June 2002

Valuation for Impairment Testing: The Finance and Accounting Professional’s Guide to Valuing Reporting Units for Compliance with SFAS 142

By Travis W. Harms, CPA, Andrew K. Gibbs, CPA, and
Matthew R. Crow, CFA, ASA, with contributions by Z. Christopher Mercer, CFA, ASA, and
Owen T. Johnson, CPA/ABV, ASA, CBA

Peabody Publishing: $69.00; Paperback, 125 pp.; ISBN: 0970069839

Reviewed by William F. Chandler

During the 1990s bull market, many companies recorded substantial goodwill resulting from acquisitions financed by the acquirer’s own stock. When the bubble burst, such stock prices came falling down. But even though the value of the acquired goodwill has declined, the recorded value on the balance sheet can remain inflated for years if amortized over its finite life.

FASB addressed this issue in SFAS 142, Goodwill and Other Intangible Assets, which eliminated goodwill amortization for financial reporting purposes. Instead, acquired goodwill is to be tested annually to determine whether each reporting unit has been impaired.

The authors of this book provide timely guidance about how to comply with the valuation rules of SFAS 142, as well as practical guidance on selecting an impairment testing expert. Each chapter includes highlighted commentaries that enhance the material covered and provide helpful recommendations. Although the chapters that discuss the principles, methods, and techniques of business valuation are clearly presented, the book is written for professionals with prior experience.
The introduction discusses two fundamental valuation issues: the importance of defining the property interest to be valued and the steps included in the goodwill impairment test. The authors underscore that a clear definition of the property to be valued is essential in any valuation engagement and that the impairment test occurs at the reporting unit level. In determining the reporting unit, SFAS 142 allows aggregating economically similar components. The book does not illustrate how to define a reporting unit but underscores the importance of a proper definition at the outset. In one of its many helpful suggestions, it recommends that the analyst and the company clearly define the reporting unit before the engagement begins.

In addition to clearly defining the property interest to be valued, SFAS 142 requires a clear understanding of the appropriate definition of value. Chapter 1 compares and contrasts the SFAS 142 fair value standard with the fair market value standard. A helpful chart highlights three critical differences: First, the willing buyers and sellers under the fair market value standard are hypothetical parties but can be identifiable buyers and sellers under the SFAS 142 standard. Second, although each standard assumes that the seller is under no compulsion to sell, the SFAS 142 standard gives consideration to a buyer’s compulsion to buy. Third, fair market value is based on financial returns to the buyer, but the fair value standard is more comparable to “investment value” to the current owners.

Chapter 1 continues to discuss the applicable level of value to be applied in an impairment test. It concludes that value is determined on a control interest basis, giving consideration to the internal synergies available to the owner to enhance cash flows. It underscores the guidance contained in Appendix B of SFAS 142, which indicates that the cash flows used in deriving fair value “should be consistent with the most recent budgets and plans approved by management.” Because these cash flows capture internal synergies, the authors caution against the application of additional control premiums.

Chapters 2 through 5 review fundamental valuation principles and discuss the determination of earnings, cash flows, valuation approaches, and the cost of capital. Although the principles discussed in these chapters are not unique to SFAS 142 valuations, they provide for a good overview. The authors’ helpful reminders, suggestions, and sanity checks make these chapters valuable reading. For example, although the sum of the parts (the value of each reporting unit) may not equal the whole, the analyst should be prepared to reconcile the reporting unit values with the market capitalization of the consolidated entity.

Chapter 6 puts it all together with a clear discussion of the steps required to perform the impairment test, combined with helpful flowcharts and illustrations. The testing is performed by comparing the fair value of the reporting unit to its carrying value. If its fair value exceeds its carrying value, no further testing is required. If its fair value is less than its carrying value, impairment exists and further testing is required to determine the amount of the loss.

The fair value of goodwill cannot be determined directly; rather, it is equal to the residual value of the reporting entity as determined by subtracting the fair value of the reporting unit from the fair value of all other assets. Therefore, quantifying the impairment loss requires a determination of the fair value of all of the assets and liabilities of the reporting unit, which, in turn, requires a determination of both recorded and unrecorded intangible assets. Because the fair value of certain internally developed intangible assets is likely to exceed its recorded value, the analyst must separately determine the fair value of any intangible asset. If the value of these intangibles exceeds its recorded value, it will correspondingly increase the amount of the impairment loss.

The book is highly recommended reading for anyone who needs to understand or comply with SFAS 142. It covers its topic in a concise, readable style that leaves the reader with a clear understanding of the impairment testing process. Implementation requires an independent assessment not only of the value of the reporting unit, but also, when impairment exists, of each asset. The authors recognize the importance and difficulties of selecting the right expert and end with helpful omments.

William F. Chandler, JD, ASA, CFA, CPA/ABV, is managing director of Centerprise’s Legal & Scientific Analysis Group, Inc., in New York City, which provides business valuations and litigation support services.

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