reporting unit). If goodwill is based on this higher value (perhaps indicating overpayment), it is likely impaired.

Reconciliation of Assumptions and Conclusion of Value

Once the analyst has developed a conclusion of value for step one, it should be tested against various yardsticks, or tests of reasonableness, that indicate whether the estimate provides a reasonable indication. These tests of reasonableness are valuable because they can uncover potential errors or unreasonable assumptions in the valuation process and provide a final reality check.

A test of reasonableness can be viewed as a reverse valuation. Given the valuation, the test works backwards to find implied valuation assumptions and multiples that then can be tested for reasonableness. The appraiser may use one or more of several potential tests of reasonableness in the final reconciliation of conclusions:

Documentation

SFAS 142 does not include explicit requirements for impairment testing documentation. Members of different appraisal societies typically have fairly stringent documentation requirements, as do the auditors relying upon the impairment test. A well-documented impairment test is only prudent, and should include the material information required to reach the impairment decision, as well as an explanation of the methodologies employed. Files should be maintained for as long as the impairment test could be exposed to internal or external scrutiny. The nature and extent of impairment testing documentation in specific cases will be a matter of discussion between appraisers, management, and auditors.

Considerations in Step Two

In many cases, step two of SFAS 142 requires that companies determine the fair value of the reporting unit's recorded and unrecorded intangible assets. Existing goodwill is excluded when calculating the fair value of acquired net assets. In the valuation of intangible assets, there are a number of practical issues that are likely to arise.

Identification of assets. Differing theories exist about what constitutes an intangible asset that can be identified, categorized, and valued. Some intangible assets will be subject to amortization and others will not. It may be reasonable to bundle certain intangible assets together. The identification of intangible assets is a potential quagmire, and will likely produce intense discussions between management, independent auditors, and valuation analysts, especially when the ultimate decision may have a material impact on the financial statements.

Valuation methods. Historically, intangible assets have been valued using traditional valuation approaches: cost, income, and market. Different approaches applied to the same intangible asset can result in widely different values. The cost approach can be useful, but is rarely definitive because value is closely linked to future benefits. The market approach is appealing, but to be effective it must be based on a reasonable number of meaningful transactions; such data is sometimes not available.

Even when ostensibly similar transactions can be identified, wide discretion in their application to the subject asset is left to the analyst. As a practical matter, this has frequently led to the use of some type of future benefit model (income approach). A discounted future benefit model is highly sensitive to its many underlying assumptions that are, at best, based on market information. At worst, they are a figment of the analyst's imagination. Furthermore, the assignment of income and expenses to particular intangible assets must be viewed within the overall cash flows of the enterprise.

Longer-Term Implications

Financial theory states that value is equal to the present value of all future benefits associated with an investment, including discretely forecasted cash flows and estimated terminal values (or benefits). If this is true, can changes in accounting methods produce changes in real valuations? Theoretically, if there is no change in cash flows, there should be no change in value. Nevertheless, some interesting questions arise in the real world.

Valuation ratios. The most basic question is whether price to earnings (P/E) ratios will adjust downward as earnings rise due to the elimination of goodwill amortization. Conversely, if most of the public companies in an industry possess goodwill (ceasing amortization) and the market adjusts their P/E ratios to achieve the same pre-accounting-change valuations, will the market similarly adjust the values of companies in the same industry with no existing goodwill? The new rules focus on public companies, yet thousands of private companies require valuation. Many of these private companies never recorded goodwill or associated amortization charges.

The issues of goodwill amortization and intangible asset recognition could become as significant to appraisers as accounting for inventories. The end result may be the valuation of companies on a cash earnings basis. Essentially, goodwill and intangible asset amortization would be eliminated from the earnings stream and all earnings would be stated on a comparable basis. While this sounds simple, it would require a considerable change in focus for institutional equity markets focused on reported earnings per share.

Getting credit for goodwill? To the extent that reporting of impairment under SFAS 142 affects the availability of credit, could an entity's real value be affected? Credit markets should be sufficiently homogeneous and sophisticated in their approach to credit extensions to rapidly internalize new accounting standards, so that no real impact in the credit markets is likely.

Nevertheless, many loan documents specify minimum equity-to-asset ratios or equity-to-liability ratios, which could be violated if existing goodwill is written off. Such documents are often based upon tangible book value, which would eliminate this issue. The definition of tangible, however, could be open to question. While it appears that the definition of tangible equity is obvious-total book value minus intangible assets-lenders may find themselves categorizing all sorts of new assets. Investment bankers have been known to place values on these assets to assist in the securitization process and help raise money.

It is also likely that many vendors will lack the same degree of sophistication in analyzing credit risks. While it is unlikely that companies will lose access to vendor credit, it is certain that more time will be spent educating vendors.

Compliance with the audit standards will be necessary to maintain credibility with third-party users of financial statements. For that reason alone, the attitude of lenders toward accounting rules will require compliance, which could raise the costs of doing business.

Comparability. To what extent will decisions by auditors and appraisers create financial statements that are less comparable than before? Even where there is agreement as to the existence of an intangible asset, there will be different valuation methods and underlying assumptions, which could lead to widely different conclusions.

Earnings versus Cash Flow

After SFAS 142, analysts may look at earnings and book values differently. Do the new rules also presage a change in emphasis and use of valuation methods? For example, does the ratio of price to book value become more relevant? Or should analysts use methods that are more cash flow driven, such as the ratio of total capital to earnings before interest, taxes, depreciation, and amortization? This is not an inconsequential decision, since the potential for error in a valuation often rises as the analyst moves up the income statement to increasingly broader measures of cash flow.

FASB will undoubtedly provide further guidance on SFAS 142, and appraisers, managers, and auditors, as well as the SEC, will gain experience in the conduct and interpretation of goodwill impairment tests. This is only an early interpretation of SFAS 142 from a valuation perspective, an interpretation to be revisited as the implementation of SFAS 142 evolves.