By Rose Marie L. Bukics and Benson J. Chapman
Changes and Challenges for All Entities with Recorded Goodwill
After long deliberation, FASB has issued SFASs 141, Business Combinations, and 142, Goodwill and Other Intangible Assets. They limit accounting for business combinations solely to the purchase method and require goodwill, and all forms of intangibles, to be tested for impairment rather than amortized. The authors identify the critical themes of SFAS 141 and 142, which affect the financial statements of all entities, regardless of size. See Goodwill and Intangible Assets: A Ten-Step Program for Public and Nonpublic Entities (page 44) for a related checklist of important questions to ask in applying the standards.
Although many issues motivated the reconsideration of APBs 16, Business Combinations, and 17, Intangible Assets, the objective of financial statement transparency dominated the considerations. The impact of accounting for business combinations, as well as goodwill and other purchased intangibles, was paramount. The resulting statements were the culmination of a process that included a special report and two exposure drafts, extensive field-testing of proposed requirements, numerous opportunities for written comment and oral testimony, and the consideration of related international projects.
Whats Covered? What Isnt?
SFAS 141 supersedes APB 16, Business Combinations, and SFAS 38, Accounting for Preacquisition Contingencies of Purchased Enterprises, and specifies how to account for a business combination using the purchase method. Business combinations encompass all combinations involving two or more parties, regardless of whether the enterprises are incorporated or unincorporated. SFAS 141 excludes, however, joint ventures, not-for-profits, acquisitions of a for-profit by a not-for-profit, and activities that are transfers between enterprises under common control.
SFAS 142, Goodwill and Other Intangible Assets, supersedes APB 17 and covers the acquisition of intangibles, whether as a group or as a single item, except those acquired as part of a business combination (covered in SFAS 141) or purchased research and development (no change in the present accounting method used). SFAS 142 specifies the post-acquisition accounting for goodwill and other intangibles, including those intangibles acquired under SFAS 141 as part of a business combination. SFAS 142 also covers acquisition of intangibles by not-for-profits, although its provisions will be deferred until the separate not-for-profit combination project is complete.
SFAS 141 recognizes the purchase method of APB 16 as the only acceptable method of accounting for all business combinations initiated after June 30, 2001, and for all business combinations with an acquisition date of July 1, 2001, or later. The pooling method has been eliminated.
The requirement to use purchase accounting reflects the view that all business combinations are acquisitions and should be accounted for as such based on the fair value of the exchange. Although the new statement is based on this fundamentally different approach, the application of purchase accounting remains essentially the same as it was under APB 16; many of the paragraphs in SFAS 141 parenthetically refer to the original source.
According to SFAS 141, a business combination occurs when one entity acquires the net assets that previously constituted another business entity or acquires an equity interest in and obtains control over another entity. To properly evaluate a business combination, the three central issues are: identifying the acquiring entity, determining the cost of the acquired entity, and allocating those costs to the assets acquired and liabilities assumed.
Identifying the acquiring entity. In a combination completed solely by distributing cash or other assets (or by incurring liabilities), the entity that distributes cash or assets (or incurs the liabilities) is generally the acquiring entity. In a combination completed through an exchange of equity interests, the entity issuing the equity is considered the acquiring entity.
SFAS 141 recognizes that the acquiring enterprise may not always be evident. Items that provide evidence to identify the acquirer include the relative post-acquisition voting rights, senior management structure of the newly formed enterprise, and the composition of the board.
Determining the cost of the acquired entity. The cost of the acquired entity is the amount of cash paid, the fair value of other assets distributed, the fair value of liabilities assumed by the acquiring entity, and the fair value of equity securities issued without restrictions. The cost also includes the direct costs of the business combination and any identifiable and measurable contingencies as of the acquisition date.
If additional consideration is contingent upon future earnings levels, the fair value of the consideration issued or issuable is also part of the cost of the entity, and it would be recorded when the contingency is resolved and the additional consideration is issued or issuable. A contingency based on the price of the securities, however, does not affect the cost of the entity acquired.
Allocation of costs to assets acquired and liabilities assumed. SFAS 141 specifies that the acquiring enterprise must allocate the acquisition costs to the assets acquired and liabilities assumed as of the acquisition date, ordinarily the date that the assets are received, liabilities assumed, or equity issued. The costs should be assigned to a reporting unit and allocated following the existing purchase price allocation guidelines contained in APB 16 (in-process research and development with no alternative uses must still be charged to expense).
Acquisition of Intangibles
While identifiable tangible assets acquired in a business combination are recorded at fair value, identifiable intangible assets must first be evaluated to determine if they meet the criteria for recognition apart from goodwill.
A two-step test determines whether an acquired intangible should be recognized separately from goodwill. The first step determines whether such an asset arises from a contractual or other legal right, regardless of whether such rights are transferable or separable from the acquired entity or from other rights and obligations. If the intangible arises from a contractual or legal right, the asset must be recognized as an asset separately from goodwill.
If the asset does not arise from legal and contractual rights, the second step determines whether the asset is capable of separation or division from the acquired entity and can be sold, transferred, licensed, rented, or exchanged, either individually or in combination with a related contract, asset, or liability. If the intangible can be separated as defined above, it must be recognized as an asset separately from goodwill. SFAS 141 states that an assembled workforce cannot be recognized separately from goodwill; its Appendix A provides an illustrative list of intangibles that meet such criteria. All separately recognized intangible assets are valued at fair value upon acquisition.
Intangible assets that do not meet either test must be included in the amount assigned to goodwill. The other element of goodwill is the excess of the total cost of the acquired entity over the amounts assigned to the net tangible and intangible assets. In the event of negative goodwill, the amounts assigned to acquired assets should be reduced on a pro rata basis, except for financial assets other than investments accounted for under the equity method, assets to be sold, deferred tax assets, prepaid assets related to pension or post-retirement plans, and other current assets. Any excess that remains after such a pro rata allocation should be recognized as an extraordinary gain in the period the combination is completed.
For each period in which a material business combination is completed, the notes to the financial statements must disclose certain information, such as the name and brief description of the acquired entity, the cost, the primary reasons for the acquisition, and summary financial information about the acquired entity. For a publicly held company, additional disclosures are required in annual and interim financial statements about pro forma operating results. Considering the announced views of the SEC regarding materiality, the detailed disclosure information will be reported for most business combinations. It would seem unlikely that a publicly held company could announce a business combination in a press release and then later conclude that the acquisition was immaterial and need not be described in the notes.
SFAS 141 applies to all business combinations initiated after June 30, 2001, and to those accounted for by the purchase method before July 1, 2001. The carrying amount for previously acquired intangible assets not meeting the new criteria for recognition apart from goodwill (such as an assembled workforce) will be reclassified to goodwill on the effective date of SFAS 142. Intangible assets arising in previous acquisitions that now meet the new requirements for separate recognition must be accounted for as either amortizable or non-amortizable assets separately from goodwill. Otherwise, no changes are permitted in purchase price allocations for preJuly 1, 2001 acquisitions.
Whereas SFAS 141 specifies the rules for the acquisition of intangible assets acquired within a business combination, SFAS 142 sets forth the accounting requirements for the acquisition of intangible assets in other circumstances, whether acquired individually or as part of a group. SFAS 142 also specifies the post-acquisition accounting treatment for all intangibles, including those acquired through a business combination.
Acquisition of other intangibles (SFAS 142). An intangible acquired in a manner other than a business combination is recorded at fair value. Should a group of intangibles be acquired, the total cost of the acquisition should be allocated to the individual intangible assets based upon relative fair value. No recognition of goodwill can result from such a transaction.
Post-acquisition accounting (SFAS 142). Regardless of the initial source of acquisition, the post-acquisition accounting for all intangibles (including goodwill) is specified by SFAS 142. The first consideration for post-acquisition accounting is whether the intangible has a definite or indefinite life. (SFAS 142 specifically states that an indefinite life does not mean infinite.)
Intangibles with a definite life. Amortization over the assets useful life is required for intangibles with a definite life. The estimated life should be determined using pertinent factors, such as the period of expected use, legal or regulatory restrictions, the effects of obsolescence, etc. If an intangible has a finite life that cannot be precisely determined, an estimate of its useful life should be made. SFAS 142 also requires an evaluation of the remaining useful life of such assets for each reporting period; if a change occurs, the amortization amount should reflect the change. Should an intangible subsequently be determined to have an indefinite life, amortization should cease.
The amount amortized is the assets initial cost less any residual value, which is presumed to be zero unless certain conditions exist. If the asset has a life that extends beyond the current entitys use and the entity has a contract with a third party to purchase the asset at the end of the entitys use, a residual value other than zero may be used. Likewise, a residual value other than zero may be used when there is a current market for such assets or the anticipation of such a market at the end of the assets useful life.
Intangible assets with a definite life are subject to impairment review under SFAS 121 guidelines. If an impairment review indicates a loss, the basis of the intangible is reduced to the current carrying value. Subsequent recovery of such losses cannot be recognized.
Intangibles with an indefinite
life. Intangible assets with an indefinite life are not subject to amortization,
but are tested annually for impairment. Such a review compares the fair value
of the intangible to its carrying amount; the excess of carrying value over fair
value is an impairment loss that must be recognized. The corresponding decrease
in asset value becomes the new basis of the asset and subsequent recovery of such
losses cannot be recognized.
An intangible not subject to amortization should be reviewed during each reporting period to determine whether changed circumstances have altered its status. Should the asset subsequently be determined to have a finite life, it must first be subject to the impairment review guidelines of SFAS 142. The asset is then amortized prospectively in accordance with the requirements for amortizing assets with a definite life.
In a significant
departure from existing practice, goodwill is no longer amortized. Instead, a
two-step impairment test must be conducted annually at the reporting unit level.
A reporting unit is either an operating segment, as specified in paragraph 10 of SFAS 131, Disclosures about Segments of an Enterprise and Related Information, or a component, which is considered to be one level below an operating segment. According to the new standard, a component can be considered a reporting unit if it constitutes a business for which discrete financial information is available and segment management regularly reviews its operations.
The two-step impairment review process can be summarized as follows:
When determining the fair value of the reporting unit A, the quoted market price is the best available indicator. But other valuation methods, such as present value or an earnings multiple, can be used if the technique is consistent with the objective of measuring fair value.
The result in step two determines the amount of impairment loss and also reduces the basis of goodwill. The impairment loss may not, however, exceed the carrying amount of goodwill, and there is no subsequent recovery of impairment losses.
The implied fair value of the reporting unit goodwill cannot be determined directly. To establish this value, SFAS 142 prescribes a what-if test, that is, what if the reporting unit had been acquired in a business combination? Under this approach, SFAS 142 assumes that the fair value of the reporting unit was the price paid to acquire the reporting unit. In such circumstances, an entity would allocate the fair value of the reporting unit to the assets and liabilities acquired and assign any excess to goodwill. Thus, the excess equals the implied fair value of the goodwill for impairment testing purposes only.
The goodwill impairment test is normally performed annually and can be completed at any time during the year, as long as it is consistent. Once calculated, the fair value of the reporting unit may be used in subsequent years if certain criteria are met. It may be necessary to test more frequently if conditions indicate a decline in fair value below the reporting units carrying amount. See the Sidebar for examples of such events.
For the purpose of performing goodwill impairment testing, the assets acquired and liabilities assumed in a business combination are assigned to a reporting unit as of the acquisition date if they are employed in or related to the operations of the unit, or if they are used in determining the fair value of the unit.
These requirements also apply to corporate assets and liabilities (such as pension and environmental obligations) allocated to a reporting unit, assuming that the assignment of such is reasonable, supportable, and applied consistently.
Likewise, for purposes of goodwill impairment testing, the goodwill resulting from a business combination must be allocated to one or more reporting units as of the acquisition date based upon the expected synergies of the combination.
Disclosure and Transition Requirements
The aggregate amount of goodwill must now be presented as a separate line item in the statement of financial position. Goodwill impairment losses must appear as a separate line item in the income statement before the subtotal for income from continuing operations. A goodwill impairment loss associated with a discontinued operation will be included on a net-of-tax basis within the results of discontinued operations.
Separate information will be reported for goodwill, other intangible assets subject to amortization, and intangibles not subject to amortization. This can be done in a tabular format and should include the gross carrying amount, accumulated amortization, amortization expense for the current and five succeeding years, and certain additional information for goodwill by reporting segment.
In addition to the volume and detail of the new disclosure requirements, the various definitional differences and the compressed reporting periods will be problematic for publicly held companies. Some reporting requirements are tied to materiality, which is variable and company-specific, while others depend on information that is significant or major. Tax directors may find the requirement to disclose tax-deductible goodwill problematic, especially because it must be disclosed long before the tax return for the year of acquisition has been prepared.
SFAS 142 is applicable in fiscal years beginning after December 15, 2001, to all goodwill and other intangible assets recognized in the statement of financial position at the beginning of the fiscal year, regardless of when those intangible assets were initially recognized. For a calendar-year company, amortization of goodwill relating to acquisitions before July 1, 2001, will continue through December 31, 2001. For acquisitions after June 30, 2001, there will be no amortization of goodwill in 2001 or thereafter.
Goodwill in each reporting unit must be tested for impairment as of the beginning of the fiscal year for which SFAS 142 is applied in its entirety. If an impairment loss is recognized as a result of this transitional test, it should be reported in the income statement as the effect of a change in accounting principle.
Similar to SFAS 121, many companies will probably report goodwill impairment losses
in the year of adoption. Some preparers and users of financial statements are
already questioning the wisdom of replacing annual, predictable amortization of
goodwill with unpredictable impairment charges. Comparability over the years for
the same reporting entity and among various companies could be challenging.
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