GOODWILL ACCOUNTING SIMPLIFIED FOR PRIVATE COMPANIES

ACCOUNTING

Goodwill Accounting Simplified for Private Companies

BY BILL FOOTE, CPA, AND DAVID SEMENDINGER, CPA

ACCOUNTING

In July 2013, the Private Company Council (PCC) released an exposure draft simplifying the accounting for goodwill subsequent to a business combination. The alternative accounting model was then finalized by PCC in October 2013, subject to endorsement by the Financial Accounting Standards Board (FASB).

In January 2014, FASB issued Accounting Standards Update No. 2014-02, Accounting for Goodwill: a consensus of the Private Company Council (ASU 2014-02). ASU 2014-02 is significant because it relaxes the requirements of previous standard setting with respect to goodwill. The fact that ASU 2014-02 was the first ASU specifically for private companies also makes it noteworthy.1

THE GOODWILL ACCOUNTING FRAMEWORK UNDER ASC 350

Goodwill is a non-current asset that results from a merger or acquisition transaction (i.e., a business combination). Under Accounting Standards Codification 805, Business Combinations (ASC 805), goodwill is the residual value, calculated as the excess of (i) the fair value of the consideration over (ii) the fair value of the identifiable assets net of liabilities. Certain identifiable intangible assets acquired in a business combination are amortized over estimated useful lives. Goodwill, however, is not amortized.2

The accounting for goodwill subsequent to the acquisition date is spelled out in Accounting Standards Codification 350, Intangibles — Goodwill and Other (ASC 350). Issued June 20013, ASC 350 originally required each of a company’s reporting units to test goodwill for impairment annually using a two-step model. Step 1 involves comparing a reporting unit’s fair value to its carrying amount. If the reporting unit’s fair value is greater than its carrying amount, no further testing is required. If the reporting unit’s fair value is less than its carrying amount, Step 2 is required in order to measure the amount, if any, by which goodwill is impaired. Step 2 of the ASC 350 impairment test requires a hypothetical purchase price allocation to be performed (as of the testing date) in order to measure the impairment loss.

In July 2012, ASU 2012-02 introduced an optional qualitative assessment prior to the performance of Step 1. Referred to as Step 0, the purpose of the qualitative assessment is to determine if it is more likely than not (i.e., better than a 50 percent chance) that a reporting unit’s fair value is below its carrying amount. The Step 1 (and possibly Step 2) test would then need to be performed only if it is more likely than not that a reporting unit’s fair value is less than its carrying amount. Examples of events/circumstances that companies can evaluate with respect to the Step 0 assessment are shown in the sidebar on page 28.

Over time, concerns have been expressed that the goodwill accounting model under ASC 350 was overly complex and burdensome. This led the PCC to place goodwill accounting on its agenda in 2013.4 THE GOODWILL ACCOUNTING FRAMEWORK UNDER ASU 2014-02

ASU 2014-02 establishes an Accounting Alternative with respect to goodwill that private companies are permitted (but not required) to adopt. Under the new framework, goodwill can be amortized over a period not to exceed 10 years. While 10 years is the default amortization period, a shorter useful life is permitted if supported by the facts and circumstances. The Accounting Alternative, if adopted, would be applied prospectively generally to business combinations that occur after 2014. However, early adoption for 2014 or even 2013 business combinations (assuming the company’s 2013 financials have not yet been issued) is allowed.

But what about goodwill that’s already on the books? ASU 2014-02 states the following with respect to pre-existing goodwill amounts: “Goodwill existing as of the beginning of the period of adoption shall be amortized prospectively on a straight-line basis over 10 years, or less than 10 years if an entity demonstrates that another useful life is more appropriate.”

Private companies would still need to monitor goodwill for impairment under the PCC’s new goodwill framework. Unlike ASC 350, which mandated impairment testing at the u

ACCOUNTING

STEP 0 QUALITATIVE ASSESSMENT CONSIDERATIONS

• Macroeconomic conditions such as a deterioration in general economic conditions, limitations on accessing capital, fluctuations in foreign exchange rates, or other developments in equity and credit markets

• Industry and market considerations such as a deterioration in the environment in which an entity operates, an increased competitive environment, a decline in market-dependent multiples or metrics (consider in both absolute terms and relative to peers), a change in the market for an entity’s products or services or a regulatory or political development

• Cost factors such as increases in raw materials, labor or other costs that have a negative effect on earnings and cash flows

• Overall financial performance such as negative or declining cash flows or a decline in actual or planned revenue or earnings compared with actual and projected results of relevant prior periods

• Other relevant entity-specific events such as changes in management, key personnel, strategy or customers; contemplation of bankruptcy; or litigation

• Events affecting a reporting unit such as a change in the composition or carrying amount of its net assets, a more-likely-than-not expectation of selling or disposing all, or a portion, of a reporting unit, the testing for recoverability of a significant asset group within a reporting unit or recognition of a goodwill impairment loss in the financial statements of a subsidiary that is a component of a reporting unit

• If applicable, a sustained decrease in share price (consider in both absolute terms and relative to peers).

Source: ASC 350-20-35c reporting unit level, when a private company adopts ASU 2014-02 it makes an election to test all goodwill for impairment at either the reporting unit level or at the entity level. The entity level option may be attractive to companies that found it difficult to properly identify reporting units for purposes of ASC 350 compliance.

While ASU 2014-02 does provide for a goodwill impairment test, it is only required when a triggering event occurs indicating the fair value of the entity (or the reporting unit) may be less than its carrying amount. In evaluating whether a triggering event has occurred, private companies should consider the factors set forth in the Step 0 qualitative assessment (see sidebar at left).

The ASU 2014-02 impairment test is streamlined in comparison to the impairment model otherwise required by ASC 350. Under ASU 2014-02, the fair value of the entity (or reporting unit) is compared to its carrying amount. If the fair value of the entity (or reporting unit) is more than its carrying amount, no impairment is recognized. If the fair value of the entity (or reporting unit) is less than its carrying amount, then an impairment loss is simply recognized for the excess of the carrying amount over fair value.5 In that case, the adjusted goodwill balance (i.e., post-impairment) would be amortized over the remaining useful life.

All other things being equal, goodwill impairment will be less frequent if the Accounting Alternative is adopted. This is because the goodwill balance will be decreasing by at least 10 percent each year (creating a larger “safety zone”), unlike in the past when the goodwill amount remained static absent impairment. As always, goodwill impairment is a one-way street; once an impairment adjustment has been made, it cannot be subsequently reversed. In addition, it is important to note that business combination accounting under ASC 805 has not changed; the manner in which goodwill is determined on day one is still the same, whether a private company adopts ASU 2014-02 or not.

CASE STUDY

Now let’s take a hands-on look at the ASU 2014-02 goodwill framework. Assume XYZ Corp. (XYZ) has a fiscal year ending Dec. 31 and it adopts ASU 2014-02 on Jan. 1, 2014. XYZ acquires PDQ Corp. (PDQ) for $100 on Dec. 31, 2014. Accounting for the business combination under ASC 805, XYZ allocates the purchase price to the following PDQ assets and liabilities: working capital — $10; property and equipment — $10; customer relationships — $30; and goodwill — $50. Absent a triggering event, XYZ would record (as part of continuing operations) $5 of goodwill amortization in each year from 2015 to 2024.

But what if the business combination occurred prior to adoption of 2014-02? To answer, we’ll use the same hypothetical from above, but assume the acquisition date is Jan. 1, 2009, rather than Dec. 31, 2014. Based on annual testing under the ASC 350 goodwill framework, XYZ previously determined that goodwill had not been impaired. As a result, the reported amount of goodwill on XYZ’s balance sheet as of Dec. 31, 2013, was $50. Absent a triggering event, XYZ would amortize

ACCOUNTING

the goodwill balance over 10 years ($5 per year) starting in 2014, unless it can demonstrate that a shorter useful life is more appropriate.

CONCLUSION

The PCC concluded that its new goodwill accounting framework “will not result in a loss of decision-useful information to the users of private company financial statements but will reduce the cost and complexity associated with performing the current goodwill impairment test.” Not all private companies will choose the simplified Accounting Alternative, but those that do should see a reduction in the amount of time and money spent addressing impairment issues.

While the Accounting Alternative may make life easier for many companies, there are several reasons why it will not be universally adopted. First, ASU 2014-02 is optional, not mandatory. So some private companies may take the “If it ain’t broke, don’t fix it” approach and continue under the pre-existing ASC 350 model. Second, users of private company financial statements have a say in this. For example, many private companies must submit their annual financial statements to a third party such as a lender, and some lenders may prefer the preexisting ASC 350 goodwill accounting framework. Third, since ASU 2014-02 does not apply to public companies, private companies need to consider whether they may in the future become a public company or be acquired by a public company. If so, it may be unwise to adopt ASU 2014-02, since it may later necessitate restating prior year financial statements (i.e., to undo the effects of adopting ASC 2014-02).

There may be additional changes on the horizon. Currently on the PCC’s agenda is an accounting alternative for identifiable intangible assets. In addition, FASB reportedly is going to consider if the goodwill accounting framework set forth in ASU 2014-02 can be appropriate for public companies and/or nonprofit organizations. n

1. ASU 2014-02 does not apply to public companies or nonprofit organizations. 2. Identifiable intangible assets with definite lives are amortized. Like goodwill, indefinite-lived intangible assets are not amortized. 3. Prior to the ASC 350 impairment testing model, goodwill accounting was governed by Accounting Principles Board Opinion No. 17, Intangible

Assets (APB 17). Issued in August 1970, APB 17 generally required goodwill resulting from mergers and acquisitions to be amortized over a period not to exceed 40 years. 4. For information about the Private Company Council, see www.fasb.org/pcc.

5. If the Accounting Alternative is adopted, Step 2 of the ASC 350 impairment test (requiring a hypothetical purchase price allocation to be performed as of the testing date) is eliminated.

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Endorsed by the VSCPA

BILL FOOTE, CPA, is a partner at Aronson LLC, a top-100 public accounting firm in Rockville, Md. He is practice leader for Forensic & Valuation Services, and currently serves on the VSCPA’s Professional Ethics Committee. * bfoote@aronsonllc.com connect.vscpa.com/BillFoote

DAVID SEMENDINGER, CPA, is a partner at Aronson LLC, where he leads the Quality Control function. * dsemendinger@aronsonllc.com

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