The Fundamentals of Goodwill Valuation and Impairment in U.S. and International by Jane Wu April 9, 2014 Professor Scott Jerris
On March 25, in a momentous decision, Facebook acquired Oculus VR, a virtual reality company, for $2 billion dollars according to Winfield and Goel, reporters for the New York Times. 1 When a business buys out another business, it must determine the amount of goodwill. According to the FASB Accounting Standards Codification (ASC) 805-30-20, goodwill, an intangible asset with an indefinite life, is an asset representing the future economic benefits arising from other assets acquired in a business combination or an acquisition that are not individually identified and separately recognized. 2 Altogether, this statement says that goodwill cannot be separated from the business and divided into individual assets on the balance sheet. As stated in Financial Accounting, 7 th edition, goodwill represents non-physical or intangible value that a company owns, such as reputation, good customer relations, exceptional management, desirable location, etc. 3 Thus, goodwill can only be determined when a business is sold and acquired by another company. In the current technological era, where people and skills represent the primary assets for both domestic and international enterprises, goodwill is a crucial value in accounting. In 2009, the Financial Accounting Standards Board (FASB) introduced the ASC, a compiled and codified database of U.S. GAAP to explain and define goodwill evaluation. Likewise, the International Accounting Standards Board (IASB) enacts the International Reporting Standards (IFRS) 3 and the International Accounting Standards (IAS), which also guide businesses on how to report goodwill as an asset. As one delves into the FASB ASC, one finds that the U.S. GAAP s valuation and impairment of goodwill shares an almost identical protocol with international GAAP except for a few minor differences. U.S. Valuation or Measurement of Goodwill In the United States, firms measure goodwill as a residual value since an intangible asset cannot be measured directly during an acquisition. However, the ASC 350-20-25-3 suggests that 1
when a company develops goodwill internally through day-to-day business operations, not from acquisition, the company shall expense this type of goodwill instead. 4 In accordance with Intermediate Accounting, 15 th Edition, goodwill is the excess cost over fair value of the identifiable net assets acquired during the sale of an entire business. 5 This is the difference between the purchase price and the fair value of all the seller s net assets. The cost or purchase price amounts to the consideration transferred, i.e. cash, equity, options, among others as denoted by the ASC 805-30-30-7. 6 As indicated in the ASC 820-10-55, many firms generate the fair value (an estimated market price of an asset), of their identifiable assets through several techniques: current market prices (if available), discounted rate adjustment technique, expected present value technique, multiple of earnings valuation technique, and others. 7 To clarify how a firm measures goodwill, here is an example. Whole Foods wants to purchase Farmer Joe Organic Market for $1,000,000. From Farmer Joe s balance sheet, total assets equal $500,000, listed at historical cost. To determine the fair value of each of Farmer Joe s assets, Whole Foods hires an outside appraisal company, who can evaluate each asset by utilizing one of the fair value methods as listed above. During Whole Foods negotiations with Farmer Joe, the outside appraisers discover that the total fair value of the net assets for Farmer Joe is actually $700,000. Then, the residual value, goodwill, is $300,000 (1,000,000 -$700,000), which represents Farmer Joe s excellent location, customer appreciation, and great customer service. U.S. Treatment of Goodwill Impairment When one business purchases another, such as Whole Foods acquiring Farmer Joe, the goodwill, bought and entered into the general ledger, must be tested annually to determine if there is a loss in its value due to poor company performance or other unforeseen economic downfalls. According to Intermediate Accounting, 15 th Edition, this loss evaluation must be done 2
annually in all businesses. 8 The FASB develops the ASC 350-20-55-25, a flowchart describing the two-step method to compare fair values and implied fair values with their carrying amounts for assessing this loss. 9 In the ASC 350-20-35-2, the codification applies the term impairment to this loss as a condition that exists when the carrying amount [book value] of goodwill exceeds its implied fair value. 10 The implied fair value of goodwill is the estimated market price of an intangible asset and is a number derived indirectly through subtraction (fair value of a reporting unit minus the carrying amount of net assets). However, before a company proceeds with step one of evaluating goodwill impairment, the ASC 35-20-35-3A gives the company an option to do a qualitative assessment a general analysis of the overall health of a business affected by changes in company performance, market prices, or economic ups and downs to investigate whether a loss on the value of goodwill exists. 11 Doing a qualitative assessment can potentially save a company a lot of money and valuable time due to high costs incurred from the two-step method. 12 However, in reference to the ASC 350-20-35-3A, if the qualitative assessment concludes more likely than not (that is, a likelihood of more than 50 percent) that the fair value of a reporting unit [an operating part or segment of a business] is less than its carrying amount, including goodwill, 13 then the business must calculate the loss on impairment. In a nutshell, if fair value is less than carrying amount, a business must implement the two-step impairment method. In step one, a company follows a logical set of rules. As stated in the ASC 350-20-35-4, a business calculates the fair value of its entire reporting unit the acquired division of a business from a purchase and contrasts this number with the carrying amount (including goodwill) of net assets obtained from the books. 14 According to ASC 350-20-35-8, if the carrying amount of a reporting unit exceeds its fair value [market price], the second step of the goodwill impairment 3
test shall be performed to measure the amount of impairment loss, if any. 15 Here, the carrying value is a reporting unit s assets including goodwill minus any liabilities from the balance sheet. In addition, companies determine fair value of net assets through various fair value measurement techniques market approach, cost approach, income approach, and present value technique all accepted by the ASC 820-10-55. 16 For example, by utilizing the present value technique to measure the fair value of its reporting unit, Whole Foods finds that Farmer Joe s entire operation is equal to $2,000,000 in market price. Whole Foods then tallies the carrying amount of Farmer Joe s net assets by adding up all its assets including goodwill less its liabilities; the result is a $2,500,000 carrying amount. In the case of the reporting unit, Farmer Joe, the carrying amount of $2,500,000 is more than its fair value of $2,000,000. Whole Foods will, therefore, need to continue on to part two to find its impairment on goodwill in order to abide by GAAP rules. However, the ASC 350-20-35-6 states clearly that if a company determines the fair value of its reporting unit to be greater than the its carrying value of net assets, then step two is not necessary. 17 The second step to obtain loss on impairment involves further mathematical reasoning. From the ASC 350-20-35-9, a company determines the implied fair value of goodwill and then compares this amount to the carrying amount of goodwill as indicated in the balance sheet. 18 Based upon the ASC 350-20-35-14, the implied fair value of goodwill shall be determined in the same manner as the amount of goodwill recognized in a business combination...as if the reporting unit had been acquired in a business combination 19 In other words, GAAP unequivocally declares that enterprises calculate implied fair value of goodwill similarly to the calculation of residual value of goodwill during formal acquisition of a company. (See U.S. Measurement of Goodwill.) Like any other residual value, the implied fair value is the difference 4
between a reporting unit s fair value and its carrying amount of net assets (excluding the book value of goodwill). 20 By using the Whole Foods example to illustrate implied fair value, one supposes Farmer Joe has a carrying amount in $2,500,00 of net assets and a fair value of $2,000,000, plus $700,000 in goodwill recorded in Whole Foods books. Whole Foods calculates implied fair value of goodwill as $2,000,000 ($2,500,000 - $700,000). After calculating implied fair value, Whole Foods compares the implied fair value of $200,000 with its $700,000 carrying amount of goodwill to find the loss on impairment according to the ASC 350-20-35-11. 21 In this scenario, the carrying amount of goodwill is the book value listed in the general ledger. Subtracting the $200,000 of implied fair value from the $700,000, Whole Foods now has a $500,000 loss on impairment of goodwill. International Valuation (Measurement) and Impairment of Goodwill Following how the U.S. deals with loss on impairment of goodwill according to FASB s policies and rules, the International Accounting Standards Board (IASB) performs a similar procedure with regards to the impairment of goodwill. Like the FASB, the IASB recognizes goodwill to be a non-physical asset and is therefore, not amortized according to International Accounting Standards (IAS) 38. 22 In addition, the International Financial Reporting Standards (IFRS) 3 states that companies measure goodwill as the difference between the purchase price and net assets during a business acquisition. 23 Furthermore, the IASB requires that international companies must use a one-step method annually to calculate impairment of goodwill. According to Steven Brice, author of Procedural Differences in Impairment Testing, the one-step method assigns goodwill to a cash- generating unit (CGU), the smallest group of distinct assets that generates cash for the business. 24 A business must then compare the carrying amount of the CGU with its recoverable amount, which is the higher of an asset s fair value less costs to sell, 5
[disposal] or the assets value in use, [a number derived from a present value calculation]. 25 Finally, if the carrying amount is greater than the recoverable amount of the CGU, then the difference between the two numbers is the loss on impairment. 26 Not unlike U.S. GAAP, the loss on impairment of goodwill is also a residual value (the difference between a carrying amount and a recoverable amount). A Brief Analysis As internationalization and the globalization of all marketplaces affect many countries worldwide, highly skilled employees, great customer service, and research have become an integral part in the valuation and impairment of goodwill. All in all, the treatment of goodwill in the U.S. closely resembles International GAAP s policies and procedures relating to this intangible asset. Both the FASB and the IASB no longer demand that companies amortize goodwill but do expect all businesses to utilize an annual impairment process to determine a loss, if any. In terms of the valuation of goodwill, both boards equate the excess cost over fair value of the identifiable net assets acquired 27 as the amount that is journalized for goodwill. Although U.S. GAAP incorporates a two-step method (with a qualitative assessment option) and international GAAP designs a one step method, both tests involve calculating a residual value of goodwill. Given how fast the world economy is changing, new rules and plans will most likely need to be designed to replace the current ones for this non-physical asset. 6
Endnotes 1 Wingfield, Nick and Vindu Goel. Facebook in $2 Billion Deal for Virtual Reality Company. The New York Times Company. 25 March 2014. 4 April 2014. www.newyorktimes.com. 2 FASB (Financial Accounting Standards Board) (n.d.) ASC 805-30-20 retrieved April 8 2014 from FASB Accounting Standards Codification database. 3 Weygandt, Jerry, Paul Kimmel, and Don Kieso, Financial Accounting, 7th ed. (Hoboken & John Wiley and Sons Inc., 2010) 417. 4 FASB (Financial Accounting Standards Board) (n.d.) ASC 350-20-25-3 retrieved April 5 Kieso, Don, Jerry Weygandt, and Terry Warfield, Intermediate Accounting, 15 th ed. (Hoboken & Sons, Inc., 2013) 658. 6 FASB( Financial Accounting Standards Board) (n.d.) ASC 805-30-30-7 retrieved April 7 FASB(Financial Accounting Standards Board) (n.d.) ASC 820-10-55 retrieved April 8, 2014 from FASB Accounting Standards Codification database. 8 Kieso, Don, Jerry Weygandt, and Terry Warfield, Intermediate Accounting, 15 th ed. (Hoboken & Sons, Inc., 2013)663. 9 FASB (Financial Accounting Standards Board) (n.d.) ASC 350-20-55-25 retrieved April 10 FASB (Financial Accounting Standards Board) (n.d.) ASC 350-20-35-2 retrieved April 11 FASB (Financial Accounting Standards Board) (n.d.) ASC 35-20-35-3A retrieved April 12 Zyla, Mark. The New Qualitative Assessments in Goodwill Impairment Testing May Not Be Simple. 2 Feb. 2012. CPA2Biz, Inc. 5 April 2014. www.cpa2biz.com. 13 FASB (Financial Accounting Standards Board) (n.d.) ASC 350-20-35-3A retrieved April 14 FASB (Financial Accounting Standards Board) (n.d.) ASC 350-20-35-4 retrieved April 7
15 FASB (Financial Accounting Standards Board) (n.d.) ASC 350-20-35-8 retrieved April 16 FASB (Financial Accounting Standards Board) (n.d.) ASC 820-10-55 retrieved April 17 FASB (Financial Accounting Standards Board) (n.d.) ASC 350-20-35-6 retrieved April 18 FASB (Financial Accounting Standards Board) (n.d.) ASC 350-20-35-9 retrieved April 19 FASB (Financial Accounting Standards Board) (n.d.) ASC 350-20-35-14 retrieved April 20 Kieso, Don, Jerry Weygandt, and Terry Warfield, Intermediate Accounting, 15 th ed. (Hoboken & Sons, Inc., 2013) 664. 21 FASB (Financial Accounting Standards Board) (n.d.) ASC 350-20-35-11 retrieved April 22 IAS 38 Intangible Assets (2012) IFRS.org (International Financial Reporting Standards) retrieved April 8, 2014 from IFRS database. 23 IFRS-3 Business Combinations IASplus.com retrieved April 8, 2014 from IASplus database, Deliotte Global Services Limited. 24 Brice, Steven. Procedural Differences in Impairment Testing. American Institute of CPAs, CPA2Biz, Inc. 8 April 2014. www.cpa2biz.com. 25 IAS 36 Impairment of Assets (2012) IFRS.org (International Financial Reporting Standards) retrieved April 8, 2014 from IFRS database. 26 Brice, Steven. Procedural Differences in Impairment Testing. American Institute of CPAs, CPA2Biz, Inc. 8 April 2014. www.cpa2biz.com. 27 Kieso, Don, Jerry Weygandt, and Terry Warfield, Intermediate Accounting, 15 th ed. (Hoboken & Sons, Inc., 2013) 658. 8
Works Cited Brice, Steven. Procedural Differences in Impairment Testing. American Institute of CPAs, CPA2Biz, Inc. 8 April 2014. www.cpa2biz.com. FASB (Financial Accounting Standards Board) (n.d.) Accounting Standards Codification (ASC) retrieved April 8, 2014, from FASB Accounting Standards Codification database. Asc.fasb.org. IFRS (International Financial Reporting Standards) retrieved April 8, 2014 from IFRS database. www.ifrs.org. Kieso, Don, Jerry Weygandt, and Terry Warfield, Intermediate Accounting, 15 th ed., Hoboken & Sons, Inc., 2013. Weygandt, Jerry, Paul Kimmel, and Don Kieso, Financial Accounting, 7th ed., Hoboken & John Wiley and Sons Inc., 2010. Wingfield, Nick and Vindu Goel. Facebook in $2 Billion Deal for Virtual Reality Company. The New York Times Company. 25 March 2014. 4 April 2014. www.newyorktimes.com. Zyla, Mark. The New Qualitative Assessments in Goodwill Impairment Testing May Not Be Simple. 2 Feb. 2012. CPA2Biz, Inc. 5 April 2014. www.cpa2biz.com. 9