Summary of When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts

On December 17, 2010, the Financial Accounting Standards Board (“FASB”) released Accounting Standards Update (“ASU”) 2010-28 entitled “When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts.” The guidance released in this update amends Accounting Standards Codification (“ASC”) 350-20, entitled “Intangibles – Goodwill and Other – Goodwill,” by addressing questions about entities that have reporting units with zero or negative carrying amounts. More specifically, the guidance addresses the inconsistencies when a reporting unit concludes that Step 1 of the test is passed (meaning no goodwill impairment is necessary) because the fair value of the goodwill is greater than zero, when in fact, factors indicating impairment of the goodwill may still exist. The amendments included in this ASU affect all entities that have recognized goodwill and have one or more reporting units whose carrying amount, for purposes of performing Step 1 of the goodwill impairment test, is zero or negative. The amendments in the ASU are effective for public entities whose fiscal years (and interim periods within those years) begin after December 15, 2010. Early adoption is not permitted for public entities. For non-public entities, the ASU are effective for fiscal years (and interim periods within those years) beginning after December 15, 2011. Non-public entities may early adopt the amendments using the effective dates for public entities.

In accordance with the guidance at ASC 350-20-35-4, the first step in the goodwill impairment test is to identify potential impairment by comparing the fair value of the reporting unit with its carrying amount (the guidance in ASC 350-20-35-22 through 35-24 should be considered when determining the fair value of a reporting unit). If the fair value of the reporting unit exceeds its carrying amount, the goodwill of that reporting unit is not considered impaired and therefore, Step 2 of the goodwill impairment testing model is not necessary. However, in accordance with ASC 350-20-35-7, if the carrying amount of the reporting unit exceeds its fair value, the second step of the goodwill impairment model needs to be performed in order to determine if any amount of impairment loss needs to be recognized in the financial statements (the guidance in ASC 350-20-35-14 through 35-17 should be used to estimate the implied fair value of goodwill).

Prior to this amendment being ratified, a company with a reporting unit whose carrying amount was either zero or negative and had goodwill could conclude that the goodwill was not impaired since the fair value of the goodwill is automatically greater than the zero, or negative, carrying amount. This amendment addresses the issues discussed above and forces the reporting entity to perform Step 2 if the carrying amount of the reporting unit is either zero or negative.

The guidance under ASC 350-20 has always required goodwill of a reporting unit to be tested for impairment at least annually, and even on an interim basis if events occur or circumstances change that would more likely than not reduce the value of a reporting unit below its carrying amount. The ASU further amends the guidance to state that the same required tests of goodwill apply if the carrying amount of the reporting unit is zero or negative.

While the FASB, International Accounting Standards Board and Securities and Exchange Commission continue to work towards forming a single, unified set of accounting standards, the above amendment does not aid those efforts as entities that follow International Financial Reporting Standards use a different impairment model, which is a single-step impairment test. However, the FASB believes that the above amendments will improve current generally accepted accounting principles as an entity will no longer be able to assert that a reporting unit is not required to perform Step 2 because the carrying amount of the reporting unit is zero or negative despite the existence of qualitative factors that indicate that goodwill is more likely than note impaired. Therefore, goodwill impairments now may be reported sooner than under current guidance and financial statements are expected to become more transparent to the users.

 John Rushford contributed to this article.