FASB s new qualitative goodwill impairment assessment Implications and opportunities

FASB s new qualitative goodwill impairment assessment Implications and opportunities

Complying with the requirement for annual goodwill impairment testing can be time-consuming and expensive for companies, especially private organizations. Recently, preparers of private companies financial statements have been striving for a less costly and complex solution. In response to their efforts, the Financial Accounting Standards Board (FASB) proposed, issued, and recently finalized Accounting Standards Update (ASU) No. 2011 08 to the existing requirement, which introduced an optional qualitative impairment assessment. This article provides an overview of the current impairment testing requirement; the introduction of the qualitative assessment and evaluation process; the potential costs and savings associated with a qualitative assessment; and possible road bumps in its adoption and application.

Background Accounting Standards Codifi cation (ASC) 350-20-35-28 requires that the Goodwill of a reporting unit shall be tested for impairment on an annual basis and between annual tests in certain circumstances. The annual goodwill impairment test may be performed any time during the fi scal year provided the test is performed at the same time every year. 1 This requirement applies to all entities, both public and nonpublic, that have goodwill recorded on their balance sheet. The annual goodwill impairment testing requirement is a two-step process involving a thorough quantitative analysis of a company s reporting units. The ASU introduces an optional qualitative impairment assessment effective for annual and interim goodwill impairments tests in fi scal years beginning after December 15, 2011. Furthermore, the ASU applies to both public and nonpublic companies and early adoption is permitted. Due to the complexity of performing Step 1 of the annual goodwill impairment testing, most companies engage valuation specialists to conduct the analysis, especially when the entity has executed a series of business combinations and has goodwill residing in various reporting units. Auditors also rely on the help of valuation specialists to evaluate the underlying data and assumptions. The complexities associated with Step 1 of the goodwill impairment testing could arise from assignment of assets/liabilities to reporting units; supportability of forecasts from a market participant perspective; discount rates and terminal value assumptions; choices of valuation multiples; and environmental awareness with respect to fi nancial reporting fair value estimates. In response to concerns raised about the complexity and cost associated with performing Step 1 of the goodwill impairment testing, the FASB proposed an update to ASC 350, Intangibles Goodwill and Other. The ASU introduced the option to perform a qualitative assessment of a reporting unit before performing Step 1 of the test, if necessary. A company may, at its discretion, bypass the qualitative assessment for any reporting unit in any period. The traditional goodwill impairment test is a two-step process: Step 1 Determine whether the fair value of the reporting unit is less than its carrying amount, including goodwill. If so, proceed to Step 2. If the fair value of the reporting unit is greater than the carrying amount, further testing of goodwill for impairment is not performed. Step 2 Determine the implied fair value of the goodwill of the reporting unit by assigning the fair value of the reporting unit used in Step 1 to all the assets and liabilities of that reporting unit (including any unrecognized intangible assets) as if the reporting unit had been acquired in a business combination (ASC 805). Compare the implied fair value of goodwill with the carrying amount of goodwill to determine whether goodwill is impaired. Calculate impairment loss as the carrying value minus the implied fair value of goodwill. The ASU: Qualitative assessment The ASU, a qualitative assessment option, is intended to reduce the costs and complexity of performing the annual goodwill impairment test. The qualitative assessment requires management to perform the assessment using a more likely than not concept. In other words, to determine whether there is a greater than 50 percent chance that the fair value of the company s reporting units is less than their carrying values. If, after performing the qualitative assessment, management determines there is less than a 50 percent chance that the fair value of a reporting unit is less than its carrying amount, then performing the two-step test is unnecessary. If a company elects to forgo the qualitative assessment and transitions directly to the traditional Step 1 reporting unit valuation, additional documentation, and associated audit procedures regarding the qualitative assessment are not required. 1 FASB Accounting Standards Codifi cation 350, Intangibles Goodwill and Other. 2

According to ASC 350-20-35-3C, In evaluating whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, relevant events and circumstances shall be assessed. 2 Examples of such events and circumstances include the following: 1. Macroeconomic conditions: a. Deterioration in general economic conditions b. Limitations on accessing capital c. Fluctuations in foreign exchange rates d. Other developments in equity and credit markets 2. Industry and market considerations: a. Deterioration in the environment in which an entity operates b. Increased competitive environment c. Decline (both absolute and relative to its peers) in market-dependent multiples or metrics d. Change in the market for an entity s products or services e. Regulatory or political development 3. Cost factors: a. Increases in raw materials, labor, or other costs that have a negative effect on earnings and cash fl ows 4. Overall fi nancial performance: a. Negative or declining cash fl ows b. Decline in actual or planned revenue or earnings compared with actual and projected results of relevant prior periods 5. Other relevant entity-specifi c events: a. Changes in management, key personnel, strategy, or customers b. Contemplation of bankruptcy c. Litigation 6. Events affecting a reporting unit: a. Change in the carrying amount of net assets b. More-likely-than-not expectation of selling or disposing all, or a portion of, a reporting unit c. Testing for recoverability of a signifi cant asset group within a reporting unit d. Recognition of a goodwill impairment loss in the fi nancial statements of a subsidiary that is a component of a reporting unit 7. A sustained decrease (both absolute and relative to its peers) in share price Complexities might prompt the need for valuation specialists While the premise of the qualitative assessment appears simple, the highly subjective nature of a qualitative assessment may often be challenging. Deloitte 3 anticipates that a signifi cant number of companies (both public and nonpublic) that elect to take advantage of the qualitative assessment option could still require the assistance of external valuation specialists to assess the relevant factors and prepare robust documentation capable of satisfying an auditor s challenge. The scrutiny of fi nancial statements by the Securities and Exchange Commission might deter large public companies, particularly those with complex business operations and an extensive goodwill balance (and private companies with public debt) from adopting the qualitative assessment option without outside valuation assistance. Another challenge could be the availability of suffi cient audit evidence that supports management s assessment. In cases where companies have a material goodwill asset, it is anticipated that a preparer would need to develop a robust analysis of the qualitative factors to support an assertion that goodwill is not impaired. Auditors will adjust the nature and extent of the procedures performed on the qualitative assessment to take into consideration the subjective nature of the assessment. Private companies and non-fi lers that choose to adopt the qualitative assessment option would be subject to the same audit procedures as public companies. However, the extent of those audit procedures is still to be determined, and will likely vary by company and its risk profi le. Some companies may not have the personnel with the knowledge and expertise to perform the assessment and provide the level of documentation necessary to support the position that goodwill is not impaired. 2 Ibid. 3 As used in this document, Deloitte means Deloitte Financial Advisory Services LLP, a subsidiary of Deloitte LLP. Please see www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. 3

It is important to note that the scope of the qualitative testing is limited to goodwill. However, as of September 14, 2011, the FASB announced, based on feedback from the proposed ASU comments, that it had added a new short-term narrow-scope project to its Technical Agenda. The project will address how to simplify the manner in which an entity tests other indefi nite-lived intangible assets for impairment, as well as how to improve the consistency of impairment testing guidance among long-term asset categories. Potential to reduce impairment test cost and complexity The FASB s exposure draft was generally well-received by those responding with comment letters, with a signifi cant number supporting the goal of a reduction in cost and complexity for the impairment test. However, Deloitte s assessment of the uncertainties surrounding the qualitative impairment assessment and the potential diversity in practice caused by the ASU indicated that while the ASU could reduce the cost and complexity of goodwill impairment testing in certain cases, particularly for small private companies, the cost and complexities might not change signifi cantly for large, multinational, and public companies. The ASU could reduce cost and complexity if an entity recently performed a quantitative assessment of the fair value of a reporting unit and this fair value exceeded carrying value by a signifi cant margin or cushion. The estimated fair value could then be used as a baseline for subsequent interim and annual testing to analyze the effects of market conditions, industry changes, and other factors on the cushion. Cost savings could be realized if a valuation specialist performed both the initial quantitative testing used as the baseline and the interim and annual qualitative assessment thereafter. The company may consider under what conditions they would determine it appropriate to perform a quantitative test to ensure the accuracy and applicability of observable and market inputs. The ASU s basis for conclusions state that there is no requirement to perform a periodic update of a reporting unit s fair value estimate. Such a periodic update would enable companies to keep track of the relative movement of the reporting unit carrying value and its fair value. However, the ASU s basis for conclusions does note that the more time that elapses since an entity last calculated the fair value of a reporting unit, the more diffi cult it may be to make a conclusion based solely on a qualitative assessment of relevant events and circumstances. 4 The ability to adequately document, and then audit, a qualitative assessment may dissipate quickly for companies with frequent changes in reporting unit carrying value and volatile stock prices, as in today s markets. In addition, companies should note that in the ASU s Basis for Conclusions (BC 20) it states, The amendments do not change the guidance about other events affecting the recognition of goodwill that require an entity to calculate the fair value of a reporting unit, such as when an entity reorganizes its reporting structure in a manner that changes the composition of one or more reporting units and when an entity disposes of a portion of a reporting unit that constitutes a business. 5 As such, companies would likely need to perform a Step 1 valuation if the company reallocates assets/liabilities/goodwill or when there is a sale of a business from inside a reporting unit. Although these situations may not be frequent, it is another area where employing the qualitative option may not be feasible. The cost benefi t of performing the qualitative assessment could easily vanish in the following circumstances: The qualitative assessment indicated more than a 50 percent chance that the fair value of a reporting unit is less than its carrying amount; and The entity performed the qualitative assessment internally, but subsequently required the assistance of a valuation specialist to perform the current Step 1 of the impairment test. 4 FASB Accounting Standards Update No. 2011-08.BC 32. 5 FASB Accounting Standards Update No. 2011-08.BC 20. 4

Potential issues One of the potential issues that could arise from a qualitative assessment is the added complexity associated with developing appropriately detailed documentation of the qualitative factors to support an assertion that goodwill is not impaired. In a situation where an entity has recently performed a quantitative test to establish a baseline fair value a fair value that shows a suffi cient cushion for a company with a positive business outlook that is operating in a thriving economy with stable fi nancial markets it should be fairly easy to perform a qualitative assessment to determine that the traditional Step 1 is not necessary. However, in times of economic or market uncertainty, a qualitative assessment may be diffi cult to perform, and companies may be better served proceeding straight to Step 1. Auditing a qualitative assessment of a business s reporting units fair value relative to its carrying value is clearly a new concept. It presents a new challenge for companies and auditors. Without a quantitative analysis of market data to justify a position, it is possible that management could be more subjective in its interpretation of market factors to reduce the chances for impairment, thus introducing more risk into the process of evaluating goodwill. Currently under Step 1 of the impairment testing, an entity is required to determine whether the fair value of the reporting unit is less than its carrying amount, including goodwill. If it is, the entity proceeds to Step 2. Fair value is defi ned in ASC 820 as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. 6 ASC 820 requires that selected valuation techniques maximize the use of observable market data. The primary inputs for this tend to be publicly available, easily accessed, industry- and market-based data. A qualitative assessment does not fall under fair value as defi ned in ASC 820 and so could potentially lack such observable and verifi able market-based data. Concluding thoughts The qualitative assessment and evaluation process aims to reduce both the cost and complexity of goodwill impairment testing. However, such an assessment can be complicated, particularly when it is conducted amid continued global economic uncertainty and a volatile stock market that might not necessarily refl ect the actual value of the company. These uncertainties may impact management s ability to effectively assess the company and its reporting unit s future outlook and apply the factors previously discussed in the qualitative goodwill impairment assessment. Deloitte suggests that a company that seeks to benefi t from the ASU develop a clear plan for future interim and annual goodwill testing. The plan which should be discussed with the company s auditors and external valuation specialists should outline the kind of supporting documentation that will be necessary and how frequently the qualitative assessment should be performed. In addition, management may consider establishing criteria for when it would be appropriate to perform a quantitative Step 1 reporting unit valuation to reset the reporting unit carrying value and fair value relationship. Due to the new ASU, communications among company management, valuation specialists, and auditors regarding the specifi c applicability of the ASU to a company s facts and circumstances will be key to arriving at reasonable and supportable goodwill impairment testing conclusions. 6 FASB Accounting Standards Codifi cation 820, Fair Value Measurements and Disclosures. 5

Contacts Stamos Nicholas Principal Phone: +1 212 436 2357 Email: stnicholas@deloitte.com Greg Forsythe CFA, ASA Director Phone: +1 412 338 7722 Email: gforsythe@deloitte.com Omotade Akinkugbe Senior Associate Phone: +1 212 436 7764 Email: oakinkugbe@deloitte.com Alexander Greenhouse, CPA Associate Phone: +1 212 436 2180 Email: algreenhouse@deloitte.com This publication contains general information only and (Deloitte FAS) is not, by means of this publication, rendering accounting, business, fi nancial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualifi ed professional advisor. Deloitte FAS, its affi liates and related entities shall not be responsible for any loss sustained by any person who relies on this publication. Certain services may not be available to attest clients under the rules and regulations of public accounting. Copyright 2011 Deloitte Development LLC. All rights reserved. Member of Deloitte Touche Tohmatsu Limited