Accounting for goodwill after a business acquisition could be changing soon as the Financial Accounting Standards Board (FASB) deliberates the current public company model. There are concerns among public companies that the benefits of accounting for goodwill do not justify the costs to prepare the information. As of July 15, 2020, the board is discussing different ways to account for goodwill with no set target date for an exposure draft.
Table of Contents
Proposed Changes to Goodwill Accounting
What is Goodwill?
The definition of goodwill is a contentious issue between practitioners. The FASB defines goodwill as “an asset representing the future economic benefits arising from other assets acquired in a business combination…that are not individually identified and separately recognized.”1
Goodwill is normally recorded after a company acquires another company. The amount recorded is calculated as the excess of the purchase price over the fair value of the net assets acquired.
Frequently, executives attribute goodwill to the synergies expected to occur between the two companies after the acquisition date.
Current Goodwill Accounting
The current model to account for goodwill after acquisition does not allow for amortization and requires annual impairment testing at the operating segment level.2
In 2011, the FASB passed ASU 2011-08, Intangibles-Goodwill and Other (Topic 350): Testing Goodwill for Impairment, which added an optional qualitative assessment to evaluate the likelihood of goodwill impairment.
In 2017, the FASB passed ASU 2017-04, Intangibles-Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment, which simplified the quantitative impairment test into one step.
Even after the passage of these two updates, impairment testing is still an expensive process. Many firms do not have the expertise to evaluate goodwill and must hire external valuation specialists.
The quantitative assessment of impairment can be broken down into the following steps:
- Calculate the fair value of the operating segment.
- Compare the fair value with the carrying amount of the operating segment (including goodwill).
- If the carrying amount is greater than the fair value: Recognize a goodwill impairment loss as the difference between the carrying amount and fair value.
Example 1:
Parent X acquires Subsidiary Y on January 1, 2020 for $30,000,000. Parent X considers Subsidiary Y to be a separate operating segment. The book value of Subsidiary Y is worth $20,000,000. Parent X assigns the excess $10,000,000 to goodwill. The carrying amount of Subsidiary Y is therefore $30,000,000. On December 31, 2020, Parent X determines the fair value of Subsidiary Y to be worth $26,000,000. Parent Y will recognize a $4,000,000 goodwill impairment loss in its consolidated financial statements.
| Impairment loss | $4,000,000 | |
| Goodwill | $4,000,000 |
Proposed Changes to Goodwill Accounting
The FASB is exploring the possibilities of adding amortization and modifying the impairment test to reduce the cost of public company accounting for goodwill.
If amortization of goodwill were to be added, the board would have to decide on a proper amortization period. The FASB is debating several ways to measure the amortization period:
- A default amortization period.
- A cap or floor on the amortization period.
- A reasonable estimate of the amortization period.
A default amortization period would most likely be over ten years, which is the amortization period that private companies can use to amortize goodwill.3 A reasonable estimate of the amortization period would be based on the useful life of the assets acquired in the business acquisition.
Two major changes to the goodwill impairment test are being considered.
The first change would remove the mandatory annual impairment assessment. This would be replaced with the requirement to only assess goodwill for impairment following a triggering event. FASB defines a triggering event as an event or change in circumstances that indicates the fair value of an entity is below the carrying amount.4 Examples include negative changes in economic position and financial performance.
The second change would remove the requirement to test goodwill impairment at the operating segment level. As an alternative, companies could use the entity level.
Example 2:
Assume Subsidiary Y’s sales fall 30% in 2020 due to changing market conditions. This qualifies as a triggering event.
If the FASB decides to use a ten-year amortization period, the following entries would be recorded in Parent Y’s 2020 consolidated statements:
| Amortization expense | $1,000,000 | |
| Goodwill | $1,000,000 |
| Impairment loss | $3,000,000 | |
| Goodwill | $3,000,000 |
Assume no triggering event. Only the amortization expense would be recorded, however, goodwill is overvalued by $3,000,000 since the company did not test for impairment.
| Amortization expense | $1,000,000 | |
| Goodwill | $1,000,000 |
Carl’s Take
Regarding Goodwill Amortization:
I believe the FASB should add mandatory goodwill amortization for public companies over a default period of 10 years. As previously mentioned, private companies have an option to amortize goodwill over 10 years. This should also be changed to be a mandatory requirement. Financial statement comparison across public and private companies would be enhanced with this change.
I believe goodwill has a definite life based on the future cash flows expected to be generated from the business acquisition. An amortization period of 10 years acknowledges this definite life while removing the subjectivity and cost of estimating an alternative amortization period.
Regarding Goodwill Impairment Testing:
I believe the FASB should add the requirement to only assess goodwill for impairment at the entity level following a triggering event. This would cut down on costs while still mandating impairment testing if a major change within the company occurs.
One concern with removing mandatory annual testing is that goodwill could be overvalued on the books. However, the likelihood of this occurrence decreases with the requirement to amortize goodwill over 10 years.