Accounting for goodwill just got a lot easier for public companies. In recently finalized guidance, the Financial Accounting Standards Board (FASB) eliminated the second step of the current two-step goodwill impairment test. That step requires certain companies, depending on the results of Step 1, to calculate the implied fair value of goodwill, a potentially complex and costly process. The new one-step test is similar to an alternative accounting treatment FASB offered to private companies starting in 2014.
Using the two-step test
Currently, companies that record goodwill on their balance sheets (because it was acquired in a merger or an acquisition) must test it annually for impairment. The rules require interim testing under certain circumstances. Companies must record a loss if the fair value of goodwill is less than its carrying amount.
Under the existing rules, goodwill impairment testing for public companies is a two-step process. In Step 1, a company determines the fair value of each reporting unit and compares it to its carrying amount, including goodwill. If a unit’s fair value exceeds its carrying amount, goodwill isn’t considered impaired and Step 2 isn’t necessary. If a unit’s carrying amount is greater than its fair value, however, the company proceeds to Step 2.
In Step 2, the company compares the “implied fair value” of a unit’s goodwill to its carrying amount. The implied fair value of goodwill is the unit’s fair value less the fair value (with certain exceptions) of its recognized net assets. In other words, the company treats a unit’s fair value as if it were the purchase price in a business combination, and allocates that value among the unit’s tangible and identified intangible assets (other than goodwill). If the unit’s fair value exceeds the value allocated to these assets, then the excess is the implied fair value of its goodwill. Any excess of the carrying amount of goodwill over its implied fair value is the amount of impairment loss that should be recognized.
A 2011 amendment gives companies the option of conducting qualitative impairment assessments that may allow them to avoid this complex quantitative impairment test. Under the qualitative option (known colloquially as “Step 0”), management evaluates certain indicators — including economic, industry, market and company-specific factors — to determine whether it’s more likely than not that a reporting unit’s fair value exceeds its carrying amount. If that threshold is met, further quantitative testing is unnecessary.
Under the current guidance, companies that have reporting units with zero or negative carrying amounts must perform a qualitative assessment to determine whether Step 2 is necessary.
Introducing the new test
Accounting Standards Update (ASU) No. 2017-04, Intangibles — Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment, simplifies impairment testing by eliminating Step 2. Under the new guidance, a company compares a reporting unit’s fair value to its carrying amount (Step 1 under the current test) and recognizes an impairment charge equal to the amount, if any, by which the carrying amount exceeds fair value (but not more than the total goodwill allocated to the unit). It also eliminates the requirement that reporting units with zero or negative carrying amounts perform qualitative assessments (subject to heightened disclosure requirements). But the new guidance retains the option of performing a qualitative assessment to determine whether quantitative testing is necessary.
For companies in jurisdictions in which goodwill amortization is tax deductible, recognizing a goodwill impairment may cause a change in deferred taxes. To avoid a never-ending cycle of impairment, the ASU provides a “simultaneous equation,” which essentially grosses up the impairment charge to reflect the deferred tax benefit.
Deciding on early adoption
Public companies that are SEC filers must adopt the new standard for annual or interim impairment tests performed in fiscal years beginning after December 15, 2019. Public companies that aren’t SEC filers should adopt the standard for annual or interim periods beginning after December 15, 2020. However, early adoption is permitted for testing dates after January 1, 2017.
Before making a decision about early adoption, however, companies should consider the potential impact on their financial statements, as the new standard may increase the likelihood of impairment losses for some companies. Talk with your advisors to help determine whether early adoption is the right course for your company.