ACCOUNTING

April 2002

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:

• Economically similar transactions could produce dramatically different financial statement results when accounted for as a pooling of interests.
  
• Entities that could not meet all of the conditions for the pooling method believed that they faced an uneven playing field in competing for acquisitions.
  
• The numerous inquiries regarding APBs 16 and 17 received by the staffs of FASB and the SEC consumed up to half of their time.
  
• The demand for internationally comparable accounting standards became more important.

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 FASB’s 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.

Acquiring Entity

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:

• The relative voting rights in the combined entity
  
• The existence of a large minority voting interest in the combined entity
  
• The composition of the governing body of the combined entity
  
• The composition of the senior management of the combined entity
  
• The terms of the exchange of equity securities.

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—

• financial assets other than investments accounted for by the equity method,
  
• assets to be disposed of by sale,
  
• deferred tax assets,
  
• prepaid assets relating to postretirement benefit plans, and
  
• any other current assets.

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:

• The asset will be employed in or the liability relates to the operations of a reporting unit.
  
• The asset or liability will be considered in determining the fair value of the reporting unit.

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.

Allocating Goodwill

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:

• The intended use of the intangible
  
• The expected useful life of a related asset or a group of assets
  
• Any legal, regulatory, or contractual provisions that may limit useful life
  
• Any legal, regulatory, or contractual provisions that enable renewal or extension of the intangible’s legal or contractual life without substantial cost
  
• The effects of obsolescence, demand, competition, and other economic factors
  
• The maintenance expenditures required to realize the intangible’s expected future cash flows.

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 asset’s 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 asset’s 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 test—a 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 unit’s 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 unit’s 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:

• Multiples of earnings, revenue, or similar performance measures are acceptable techniques if the comparison entity has comparable operations and economic characteristics, is observable, and if the relevant multiples are known.
  
• Present value of future cash flows should incorporate assumptions that marketplace participants would use in their estimates of fair value (if available without undue cost). If this information is unavailable, an entity may use its own reasonable and supportable assumptions. Entities should consult FASB Concepts Statement 7, Using Cash Flow Information and Present Value in Accounting Measurements.

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 assets and liabilities of the reporting unit have not changed significantly since the most recent fair value measurement.
  
• The most recent fair value measurement resulted in an amount that exceeded the carrying amount of the reporting unit by a substantial amount.
  
• Based upon an analysis of events and circumstances since the most recent fair value measurement, there is only a remote chance that a current fair value measurement would be lower than the current carrying amount of the reporting unit.

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:

• A current period operating or cash flow loss combined with a history of losses or forecast of continuing losses
  
• A significant adverse change in one or more assumptions used in the most recent determination of fair value
  
• A change in legal factors or an action or assessment by a regulator that is expected to have a significant adverse effect
  
• A more-likely-than-not expectation that a reporting unit or a significant portion thereof will be disposed of
  
• A test of a significant asset group within the reporting unit for recoverability under SFAS 144
  
• An other-than-temporary decline in the market capitalization of an entity or unit below the carrying amount of its net assets
  
• An other-than-temporary decline in the market price of the common stock of an entity or reporting unit
  
• A decline in the credit rating of publicly traded debt of an entity or reporting unit
  
• A goodwill impairment loss recognized by a subsidiary that is part of a larger or different reporting unit at a higher level of consolidation.

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.

Disclosures

The notes to the financial statements must disclose the following information for the period in which a material business combination is completed:

• Name and brief description of the acquired entity
  
• Percentage of voting shares acquired
  
• Primary reason for the acquisition
  
• Description of the factors that contributed to a purchase price that results in the recognition of goodwill
  
• The period for which the results of operations of the acquired entity are included in the acquirer’s income statement
  
• Cost of the acquired entity
  
• Number of shares issued or issuable
  
• The value of the shares and how this was determined
  
• Condensed balance sheet disclosing the amount assigned to each major asset and liability caption of the acquired entity at the acquisition date
  
• Contingent payments, options, or commitments specified in the acquisition agreement and their accounting treatment
  
• Amount of purchased research and development assets acquired and written off in the period, and the line item in the income statement in which the write-offs are aggregated
  
• For any purchase price allocation that has not been finalized, the reasons why and, in subsequent periods, the nature and amount of any material adjustments made to the initial allocation of the purchase price.

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:

• For each major intangible asset class subject to amortization, and in total, the—
  
• amount assigned,
  
• amount of any significant residual value, and
  
• weighted-average amortization period.
  
• For intangible assets not subject to amortization, the total amount assigned and amounts assigned to any major intangible asset class.
  
• For goodwill—
  
  • The total amount of goodwill and the amount that is expected to be deductible for tax purposes, and
    
  • The amount of goodwill by reportable segment (for enitites required to disclose segment information, unless not practicable).

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:

• The number of entities acquired and a brief account of each.
  
• The aggregate—
  
  • cost of the acquired entities,
    
  • number of equity interests issued or issuable and the value assigned to them, and
    
  • amount of any contingent payments, options, or commitments, and their accounting treatment.

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:

• Results of operations for the current period as if the business combination occurred at the beginning of the period, unless the acquisition occurred at or near the beginning of the period.
  
• Results of operations for the comparable prior period as though the business combination had been completed at the beginning of that period, if comparative financial statements are prepared.
  
• At a minimum, the entity must disclose—
  
  • Revenue,
    
  • Income before extraordinary items and cumulative effect of accounting changes,
    
  • Net income, and
    
  • Earnings per share.

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:

• For each major intangible asset class subject to amortization, and in total, the—
  
• Amount assigned,
  
• Amount of any significant residual value, and
  
• Weighted-average amortization period.
  
• For intangible assets not subject to amortization, the total amount assigned and the amounts assigned to major intangible asset classes.
  
• The amount of research and development assets acquired and written off in the period, and the line item in the income statement in which the amounts written off are aggregated.

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.

Impairment Losses
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:

• A description of the impaired intangible asset
  
• The facts and circumstances that led to impairment
  
• The amount of the impairment loss and the method for determining the fair value of the intangible
  
• The caption in the income statement or statement of activities in which the impairment loss is aggregated
  
• The segment in which the impaired intangible asset is reported under SFAS 131 (if applicable).

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:

• A description of the facts and circumstances that led to impairment
  
• Amount of the impairment loss
  
• The method of determining the fair value of the reporting unit
  
• If the impairment loss is an estimate that has not yet been finalized—
  
• That fact and the reason the estimate has not been finalized, and
  
• In subsequent periods, the nature and amount of any significant adjustment to the initial estimate of the impairment loss.

Effective Date

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 entity’s 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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