Under generally accepted accounting principles (GAAP), the acquirer in the purchase of a business is required to allocate the purchase price to the tangible and identifiable intangible acquired as part of the transaction. Once the process, typically referred to as a “purchase price allocation” under ASC 805, is complete, GAAP further requires that any remaining unallocated purchase price be recorded as goodwill. Once the goodwill and intangible asset values are determined, however, the accounting for these items is not done – they must be tested for impairment on at least an annual basis. The accounting for intangible asset impairment testing is governed by ASC 350 – Intangibles – Goodwill and Other (formerly SFAS 142).
Many factors can lead to goodwill and intangible asset impairment, but the primary culprits are overpayment for a target company and underperformance of the target company compared to pre-deal expectations. If impairment is indicated, it requires a write-off of some portion (or potentially all) of the goodwill or intangible asset balance.
The annual goodwill, indefinite-lived intangible asset and finite-lived intangible asset impairment testing processes each require unique multi-step analyses. Supportable valuations of the company and certain intangible assets are critical of the impairment testing process and need to well-supported and documented, which often requires the assistance of a third-party valuation analyst.
Given the complexity of ASC 350, it is a best practice for companies to get out in front of their annual goodwill and indefinite-lived intangible asset impairment analysis before their year-end audit begins. Companies should discuss their planned impairment testing process with their auditors and determine whether the use of a third-party valuation expert will be necessary. Proactively addressing these issues can lead to a much smoother audit process and avoid potential delays that may be encountered otherwise.
ASC 350 provides guidance on a number of topics encountered in intangible asset impairment testing, particularly for goodwill. Some of the more common issues encountered in the impairment testing process that are addressed in ASC 350 are summarized below:
The following steps must be taken in order to determine whether goodwill is impaired and, if it is impaired, the amount of the impairment:
Step Zero: The Step Zero approach to the goodwill impairment testing process is simpler and less burdensome for companies than starting with Step One because it allows them to perform a qualitative (rather than quantitative) assessment as to whether goodwill is impaired. This gives companies the option to bypass a valuation analysis and first assess certain qualitative factors to determine whether it is a more likely than not (greater than 50% likelihood) that goodwill is impaired. Goodwill impairment occurs when the fair value of a reporting unit is less than its book value. If this analysis indicates that goodwill may be impaired, the company must proceed to Step One.
Step One: Prior to Step Zero being permitted by GAAP, all goodwill impairment analyses started with this step. Step One requires that a valuation analysis be performed to determine the fair value of the reporting unit with the goodwill on its books (a much more involved analysis than the qualitative Step Zero analysis — hence the elation of many CFOs when Step Zero was introduced). If the book value of the reporting unit is greater than its fair value, this is an indication of goodwill impairment and the company must recognize an impairment loss for the amount by which the reporting unit’s carrying amount exceeds its fair value.
So what does it mean if a company's goodwill is impaired? Impairment indicates that the value of an acquired business is less than what was originally paid for it, which can happen over time as companies and industries change. However, impairment that occurs shortly after a transaction is complete typically indicates an overpayment for the business. The more that an acquirer is willing to pay for expected synergies, or as a result of a purchase price being bid up by multiple buyers, the larger the recorded goodwill balance will be and the higher the likelihood that impairment may occur at some point.
It should be noted that an exception exists that allows privately-held companies to elect to amortize goodwill over a period not to exceed 10 years for those that want to minimize their annual impairment testing burden. It is important that before a company makes this election it discusses the issue with its auditors and considers any potential impact on bank covenants or the perception of the company in the eyes of current or potential investors.
The impairment testing for indefinite-lived intangible assets is similar to goodwill impairment testing, as described below:
Step Zero: GAAP allows for a qualitative Step Zero test to be used in testing indefinite-lived intangible assets for impairment– just as with goodwill. Like Step Zero for goodwill impairment testing, this gives companies the option to bypass a valuation analysis and first assess certain qualitative factors to determine whether it is more likely than not (greater than 50% likelihood) that an indefinite-lived intangible asset is impaired. Impairment occurs when the fair value of an indefinite-lived intangible asset is less than its book value. If this analysis indicates that an indefinite-lived intangible asset may be impaired, the company must proceed with a fair value analysis.
Fair Value Analysis: A fair value analysis determines the fair value of the indefinite-lived intangible asset. If the fair value of the asset is lower than its book value, impairment is indicated and the asset is written down to its newly-determined fair value. It should be noted that indefinite-lived intangible assets are not written up if their value increases after initial recognition or if their value subsequently rebounds after an impairment has been recorded.
The accounting rules for finite-lived intangible asset impairment testing require a company to compare the undiscounted future cash flows associated with the asset to the asset’s net carrying value on the balance sheet. If the future undiscounted cash flows are greater than the net carrying value of the asset (which is most often the case), then there is no impairment. If the future undiscounted cash flows are less than the net carrying value of the asset, however, then impairment exists and those future cash flows are discounted back to the testing date to determine the new fair value of the asset and an impairment charge is recorded to write down the asset to its fair value. Because finite-lived intangible assets are amortized, they decrease in value on a company’s balance sheet each year. As a result, GAAP allows companies to consider the undiscounted future cash flows associated with finite-lived intangibles in testing for impairment, which makes it much less likely that they will be deemed impaired.