Simplified accounting for private companies: Goodwill
INSIGHT ARTICLE |
On January 16, 2014, the Financial Accounting Standards Board issued Accounting Standards Update (ASU) 2014-02, Intangibles—Goodwill and Other (Topic 350): Accounting for Goodwill. This ASU introduces an accounting alternative for private companies that simplifies and reduces the costs associated with the subsequent accounting for goodwill. The effects of a private company electing the accounting alternative as its accounting policy for goodwill include:
- Amortizing goodwill over a period not to exceed 10 years instead of not amortizing it
- Choosing to test goodwill for impairment at either the entity level or the reporting unit level instead of having to test goodwill at the reporting unit level
- Testing goodwill for impairment only when there is a triggering event instead of testing it every year
- Testing and measuring goodwill for impairment by comparing the fair value of the entity (or reporting unit) to its carrying amount instead of performing a two-step goodwill impairment test that requires hypothetical business combination accounting for purposes of measuring an impairment loss
If the accounting alternative is elected, all aspects of it must be elected. In other words, a private company cannot elect to apply the impairment guidance and not elect to apply the amortization guidance.
While the ASU is not effective until annual periods beginning after December 15, 2014, and interim periods within annual periods beginning after December 15, 2015, early adoption is permitted. As such, private companies may elect the accounting alternative to account for goodwill in their 2013 financial statements as long as those statements have not yet been made available for issuance. Prior to making the election, a private company needs to carefully consider the possibility of becoming, or being acquired by, a public business entity in the future, as discontinuing the election would currently require (absent additional standard setting) retrospective application of the legacy goodwill accounting model (i.e., the goodwill accounting model applicable to entities that cannot elect the accounting alternative). A private company also needs to be certain that the users of its financial statements will accept financial statements in which the accounting alternative has been applied.
This summary provides additional information about each aspect of the new accounting alternative as well as information about its scope and the related presentation and disclosure requirements. In addition, discussion about adoption of the accounting alternative, including early adoption and the effects on existing goodwill as well as factors that should be considered before electing the accounting alternative, is provided later in this summary.
Private companies include entities other than the following: (a) those that meet the definition of a public business entity or not-for-profit entity as defined in the Master Glossary of the FASB’s Accounting Standards Codification (ASC) or (b) employee benefit plans that fall within the scope of the related topics in the ASC (Topics 960, 962 and 965). The FASB recently issued ASU 2013-12, Definition of a Public Business Entity: An Addition to the Master Glossary, which added the definition of a public business entity to the ASC. This definition is broader than the definitions of public entity and publicly traded company currently included in the Master Glossary of the ASC.
If elected, the accounting alternative applies to all new and existing goodwill. In other words, the accounting alternative cannot be elected for the goodwill related to some acquisitions, but not the goodwill related to other acquisitions. The accounting alternative also applies to the excess reorganization value that may arise in applying fresh-start reporting as described in ASC 852, Reorganizations. In addition, the amortization component of the accounting alternative applies to equity method goodwill, which is a component of an investor’s equity method investment (i.e., it is not recorded separately from the equity method investment). As a result, when an investor determines its equity method income/loss, the amortization of any equity method goodwill must be included in this amount if the accounting alternative is elected. However, consistent with current guidance, equity method goodwill is not tested for impairment separately from the overall equity method investment. In other words, neither the accounting alternative nor the legacy goodwill accounting model is used to test equity method goodwill for impairment.
The unit of accounting for goodwill amortization (or the amortization of excess reorganization value) is the goodwill related to each acquisition (or the excess reorganization value related to each reorganization event).
If the accounting alternative is elected, goodwill is amortized on a straight-line basis over a period not to exceed 10 years. A private company can default to a 10-year amortization period (without justification) for goodwill or choose to identify and use a shorter useful life if it can demonstrate that it is more appropriate. For example, if a private company acquires a target primarily to gain control of the target’s proprietary intellectual property and the underlying patent for that intellectual property expires in 7 years, it may be appropriate to use a useful life of 7 years to amortize any related goodwill. It would rarely, if ever, be possible to demonstrate that a useful life of zero is appropriate.
If the facts and circumstances related to the useful life of a private company’s goodwill warrant a revision to that life, the private company can choose to (but does not have to) change the goodwill’s useful life. When a private company chooses to change the useful life of goodwill, it should ensure that the change will not result in a cumulative useful life for that goodwill in excess of 10 years. The effects of a change to the useful life of goodwill are accounted for prospectively.
Unit of accounting
If the accounting alternative is elected, a private company must make an accounting policy election with respect to whether it performs its goodwill impairment testing at the entity level or the reporting unit level. The definition of a reporting unit and the related guidance in the ASC has resulted in numerous practice issues for private companies over time. Some of these practice issues arise because the definition of a reporting unit has its origins in ASC 280, Segment Reporting, which is only directly applicable to public entities. Electing to perform goodwill impairment testing at the entity level under the accounting alternative will save a private company from having to deal with these practice issues and the related costs.
If the accounting alternative is elected, goodwill should only be tested for impairment when a triggering event occurs. The occurrence of a triggering event draws into question whether the fair value of the entity (or reporting unit) may be below its carrying amount. ASC 350-20-35-3C provides many (but not all of the potential) examples of triggering events, including a deterioration in general economic conditions, an increased competitive environment, increases in the costs of raw materials or labor, negative or declining cash flows and changes in key personnel. A determination should be made at the end of each reporting period as to whether any triggering events occurred during the reporting period. If one or more triggering events occurred, then the private company should test its goodwill for impairment.
Testing and recognition
If the accounting alternative is elected and one or more triggering events occur, a private company must test its goodwill for impairment. As part of that testing, a private company must first decide whether it will perform a qualitative assessment of whether its goodwill is impaired. If elected, the qualitative assessment requires the private company to answer the following question after considering all the relevant information available: Is it more likely than not that the fair value of the entity (or reporting unit) is less than the carrying amount of the entity (or reporting unit)? Each time a triggering event occurs, the private company can choose to perform or not perform the qualitative assessment. In other words, the private company’s decision to perform or not perform the qualitative assessment when a triggering event occurs does not pre-determine what it will have to do the next time a triggering event occurs.
Spending the time and effort to perform a qualitative assessment is likely not justified from a cost-benefit perspective under the accounting alternative given that the performance of the goodwill impairment assessment was prompted by the private company concluding that the fair value of the entity (or reporting unit) may be below its carrying amount because a triggering event occurred. In other words, we believe it would be very unlikely that a private company would be able to conclude that it is not more likely than not that the fair value of the entity (or reporting unit) is less than its carrying amount (i.e., passing the qualitative assessment) after having just concluded that the fair value of the entity (or reporting unit) may be below its carrying amount (which was the outcome of the triggering event analysis that led to the goodwill impairment testing in the first place). For additional discussion on the qualitative impairment assessment, refer to our white paper, FASB issues final standard on qualitative goodwill impairment assessment.
In the unlikely event that a private company opts to perform the qualitative assessment under the accounting alternative and passes, the private company is finished with its impairment testing and no impairment is recognized. Otherwise, the private company must proceed to a quantitative assessment, which is also performed if the private company chooses not to perform the qualitative assessment. The quantitative assessment compares the fair value of the entity (or reporting unit) to its carrying amount (which includes goodwill). If the fair value of the entity (or reporting unit) is more than its carrying amount, no impairment is recognized. If the fair value of the entity (or reporting unit) is less than its carrying amount, then an impairment loss is recognized for the excess of the carrying amount over fair value. However, the amount of the impairment loss cannot be more than the carrying amount of the goodwill. The method used to calculate an impairment loss under the accounting alternative eliminates the need to perform a two-step goodwill impairment test that requires hypothetical business combination accounting for purposes of measuring an impairment loss, which is one of the most complex and costly elements of the legacy goodwill accounting model.
Under the accounting alternative, deferred income taxes should be included in the carrying amount of the entity (or reporting unit) for those private companies subject to the provisions of ASC 740, Income Taxes. The inclusion of deferred income taxes in the carrying amount is not dependent on whether the fair value of the entity (or reporting unit) is measured assuming a taxable or nontaxable transaction.
Under the accounting alternative, if a goodwill impairment loss is recognized and the private company has goodwill from more than one acquisition on its books, the impairment loss should be allocated among the goodwill related to each acquisition using a reasonable and rational method. One such method allocates the impairment loss based on the carrying amount of each acquisition’s goodwill relative to the entity’s (or reporting unit’s) total goodwill. Another method might take into consideration whether the impairment loss could be attributed to a particular acquisition.
Recognition of a goodwill impairment loss establishes a new basis for the goodwill. It is not appropriate to reverse the impairment loss under any circumstances. The new basis in goodwill is amortized over its remaining useful life. For example, assume a private company has goodwill that it is amortizing over 10 years and it recognizes an impairment loss on that goodwill four years after the related acquisition. After the impairment loss is recognized, the private company would recognize the new basis in goodwill over the remaining life of six years. However, the private company could choose to revise the useful life in accordance with the guidance discussed earlier. In doing so, the private company would not be able to use a useful life greater than six years because it is limited to a cumulative useful life of 10 years.
Sequencing of impairment testing
If other assets have to be tested for impairment at the same time goodwill is being tested for impairment (because other applicable guidance in the ASC requires those assets to be tested for impairment), those other assets should be tested for impairment before goodwill is tested. For example, a triggering event that gives rise to testing goodwill for impairment under the accounting alternative may also result in the private company having to test property, plant and equipment for impairment in accordance with ASC 360-10, Property, Plant, and Equipment – Overall. In that situation, the property, plant and equipment should be tested for impairment before the goodwill. Given the implications of this guidance, private companies should carefully consider whether the triggering event giving rise to the goodwill impairment test would also cause other assets of the entity (or reporting unit) (e.g., accounts receivable, inventory, equity method investments, property, plant and equipment) to be tested for impairment.
Under the accounting alternative, when part of a private company is going to be disposed of, consideration should be given to whether any goodwill should be allocated to that part. If the part being disposed of meets the definition of a business, goodwill should be allocated to it using a reasonable and rational approach. If the private company tests goodwill for impairment at the reporting unit level, we believe the guidance in ASC 350-20-40-1 through 6 generally represents a reasonable and rational approach to allocating goodwill in this situation. If the part being disposed of does not meet the definition of a business, goodwill should not be allocated to it. When goodwill is allocated to a business to be disposed of, it factors into the amount of gain or loss recognized upon its disposal.
Private companies that elect the accounting alternative must present goodwill net of accumulated amortization and impairment as a separate line item on its balance sheet. Income statement charges related to goodwill (i.e., amortization and impairment) should be included in income from continuing operations, unless the goodwill relates to a discontinued operation, in which case the charges (net of tax) should be included in the results from discontinued operations. For those amounts included in income from continuing operations, there is no specific requirement to present them as a separate line item or within a specific line item.
Introducing the accounting alternative in U.S. generally accepted accounting principles (GAAP) results in a private company having an accounting policy choice related to how it subsequently accounts for goodwill. As a result, a private company’s policy related to its accounting for goodwill should be disclosed in accordance with ASC 235-10-50. In addition, if a private company elects the accounting alternative, it would also be required to provide the necessary disclosures regarding the change in accounting principle.
If a private company elects the accounting alternative, it would be required to provide many of the same disclosures required related to the legacy goodwill accounting model. However, some new disclosure requirements would apply. For example, the private company would have to disclose information related to the amortization of goodwill, including accumulated amortization, total amortization expense and the weighted-average amortization period for goodwill in total as well as for each major business combination. Other disclosures related to goodwill and goodwill impairment losses would also apply. Refer to ASC 350-20-50-4 through 7 for all of the disclosures that would be required if a private company elects the accounting alternative. While private companies that elect the accounting alternative no longer have to disclose changes to goodwill in a tabular format, much of the information that was required to be included in the table is still otherwise required.
Effective date and transition
The accounting alternative is effective prospectively for new goodwill recognized in annual periods beginning after December 15, 2014, and interim periods within annual periods beginning after December 15, 2015. Early adoption is permitted provided financial statements for the period of adoption have not yet been made available for issuance. If the accounting alternative is elected, a private company can default to a 10-year amortization period (without justification) for goodwill that exists as of the beginning of the period of adoption or it can choose to identify and use a shorter useful life if it can demonstrate that it is more appropriate.
If a private company early adopts the accounting alternative in its 2013 calendar year-end financial statements because it has not yet made those financial statements available for issuance, it would adopt the accounting alternative as of January 1, 2013. As such, amortization of any goodwill in existence on January 1, 2013 would start on that date (and, absent any derecognition events, a full year of amortization expense would be recognized on that goodwill in 2013) and amortization of any new goodwill related to acquisitions in 2013 would begin on the acquisition date of the related business combination.
Considerations related to the election of the accounting alternative
A private company should carefully consider whether electing the accounting alternative makes sense in its facts and circumstances. Factors to consider in this regard include:
- Definition of public business entity. As indicated earlier, the new definition of a public business entity, which is integral to determining the entities that can apply the accounting alternative, is broader than the definitions of public entity and publicly traded company that previously existed in the Master Glossary of the ASC. For additional information about the new definition, refer to our article, FASB defines public business entity. Given that the new definition is broader than the pre-existing definitions, careful consideration should be given to whether an entity falls within that new definition. In addition, if a business entity concludes that it is eligible to elect the accounting alternative because it is not a public business entity, it should consider whether there is a reasonable possibility that it may go public in the future or be acquired by a public business entity in the future. If a private company goes public after it has elected the accounting alternative, absent additional standard setting, it would have to discontinue that election. A private company would also have to discontinue an election to apply the accounting alternative if it is acquired by a public business entity that is required to include the private company’s financial statements (prepared in accordance with U.S. GAAP applicable to a public business entity) in a filing with the Securities and Exchange Commission (SEC). The consequences of discontinuing the election to apply the accounting alternative are discussed below.
- Needs of financial statement users. A private company should explicitly and deliberately seek input and feedback from its financial-statement users before electing the accounting alternative. A private company should confirm with its financial-statement users that they will accept financial statements in which the accounting alternative has been applied. The users that should be considered in this regard include investors, lenders and regulators, among others. If a financial-statement user will not accept financial statements in which the private company elected to apply the accounting alternative, the private company would have to discontinue that election. The consequences of discontinuing the election to apply the accounting alternative are discussed below.
- Consequences of discontinuing the election to apply the accounting alternative. A private company may decide after it has elected and reflected the accounting alternative in its financial statements that it must discontinue that election, perhaps because it is going public or because a new lender will not accept financial statements in which the accounting alternative has been elected and applied. In this situation, absent additional standard setting, the private company has to follow the guidance on how to account for a change in accounting principle in ASC 250, Accounting Changes and Error Corrections, which requires an entity to conclude that the accounting principle it is changing to is preferable to the accounting principle it is changing from. In addition, it requires retrospective application of the change in accounting principle unless doing so is impracticable. While applying the legacy goodwill accounting model may be challenging, it would not be impracticable. It is possible that the FASB or SEC could issue supplemental guidance that would provide a transition method other than retrospective application; however, we are not aware of plans on the part of either the FASB or SEC to provide such guidance.
To illustrate the consequences of discontinuing the election to apply the accounting alternative, consider a situation in which a private company goes public three years after electing the accounting alternative. To prepare historical financial statements to be included in its filings with the SEC, the private company will have to reverse goodwill amortization during the three years it applied the accounting alternative and retroactively test its goodwill for impairment in each of those three years. While the reversal of goodwill amortization may not be time consuming, retroactive performance of goodwill impairment tests at a reporting unit level for those three years would likely be quite time consuming. In addition, the benefit of reduced financial reporting costs as a result of electing the accounting alternative would be negated by the costs incurred to retroactively test goodwill for impairment. If there is a reasonable possibility that a private company may become a public business entity in the future and it still wants to adopt the private-company accounting alternative, it may want to elect to test goodwill at a reporting unit level under the accounting alternative to help simplify the potential transition.
Another consideration related to electing the accounting alternative involves a decision made by the FASB (when it endorsed the accounting alternative) to add a project to its agenda to address potential changes to the subsequent accounting for goodwill for public companies and not-for-profit entities. During its endorsement discussions, the FASB indicated that the decisions it reaches in this broader project could affect the accounting alternative. In other words, if a private company elects the accounting alternative and the FASB changes that accounting alternative at some point in the future as a result of its broader project, the private company’s accounting for goodwill may be subject to further changes.
For additional information about the accounting alternative and assistance in the evaluation of your specific facts and circumstances, contact your RSM professional.