Goodwill Hunting: Elimination of Step 2 and the implications for public companies
In Accounting Standards Update No. 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment, the Financial Accounting Standards Board eliminated Step 2 of the goodwill impairment test.
In the Step 2 test, an entity performs a hypothetical purchase price allocation to determine the amount of an impairment. With the elimination of Step 2, entities will now record impairment based solely on Step 1, which compares the fair value of a reporting unit with the carrying amount. If the fair value is greater than the carrying amount, there is no impairment. If the fair value is less than the carrying amount, the entity will record an impairment charge equal to the difference (not to exceed the carrying amount of goodwill). This change also applies to reporting units with zero or negative carrying amounts, which will always pass Step 1 as the fair value of a reporting unit cannot be lower than zero. Previously, reporting units with zero or negative carrying amounts had to perform a qualitative assessment to determine whether to proceed to Step 2. The qualitative assessment is eliminated and entities with reporting units with zero or negative carrying amounts will simply be required to disclose the amount of goodwill allocated to each reporting unit.
For entities with tax-deductible goodwill, FASB will require them to consider the deferred tax effect when measuring the goodwill loss. When goodwill is tax deductible, a goodwill impairment charge would increase a deferred tax asset or decrease a deferred tax liability, causing a subsequent change in the carrying amount. In order to avoid a continuous cycle of impairment charges, an entity should consider the impact on deferred taxes concurrent with the impairment charge.
Not Unanimous Support
FASB voted 4 to 3 to eliminate Step 2. There was not unanimous support to eliminate Step 2 in its entirety, and some public entities have expressed concern about the ongoing implications of this change.
FASB has sought to simplify the accounting for goodwill impairment for several years. In 2011, the board revised the way entities account for goodwill impairment by allowing entities to qualitatively assess whether it is “more likely than not” that the fair value of a reporting unit is less than its carrying amount in what is commonly referred to as Step 0. In 2014, FASB issued Accounting Standards Update No. 2014-02 to simplify goodwill impairment for private companies. Under the accounting alternative on goodwill, private companies amortize goodwill over a period not to exceed 10 years and impairment testing is a one-step process at either the entity level or the reporting unit level, and only when there is a triggering event.
The elimination of Step 2 for public companies is the next step in the process to simplify goodwill impairment testing. In contrast to the accounting alternative for private companies, public companies are not allowed to amortize goodwill and still must test for impairment at least annually, with more frequent testing in the case of financial duress, changed circumstances or another triggering event. They must still assign goodwill to reporting units, and if they make a business combination, allocate goodwill to the appropriate units. Entities can also use the optional Step 0 to minimize the need to get a fair value of a reporting unit if impairment is not evident.
The elimination of Step 2 may result in more frequent reporting of impairment, as well as a change in the magnitude of the impairment charge. Previously, an entity could fail Step 1, proceed to Step 2 and determine that there was no goodwill impairment. Now if you fail Step 1, you must report an impairment charge. With the elimination of Step 2, an entity that has created intangible value that is not recorded on the balance sheet will find a lower measurement of impairment than would have been indicated in Step 2.
While some public companies may initially embrace the simplification, some may recognize their fair value will now be equal to the carrying amount post impairment. For entities that had created intangible value, the Step 2 analysis resulted in a lower implied goodwill value and a larger impairment charge. This would create a cushion for the Step 1 test in the following year. Determining the amount of impairment based on Step 1 only leaves no cushion for subsequent tests. Companies will have to monitor the issue quarter after quarter and a subsequent decline in value would result in another impairment charge.
FASB is allowing entities to transition to the new rule over several years. While early adoption is permitted for testing dates after Jan. 1, 2017, public businesses that file with the SEC should adopt this amendment for fiscal years beginning after Dec. 15, 2019 while public businesses that are non-SEC filers should adopt the amendments for fiscal years beginning after Dec. 15, 2020.
While we expect many to adopt this in 2017, there will be others who will take their time transitioning to this new approach. In fact, we expect some to measure goodwill impairment both ways to see which creates the better outcome.