The Importance of Expert Valuation Advice
By Gabe Lengua
Two recent revolutionary FASB accounting standards were finalized in June 2001. SFAS 141, Business Combinations, and 142, Goodwill and Other Intangible Assets, dramatically changed GAAP governing business combinations. SFAS 141 eliminated the popular pooling of interest method. SFAS 142 addressed the financial accounting and reporting for acquired goodwill and other intangibles. It basically did away with goodwill amortization, and limited amortization to intangibles with determinable useful lives.
FASB clearly needed to deal with business combinations. Pooling criteria did not distinguish economically dissimilar transactions. As a result, similar business combinations were accounted for using different methods that produced dramatically different financial statements. Many believed that better information was needed about increasingly important intangible assets, and that goodwill amortization expense was not useful in analyzing investments.
While companies typically seek some guidance with the interpretation of a new statement, these new pronouncements create a specific need for outside assistance from qualified and knowledgeable valuation professionals. Although some companies have taken it upon themselves to try to deal with the valuation and impairment issues, such in-house work can cause headaches down the road.
Goodwill. The new rules call for companies to assess goodwill for impairment each year, and more frequently if circumstances warrant. A company begins the two-step impairment test by dividing itself into reporting units that are the company’s operating segments or the individual businesses within those operating segments. SFAS 131 defines an operating segment as a component of an enterprise for which separate financial information is available and often reviewed by a decision maker. Additionally, criteria such as the nature of the product or service, the production process, or the customer are taken into consideration when determining whether a component of the business is a separate operating segment.
In step one of the impairment test, companies compare the estimated fair value of each reporting unit with acquired goodwill to the carrying amount of that unit’s assets and liabilities. If the fair value of the reporting unit exceeds its carrying amount, no goodwill impairment charge is taken. If fair value of the reporting unit is below its carrying amount, then step two of the impairment test is necessary. It requires the hypothetical allocation of the reporting unit’s estimated fair value to its assets and liabilities, as though the reporting unit had just been acquired in a business combination. From this, the current fair value of the unit’s goodwill is determined. The impairment loss is the amount by which the fair value of goodwill is less than that unit’s goodwill carrying amount. Impairment losses are reported as an operating expense, except at the transition date.
Other intangibles. The new rules require acquired intangibles to be separately recognized if the benefit of the intangible asset is obtained through contractual or other legal rights, or if the intangible asset can be sold, transferred, licensed, rented, or exchanged, regardless of the acquirer’s intent. Some of the intangibles that must be recognized separately include trademarks, noncompete agreements, customer lists, order backlog, supply contracts, and secret formulas or processes. An intangible asset with a determinable useful life is amortized, while an intangible asset with an indefinite useful life is not. An indefinite useful life is defined as extending beyond the foreseeable horizon. Indefinite does not mean infinite, nor is an intangible asset’s useful life considered to be indefinite because a precise finite life cannot be determined. If this sounds easy, it is probably time to call an outside professional.
There are numerous implementation issues related to SFAS 141 and 142, including identifying the reporting units, complying with all new disclosure requirements, and assessing the effect on combinations already consummated (e.g., if in a prior business combination identifiable intangibles were separately valued but were included in goodwill, then upon adoption the company must reclassify that intangible asset out of goodwill).
The most complex implementation issue is the fair-value-based goodwill impairment test. Companies can use different methods to determine fair value, including: a market approach, which estimates fair value by analyzing the characteristics of comparable companies or the recent sale of similar companies; an income approach, which is based on discounting expected future cash flows; or a cost approach, which estimates fair value by determining the cost of replacing the depreciated asset. All of these methods have advantages and disadvantages that are important for companies to understand. For example, the market approach appears to be fairly straightforward and intuitively appealing, but what is comparable? Comparable industries? Comparable growth? Comparable cashflow? Comparable risk? The income approach is intuitively appealing, but requires an estimate of future cash flows and an analysis of risk of achieving those. The cost method is generally the easiest to apply but the least useful, because it does not take into account earning power.
As the SEC chief accountant has indicated, whether it is in conjunction with the acquisition of a business, the performance of the impairment test, or the evaluation of recorded intangible assets in transition, companies should generally obtain the assistance of a competent and knowledgeable professional to assist in the process. While companies may not want to budget for the cost of an outside professional to assist in the process, it will almost certainly be money well spent.
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