Mark Zyla

FASB Issues Accounting Standards Update 2010 – 28

When to perform step two of the goodwill impairment test for reporting units with zero or negative carrying amounts.

January 10, 2011
by Mark Zyla CPA, ABV

Under FASB ASC 350, Intangibles — Goodwill and Other (formerly SFAS No. 142), goodwill recognized as part of a business combination is not amortized for financial reporting purposes, but is rather tested for impairment at least annually. FASB ASC 350-20 provides specific guidance for testing goodwill for impairment using a two-step process:

  1. The first step is a test for potential impairment.
  2. The second step is performed to determine whether impairment has occurred and to measure the amount of the impairment. This is done only if the reporting unit fails the first step.

Under the first step, the reporting unit’s fair value, including goodwill, is measured by using an appropriate valuation technique, such as a discounted cash-flow method. Fair value is compared to the reporting unit’s carrying amount or book value. If the reporting unit’s fair value is greater than its carrying amount, the reporting unit’s goodwill is not considered to be impaired. If the reporting unit’s fair value is less than its carrying amount, then the second step is performed to determine if goodwill is impaired.

Under the second step, goodwill’s implied fair value is calculated by subtracting the sum of the fair values of all of the tangible and other intangible assets less liabilities existing on the measurement date from the fair value of the reporting unit. The calculation of the implied fair value of goodwill includes all assets and liabilities existing on the test date, whether or not they were previously recorded. There is no impairment if the implied fair value of goodwill exceeds its carrying amount. Goodwill is impaired if its carrying amount exceeds its implied fair value and because of which an impairment loss should be recognized equal to that excess.

The fair value of a reporting unit is determined in accordance with guidance in paragraphs 22-24 of FASB ASC 350-20-35 and in FASB ASC 820. There is significant diversity in practice about the appropriate interest to be measured when comparing the carrying amount of reporting unit to its fair value under step one of goodwill impairment testing. Many valuation specialists believe the appropriate interest to be measured is the invested capital of the reporting unit (equity plus interest bearing debt). The supporters of this approach argue that measuring invested capital eliminates any issues related to how debt is allocated to the reporting unit or how the entity actually financed it. Other valuation specialists take the position that the appropriate interest to be measured is the equity of the reporting unit. This belief is often based upon FASB ASC 350-35-22 and its reference to quoted market prices. Yet other valuation specialists consider net assets to be the appropriate interest being measured. However, under most circumstances, the interest used as the basis for comparing carrying amount and fair value under step one does not matter as long as the interest is used consistently in the measurement process.

However, one circumstance in which the basis of measurement may matter is when the carrying amount of the equity is either zero or negative. In this situation, if the first step of the goodwill impairment test is performed on an equity basis, some have argued that the reporting unit will always pass the step one test because equity’s fair value will always exceed its zero or negative carrying amount. Supporters of this view believe that fair value of equity will always be positive because an investment in equity will have some value even if that value may be de minimis. This is due to the nature of equity itself. In other words, investors in equity typically do not have exposure on the downside beyond their initial investment. However, they may participate in the upside of their investment, even if that upside seems remote.

The lack of clarity created a wide diversity in practice among entities which had negative carrying amounts. The FASB recently addressed this issue in Accounting Standards Update (ASU) 2010–28, When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts. ASU 2010–28 amends FASB ASC 350–20 to require performing the second step of the goodwill impairment test if the carrying amount of the reporting unit is zero or negative and if qualitative factors indicate that existence of a goodwill impairment is more likely than not.

Specifically, the newly added paragraph FASB ASC 350–20–35–8A states that “If the carrying amount of a reporting unit is zero or negative, the second step of the impairment test should be performed to measure the amount of impairment loss, if any; when it is more likely than not that a goodwill impairment exists. In considering whether it is more likely than not that goodwill impairment exists, an entity shall evaluate whether there are adverse qualitative factors.”

The qualitative factors are consistent with the existing guidance and examples in FASB ASC 350-20-35-30 and include the following:

  1. A significant adverse change in legal factors or in the business climate;
  2. An adverse action or assessment by a regulator;
  3. Unanticipated competition;
  4. A loss of key personnel;
  5. A more-likely-than-not expectation that a reporting unit or a significant portion of a reporting unit will be sold or otherwise disposed of;
  6. The testing for recoverability under the “Impairment or Disposal of Long-Lived Assets” subsection of FASB ASC 360–10 of a significant asset group within a reporting unit;
  7. Recognition of a goodwill impairment loss in the financial statements of a subsidiary that is a component of a reporting unit (Financial Accounting Standards Board Accounting Standards Update 2010–28, Intangibles — Goodwill and Other (Topic 350): When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts).

Additional information about this topic as well as other issues in Fair Value Measurements can be found at both the AIPCA’s Fair Value Measurement Workshop to be held in the AICPA’s New York City offices March 7 to March 8 as well as at the AICPA’s Fair Value Measurement Conference to be held June 6 to June 7 in Las Vegas. Also, the AICPA has formed a task force that is pursuing the development of a Practice Aid to address issues related to the impairment testing of goodwill, as well as indefinite-lived intangible assets and other long-lived assets.

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Mark L. Zyla, CPA, ABV, CFA, ASA is a managing director of Acuitas, Inc. a valuation consultancy firm based in Atlanta Georgia. He is author of Fair Value Measurements: Practical Guidance and Implementation, published in 2010 by John Wiley & Sons.