As one comment letter responding to the FASB’s recent Invitation to Comment (ITC) on subsequent accounting for goodwill noted “how to account for goodwill is a question that has long perplexed the accounting profession.” Unfortunately, I do not believe FASB’s recent roundtable to discuss the issue, or the over 100 comment letters received in response to the ITC, have revealed an easy path to addressing this perplexing issue. But why is the accounting for goodwill such a complicated issue?
Not all accountants agree on what goodwill is. Fundamentally, most will agree that goodwill represents the excess of the price paid for a business above the separately identified assets and liabilities; but beyond that, what is it? And, more importantly, is it even an asset?
I remember debating that very question with individual board members when I was a member of the FASB. Clearly, the banking industry does not believe goodwill meets the current definition of an asset as evidenced by the comment letters received from the American Bankers Association (ABA) and some of the major financial institutions that responded to the ITC. The ABA writes “goodwill represents the premium for buying a business for a higher price than that supported by the identifiable assets and liabilities of that business. However, in our view this amount does not represent a probable future economic benefit. Rather, this premium represents a deployment of capital that allows the opportunity to utilize the acquired identifiable assets in combination with the company’s existing assets (prior to the acquisition) for future economic benefit (emphasis added) in excess of the fair value of the identified acquired assets.” In commenting on Amazon’s acquisition of Whole Foods in 2018, the president of a financial research firm indicated that Amazon was mostly buying the opportunity to break into the grocery business, not because of Whole Food’s existing business. He then indicated that Amazon’s issue is going to be whether it can strategically create the value that is now reflected on the balance sheet as goodwill. Does that sound like it meets the FASB’s definition of an asset as “probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events?” Is the opportunity to create value in the future an asset today?
The ITC specifically states that it will not consider as an acceptable alternative to write off goodwill on the acquisition date (which presumably would be the accounting if goodwill did not meet the definition of an asset) because “the weight of … past feedback has been significantly more negative than positive.” So, right out of the box the FASB appears to have “assumed away,” perhaps, the question that makes the accounting for goodwill accounting so perplexing; after all, what is the appropriate accounting for something recorded as an asset that might not even meet the definition of an asset?
The 15 years I spent at the FASB caused me to lean more towards improving accounting through incremental changes, rather than through, what I would characterize as “major” changes. However, I can’t help but wonder whether ignoring a legitimate fundamental question such as, whether goodwill really meets the definition of an asset, will lead to the best answer in terms of providing users with financial information that meets the cost/benefit test. At the same time, I understand some of the factors the FASB may have considered in deciding not to address this fundamental question. First, the adoption of an immediate write-off of goodwill would diverge from the accounting required by international accounting standards. Second, there could be significant resistance to the notion of an immediate write-off. (Just imagine being a CEO of a company explaining to your investors why you decided to invest $20 billion in an acquisition that resulted in a $15 billion reduction in stockholders’ equity!) Finally, an immediate write-off could, in some circumstances, prevent companies from the legal ability to pay dividends.
Before proceeding further, let’s briefly review the existing requirements of accounting for goodwill:
- Goodwill is recorded on the day of the acquisition and is measured at the excess of the purchase price over the fair value of the identified assets and liabilities of the acquired company.
- Goodwill is not amortized. The FASB’s basis for not amortizing goodwill, as required prior to the issuance of SFAS 142 in 2001, was that not all goodwill declines in value and for that which does, it does not necessarily decline ratably after the acquisition.
- When SFAS 142 was implemented, it required an annual impairment test in which entities estimate the fair value the reporting unit in which goodwill resides (Step 1), and then allocate the fair value of the reporting unit to its identifiable assets and liabilities (Step 2) to arrive at a value of goodwill, which, if below the carrying value, required an impairment charge to be recorded.
- In 2011 the FASB issued ASU 2011-08, which allowed companies the option to assess qualitative factors (Step 0) to determine whether the entity needed to perform the quantitative tests referred to in the previous bullet. This was adopted to reduce the cost of implementing the impairment test.
- In 2017 the FASB issued ASU 2017-04, which removes Step 2 of the quantitative test. Under this change, an impairment is recorded at the amount by which the fair value of the reporting unit (including goodwill) is less than its carrying value. This change, which is not yet fully effective, was also created to reduce the cost of implementing the impairment test.
- Additionally, simplifications were adopted for privately held entities.
Despite the simplifications referred to in the preceding bullets, many FASB constituents have told the FASB that the benefits of the current accounting for goodwill (i.e., non-amortizing still do not justify the cost to prepare and audit the impairment assessments.
I listened to the recordings of the roundtables held to discuss the issues highlighted in the ITC, and I read the comment letters. Attendees of the roundtable and comment letter writers represented the FASB’s three major constituent groups: preparers of financial statements, auditors, and users of financial statements. Not only is there diversity between these three constituent groups, there is also diversity of views within each of the groups.
Ed Trott, a former FASB member, observed in his comment letter that it should not matter how many respondents supported amortization, or how many thought an annual impairment test should be scrapped for a test that need only be performed upon the occurrence of certain triggering events, or the number of respondents on either side of the other issues noted in the ITC. Rather, what should be considered is whether there is relevant information that is provided in financial statements when impairments do (or do not) occur, and whether the cost of supplying that information justifies its benefits.
Consistent with Mr. Trott’s suggestions, the types of things I believe the FASB should consider include: will relevant information still be provided if FASB were to revert back to an amortization approach; does the information that is provided after the simplifications provided for in ASUs 2011-08 and 2017-04 provide investors with sufficient information, or, did the reduction of benefits of those simplifications (i.e., information) exceed the reduction of cost to provide the information; are the assertions of those people who proclaim that users ignore goodwill and impairment charges accurate; are there additional changes to the accounting for goodwill or disclosures that can reduce costs further and still provide investors with the information they need.
These issues are not easy to address, especially since what goodwill represents varies from acquisition to acquisition. Many people commenting on the ITC acknowledged that embedded in goodwill are various “things”: workplace in force; synergies expected from combining the entities; the cost of acquired future profits; the cost of an ongoing stream of cash flows expected from the utilization of institutional knowledge and the ability of acquired management to create returns from that knowledge; the cost of entering into a business area or industry directly, rather than growing it organically; an overpayment for the acquired business; and the list goes on.
Depending on the relative contribution of these various elements to the amount of goodwill, one could make a strong case for amortization, or, a strong case for no amortization. Additionally, many commenters raised questions about the period over which goodwill should be amortized. Should the period be prescribed, or should the company determine an appropriate period? If the company was required to determine the amortization period, would the cost to determine and audit the amortization period justify the benefit of providing that information, especially when many investors indicate they ignore the amortization charge. In any event, even though many respondents to the ITC supported an amortization approach, few, I believe, expressed the view that a straight-line amortization would provide more relevant information to financial statement users than what is provided under today’s impairment model. Rather, they supported amortization based on their view that users learn little incrementally from the information that is embedded in an impairment charge, and, consequently, the benefit of that information is not worth the cost to provide it. Yet, some users at the roundtables fundamentally disagreed with those individuals who indicated users learn little from an impairment charge.
One significant aspect of goodwill that makes the accounting difficult is that acquired businesses rarely continue to exist as individual components of an entity. Rather, the acquired business frequently is integrated with existing businesses of the acquiror, and, once combined, the value of the reporting unit, which is the level at which goodwill is tested, can include unrecorded organically created intangible assets of the units with which the acquired business is combined that can easily mask a reduction in value of acquired goodwill.
Some respondents to the ITC recommended moving the level at which an impairment is assessed up to the operating segment level. This was suggested because many companies do not organize their accounting records based on reporting units. Allowing companies to consider evaluating goodwill at an operating segment level would reduce the cost of implementing the standard. However, such a move could easily result in fewer impairments since the fair value of the components comprising the operating segment could include even more unrecorded (organic) goodwill or other intangibles than what exists at the reporting unit level. Clearly, if these unrecorded intangibles (or increases in the fair value of recorded net assets) exceed any reduction in the value of acquired goodwill there would be a reduction in information to investors. Yet again, those that supported this approach appeared to do so because of their view that investors appear not to place a lot of value on the accounting for goodwill.
One of the challenges the FASB faces is gathering and analyzing the views of the investor, or user, community. It is extremely important for the FASB to understand what information is relevant to users and how users use (or would use) that information. However, users do not frequently respond to exposure documents in the form of comment letters. And, when roundtables are held, as in the case of the goodwill ITC, there are only a handful of users represented at the table because of space restrictions. Additionally, it is common for there to be a wide array of views expressed by individuals in the user community. The goodwill ITC was no exception.
From a practical standpoint, I do not believe the comment letters and roundtables resulted in any earth-shattering breakthrough in how to account for goodwill. Recent simplifications created to reduce the cost of accounting for goodwill impairments have clearly reduced both the potential for identifying impairments, and, when identified, the accuracy of the amounts of impairments. Acquired goodwill frequently loses its identity once an acquired business is integrated into an acquiring entity’s existing businesses, which, in turn, makes its accounting even more difficult. In my mind, the FASB needs to better understand what information users need to evaluate business combinations before proceeding with any more changes in the accounting for goodwill. I would think users would welcome robust disclosure of both the purpose and expectations about a business acquisition, both quantitative and qualitative information. Then, in ensuing years, I expect users would be interested in how the acquisition has impacted the company’s performance and whether the purpose and expectations that existed when the entity was acquired were in fact met. While I understand the reluctance to consider direct write-off as a viable option, I would not dismiss it without a robust discussion. Clearly, such a move would remove any cost associated with impairment, and, combined with the type of information proposed above, may satisfy the needs of users more than the information content that is embedded in today’s impairment model.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Larry Smith is a Senior Managing Director in FTI Consulting’s Forensic & Litigation Consulting segment serving as a member of FTI Consulting’s National Office, consulting with engagement teams and clients on complex accounting issues and as a testifying expert in litigation matters involving the application of GAAP. On June 30, 2017, Larry completed his second five-year term as a member of the Financial Accounting Standards Board.
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