Accounting for Business Combinations and Intangible Assets
By Anthony F. Cocco and Tommy Moores
In 1996, FASB decided to readdress the issues of business combinations and intangible assets. The prevailing accounting standards at that time were APBs 16 and 17, dating from 1970. In the interim, an increase in merger and acquisition activity highlighted the following problems:
A FASB special report, Issues Associated with the FASB Project on Business Combinations, was issued in June 1997. In 1998, the G4+1 issued a position paper, Recommendations for Achieving Convergence on the Methods of Accounting for Business Combinations, in which it recommended using only the purchase method. In December 1998, FASB issued an invitation to comment on the G4+1 position.
After considering the responses, in September 1999 FASB issued an exposure draft, Business Combinations and Intangible Assets, which indicated that only the purchase method should be used to account for business combinations. FASB also concluded that certain changes were necessary in the purchase method. In addition, based on numerous comments received on the 1999 exposure draft, FASB decided to reconsider accounting for goodwill. In 1999, an exposure draft proposed that goodwill should be amortized over a period not to exceed 20 years. In February 2001, FASB issued a revised exposure draft that separated goodwill and other intangible assets from business combinations. The new exposure draft reiterated FASBs commitment to disallow the pooling method and established goodwill impairment testing to replace amortization. FASB issued two final documents, SFAS 141, Business Combinations, and SFAS 142, Goodwill and Other Intangible Assets. SFAS 141 supersedes APB 16, Business Combinations, and SFAS 38, Accounting for Preacquisition Contingencies of Purchased Enterprises. SFAS 142 supersedes APB 17, Intangible Assets.
SFAS 141 requires that one of the entities involved in the business combination be designated as the acquiring entity. If the combination involves only the distribution of cash or other assets or the incurring of liabilities, the entity that distributes the cash or other assets or incurs the liabilities is usually the acquiring entity. In most business combinations that involve an exchange of equity interests, the entity that issues the equity securities is usually the acquiring entity. In cases involving the creation of a new entity, one of the existing combining entities must be determined as the acquiring entity. In some cases involving an exchange of equity interests, identification may be more difficult. In those cases, all relevant facts and circumstances should be considered, including the following:
Cost of the Acquired Entity
Where applicable, the fair value of the assets distributed and liabilities incurred should be used to measure the cost of the acquired entity. If the acquiring entity issues securities, the fair value of those securities should normally be used. The acquiring entity should also consider other factors (e.g., possible effects of price fluctuations, quantities traded, and issue costs) which suggest that the quoted market price of the securities should be adjusted in determining their fair value. If the fair value of the securities issued cannot be determined reliably, an estimate of the fair value of the net assets acquired would be used.
If a business combination involves contingent consideration, the contingent consideration is usually recorded when the contingency is resolved and consideration is issued or becomes issuable. Contingent consideration that is determinable at the date of acquisition, however, is included in the acquisition cost of the business combination and recorded at the acquisition date.
The acquiring entity must allocate the total acquisition cost to the assets acquired and liabilities assumed. All identifiable assets acquired (all assets other than goodwill) are assigned a portion of the acquisition cost equal to their fair values at the date of acquisition. Any excess of the acquisition cost over the amounts assigned to identifiable assets and liabilities is recognized as goodwill.
Allocation of Purchase Price
SFAS 141 treats the acquisition of goodwill and other intangible assets differently from tangible assets and liabilities. The assignment of the acquisition cost to specific assets and liabilities occurs as seen in the Exhibit.
The acquiring entity may not recognize any goodwill or deferred tax asset or liability previously recorded by the acquired entity. The acquiring entity must, however, recognize a deferred tax asset or liability for differences between the assigned values and the tax bases of the recognized assets acquired and liabilities assumed.
An intangible asset is recognized separately from goodwill if it meets either of two tests described in SFAS 141: the contractual test and the separability test. An intangible asset meets the contractual test if it arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the acquired entity or other rights and obligations. An intangible asset meets the separability test if it is capable of being separated or divided from the acquired entity and sold, transferred, licensed, rented, or exchanged, regardless of whether there is an intent to do so. For the purposes of the separability test, an intangible asset that cannot be sold, transferred, licensed, rented, or exchanged individually is, nevertheless, considered separable if it can be sold, transferred, licensed, rented, or exchanged in combination with a related contract, asset, or liability. Appendix A of SFAS 141 contains examples of intangible assets that meet the conditions for recognition separate from goodwill.
If the cost of the acquired entity exceeds the fair value of the net assets acquired, this amount should be recognized as goodwill. This goodwill amount will include any acquired intangible assets that cannot be separately recognized.
On the other hand, if the fair value of the acquired net assets exceeds the cost of the acquired entity, SFAS 141 specifies that this amount must be allocated as a pro rata reduction of the amounts that otherwise would have been assigned to all of the acquired assets except for
If the fair value of acquired net assets less cost is greater than the total fair value of eligible assets, eligible assets are reduced to zero and any remaining excess is recognized as an extraordinary gain.
Assignment of Assets and Liabilities to Reporting Units
As defined in SFAS 141, a reporting unit is an operating segment or one level below an operating segment (referred to as a component). Operating segment is defined in SFAS 131, Disclosures about Segments of an Enterprise and Related Information. A component of an operating segment constitutes a reporting entity if the component is a business for which discrete financial information is available and if segment management regularly reviews its operating results.
Assets acquired and liabilities assumed must be assigned to a reporting unit as of the acquisition date if both of the following criteria are met:
Corporate assets and liabilities must be assigned if they meet both of the above criteria. If assets or liabilities relate to multiple reporting units, they must be allocated among the relevant reporting units by using a methodology that is reasonable, supportable, and applied in a consistent manner.
All goodwill acquired in a business combination must be assigned to one or more reporting units as of the acquisition date. SFAS 142 specifies that goodwill should be assigned to reporting units expected to benefit from the synergies of the combination even though other assets or liabilities of the acquired entity may not be assigned to that reporting unit. The methodology used to assign goodwill must be reasonable, supportable, and applied in a consistent manner.
According to SFAS 142, the amount of goodwill assigned to a reporting unit is calculated similarly to the way the goodwill recognized in a business combination is determined. The fair value of each reporting unit represents a purchase price allocated to the assets and liabilities of the reporting unit. The goodwill is equal to the purchase price less the net assets (excluding goodwill) of the reporting unit.
In some instances, goodwill must be assigned to a reporting unit that was not assigned any of the assets acquired or liabilities assumed in the acquisition. In that case, the amount of goodwill assigned to the reporting unit is the difference between the fair value of the reporting unit before and after the acquisition.
Amortization of Intangibles Other than Goodwill
The amortization method selected by an entity should reflect the pattern in which the economic benefits of the intangible asset are consumed. If a pattern cannot be reliably determined, the straight-line method must be used. Only intangible assets with a finite life are amortized. Intangibles with an indefinite life are instead tested annually for impairment.
The useful life of an intangible asset is the period over which the entity expects the intangible asset to contribute to future cash flows. When establishing the useful life of an intangible asset, the entity should consider the following relevant information:
If there are no legal, regulatory, contractual, competitive, economic, or other factors limiting the useful life of the intangible asset, it is considered indefinite. Entities must reevaluate the useful life of intangible assets annually. If it has changed, the remaining carrying value is amortized prospectively over the revised remaining useful life. If an amortized intangible asset is subsequently determined to have an indefinite life, the asset is no longer amortized and is accounted for similar to other intangible assets that are not subject to amortization.
The amount of an intangible assets amortization is its acquisition cost less any residual value (net of costs of disposal). The residual value of an intangible asset is assumed to be zero at the end of its useful life unless the entity has a commitment from a third party to purchase the asset or unless the residual value can be determined by reference to an exchange transaction in an existing market that is expected to exist at the end of the assets useful life.
Impairments of Intangible Assets Other than Goodwill
In accordance with SFAS 144, recognized intangible assets other than goodwill that are subject to amortization must be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. A recognized intangible asset that is not amortized must be tested for impairment annually, and on an interim basis if events or circumstances indicate the asset might be impaired. The impairment test for an intangible asset with an indefinite life is a simple one-step testa comparison of its fair value to its carrying amount. If the carrying amount exceeds the fair value, an impairment loss is recognized equal to the excess. Once an impairment loss is recognized, it may not be recovered in subsequent periods.
The impairment test under SFAS 144 consists of two steps:
Step 1. Estimate the future cash inflows expected to be generated by the intangible asset (including its eventual disposition), less the future cash outflows expected to be necessary to obtain the inflows. If the sum of the expected undiscounted future cash flows is less than the carrying amount of the intangible asset, an impairment loss may need to be recognized.
Step 2. Compare the fair value of the intangible asset to its carrying amount. If the carrying amount of the intangible asset exceeds its fair value, this impairment loss is recognized. Estimates of expected future cash flows must be based on reasonable and supportable assumptions and projections. All available evidence must be considered in developing estimates of expected future cash flows.
If the carrying amount of an intangible asset with an indefinite life exceeds its fair value, this impairment loss is recognized.
Goodwill Impairment Test
Goodwill must be tested for impairment at least annually and during an interim period if events or circumstances would more likely than not reduce the fair value of a reporting unit below its carrying value. Other assets, tangible or intangible, are tested for impairment before goodwill.
An impairment loss is recognized if the implied fair value of a reporting units goodwill is less than its carrying amount. The goodwill impairment test consists of two steps:
Step 1. Compare the carrying amount of the reporting unit (including goodwill) to its fair value. If the carrying amount of the reporting unit is less than its fair value, goodwill is not impaired. If the carrying amount of the reporting unit is greater than its fair value, the second step is necessary to measure the amount of goodwill impairment.
Step 2. Compare the carrying amount of the goodwill to its implied fair value. If the carrying amount of the goodwill exceeds its implied fair value, this impairment loss is recognized.
The fair value of a reporting unit will not generally be equal to the net of the fair value of its identifiable assets and liabilities. Consequently, an entity must measure the fair value of the reporting unit as a whole. If the reporting units stock is actively traded, a quoted market price should be used as the basis for the measurement.
When a quoted market price is not available, the entity must estimate the fair value using the best information available, including prices for similar assets and liabilities and the results of other valuation techniques, such as the following:
An entity may carry forward the fair value of a reporting unit from one year to the next if all of the following criteria are met:
The implied fair value of goodwill is calculated just as in a business combination. An entity must allocate the fair value of the reporting unit to all of the assets and liabilities of that unit (including unrecognized intangible assets), as if acquired in a business combination. The implied fair value of goodwill would be equal to the excess of the purchase price less the assigned assets and liabilities.
The following are events or circumstances that indicate it is more likely than not that the fair value of a reporting unit is below its carrying value and that goodwill may be impaired:
Disposal of Goodwill
If a reporting unit is disposed of in its entirety, its goodwill is included in the carrying amount of the net assets disposed of when determining the gain or loss. When a significant portion of a reporting unit is disposed of, goodwill must be allocated to the net assets disposed of as if those net assets constitute a business. Allocations are based on the relative fair values of the business disposed of and the remainder of the reporting unit.
The notes to the financial statements must disclose the following information for the period in which a material business combination is completed:
If the amounts assigned to goodwill or to other intangible assets acquired in a material business combination are significant in relation to the total cost of the acquired entity, the acquiring entity must disclose the following:
When an entity engages in several combinations during a period that are individually immaterial, but material when aggregated, the notes to the financial statements must disclose:
Additionally, the entity must present the same disclosures for intangible assets and goodwill as it would for a material business combination.
If the combined entity is a public business enterprise and the combination is material (or the individual immaterial combinations are material in the aggregate), the following pro forma information is required in the period the combination occurs:
In calculating pro forma amounts, income taxes, interest expense, preferred stock dividends, and depreciation and amortization of assets must be adjusted to the accounting base recognized for each. Pro forma information related to results of operations for periods before the combination is limited to the results of operations for the immediately preceding period. The nature and amount of any material, nonrecurring items included in the reported pro forma results of operations must also be disclosed.
For intangible assets acquired either individually or with a group of assets, an entity must disclose the following:
Financial Statement Presentation
The aggregate amount of goodwill is presented as a separate line item in the balance sheet. The aggregate amount of goodwill impairment loss is presented as a separate line item in the operating section of the income statement unless the goodwill impairment loss is associated with a discontinued operation, in which case it is included net-of-tax within the results of discontinued operations.
At a minimum, intangible assets must be aggregated and presented as a separate line item in the balance sheet; however, this does not prevent an entity from presenting individual intangible assets or classes of intangible assets as separate line items. Amortization expense and impairment losses for intangible assets other than goodwill should be presented in income statement line items as appropriate.
For each impairment loss on an intangible asset not attributable to goodwill, the entity must disclose the following information in the notes to the financial statements for the period in which the loss is recognized:
For goodwill impairment losses recognized, the entity must disclose the following information in the notes to the financial statements for the period in which the loss is recognized:
SFAS 141 applies to all business combinations (except for combinations between two or more mutual enterprises) with an initiation date after June 30, 2001. The pooling-of-interest method is prohibited for those business combinations. The statement also applies to all business combinations accounted for by the purchase method for which the date of acquisition is July 1, 2001, or later.
For combinations between two or more mutual enterprises, SFAS 141 will not be effective until interpretative guidance related to the application of the purchase method to those transactions is issued. FASB plans to address these issues in a separate project.
All SFAS 142 provisions are effective for fiscal years beginning after December 15, 2001. All goodwill and other intangible assets recognized in an entitys balance sheet at the beginning of this fiscal year are affected, regardless of when those assets were initially recognized. Entities with fiscal years beginning after March 15, 2001, can elect early adoption if the first interim financial statements have not previously been issued.
Goodwill acquired in a business combination after
June 30, 2001, may not be amortized. Intangible assets other than goodwill acquired
after June 30, 2001 (either in a business combination or otherwise), will be amortized
or not in accordance with SFAS 142.
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