Goodwill Impairment Testing – Equity Value Premise or Enterprise Value Premise
By Christopher Soutar, Supervisor - Assurance Services & Jeff Yonkers, Manager - Assurance Services
The sharp decline in equity values brought on by the economic downturn over the past two years has caused many registrants to direct focus on whether the goodwill reported on their balance sheets is impaired. A survey of 2,500 executives associated with publicly-held companies conducted by financial advisory firm Duff & Phelps for the Financial Executives Research Foundation indicated that approximately two-thirds of U.S. public companies have recognized an impairment of goodwill at some point over this period. Not surprisingly, the biggest challenge facing many of these registrants recognizing impairment based on their response to this survey was described as "auditor issues." These "auditor issues" revolved around communication and interpretation of theories, methodologies, expectations and assumptions used in impairment testing, and more importantly, getting the "experts" on both the auditor and client sides to agree on them.
As now specified in Accounting Standards Codification 350: Intangibles – Goodwill and Other ("ASC 350"), an impairment test of goodwill is to be performed annually and whenever events or changes in circumstances indicate potential impairment. Goodwill is defined as a non-amortizable asset representing the future benefits arising from other assets acquired in a business combination that are not individually identified and separately recognized. Goodwill impairment testing consists of one, and possibly two steps: Step (1) identify potential impairment by comparing the entity’s (or reporting unit’s) carrying amount to its fair value, and Step (2) if, and only if, the entity’s carrying value is greater than its fair value, determination is made as to how much of the fair value relates to its other assets and liabilities, leaving a remainder which relates to its goodwill. If the remaining portion of its fair value, commonly referred to as "implied goodwill", is less than the amount of goodwill recorded, an impairment charge is required for the difference. It is the calculation of the entity’s fair value, which ASC 350 defines 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, that is at the heart of many of the issues alluded to above.
This ripple effect of increased impairment testing due to the recessionary economy has created much interaction between those in the valuation and accounting professions, and highlighted how basic economic philosophies can differ between the two. Philosophies differ as seen in the determination of the fair value of a reporting unit. While accounting rules have historically led registrants performing the first step of impairment testing to establish the "equity value" (generally the market capitalization of the company), valuation methods generally dictate that the first step should be performed by establishing the "enterprise value" (generally the fair value of the equity and the debt). The question of which method is more appropriate was raised in a speech last December before the 2009 American Institute of Certified Public Accountants ("AICPA") National Conference on Current Securities and Exchange Commission ("SEC") and Public Company Accounting Oversight Board ("PCAOB") Developments by Evan Sussholz, an accounting fellow in the Office of the Chief Accountant at the SEC. While in many instances, the method used will not impact whether a reporting unit passes or fails a step one test, there are also instances, as Mr. Sussholz pointed out, when the selected approach does impact this crucial determination, and even sometimes produce illogical results. The example used by Mr. Sussholz to demonstrate such an instance related to when the carrying value of equity in a reporting unit is negative. Since the fair market value of a reporting unit could never fall below zero, any entity using its negative book value in its impairment testing will always pass the step one test regardless of any other circumstances. While negative book values may not necessarily mean a company is on the verge of bankruptcy, it is all too conceivable that a truly financially troubled entity following accounting rules in place can be precluded from going to step two because it is not possible to fail step one.
This issue is better illustrated by delving into the differences between the two values being calculated. "Equity value", also referred to as "market value" or "offer value", as noted above, represents the market capitalization of a given entity. Although obtaining this value may involve some difficulty for non-public entities, for SEC registrants it is as simple as calculating the total value of all outstanding stock for the entity (the price of a single share of stock multiplied by the number of shares currently outstanding held by non-affiliates). "Enterprise value", also referred to as "firm value" or "transaction value", is most simply defined as equity value plus net debt. Net debt equals debt & equivalents minus cash & equivalents. For example, if someone starts a business by investing $100K of their own money, and borrows an additional $200K from a bank and invests it into the business as well, the "equity value" for the business would be $100K, yet the enterprise value would be $300K ($100K in equity value plus $200K of debt.) As shown by this example, equity value represents the value to the contributors of equity into the business, whereas enterprise value represents the value for all contributors of capital (in this case, the owner of the business as well as the debt holder). To summarize, enterprise value, just as Mr. Sussholz suggests, appears to serve in certain cases, as a better economic indicator of what the fair value of a business should be by taking into account everything that has been invested into it.
While Mr. Sussholz concedes that there is a lack of current authoritative guidance addressing this topic, he notes that the SEC staff would expect management of registrants to consider which approach to a step one test would provide the best economic indicator of goodwill impairment to ensure that the composition of carrying values and fair values are identical regardless of the approach, and to exercise reasonable judgment in determining a course of action when the methodology used appears to produce a counterintuitive result. This is easier said than done, as it can be presumed most registrants have now consistently followed a methodology for several reporting periods in accordance with accounting literature, and any deviation from that could be construed as an accounting change, which involves a complex process that is closely monitored by the SEC which these registrants would likely avoid. On the bright side, this should not affect a majority of registrants, as results of the Duff & Phelps survey also indicate that most registrants used valuation consultants and compared enterprise values in performing Step 1 of its goodwill impairment testing by an approximate 3 to 1 ratio. Still, it can be expected the SEC will further emphasize that registrants fully support their assertions, and provide more robust and comprehensive disclosures with regard to goodwill impairments.
So where does that leave registrants right now? In response to these issues being raised, both the AICPA and the Financial Accounting Standards Board ("FASB") have commissioned task forces to determine what, if any, additional guidance is needed. Both organizations have documented the issue at hand similarly, and have even noted other scenarios that produce what is described as an "inappropriate shield" in the first step of impairment testing, such as when there is a significant difference between the fair value of an entity’s debt and its carrying amount. In addition, they have both similarly laid out the differing viewpoints as three distinct sides to the argument:
- View A – represents the Enterprise Value Premise, the proponents of which believe that testing for goodwill recoverability should be "capital structure neutral", meaning that the amount of leverage within the capital structure is irrelevant and does not relate to the "operations" of a business in accordance with ASC 350, therefore debt should always be excluded from the liabilities assigned to a reporting unit and its measured fair value.
- View B – represents the Equity Value Premise, the proponents of which believe debt is similar to other liabilities, and its inclusion in the calculation is more consistent with ASC 350, as well as with a previous Emerging Issues Task Force ("EITF") Agenda Committee Report (October 31, 2002), which opined that if an entity has one reporting unit, all of the entity’s assets and liabilities should be included in that reporting unit.
- View C – proponents do not believe in proscribing a specific method for determining the method used, but rather believe this decision is an accounting policy election, which should be made with consideration of how a market participant would value the reporting unit. Regardless of the election made, the method used should incorporate an "apples-to-apples" comparison of carrying and fair values, should be applied consistently, and any change in premise applied should be considered a change in accounting principle.
The AICPA Impairment Task Force is currently pursuing the development of an AICPA Practice Aid to address this and other goodwill impairment issues. Meanwhile the FASB EITF reported that this issue was added to the EITF agenda, as the FASB staff is currently preparing a Discussion Document for a future Working Group meeting to be held sometime this Spring.