On November 25, 2013, the Financial Accounting Standards Board (FASB) endorsed an accounting alternative proposed by the Private Company Council (PCC) of the American Institute of CPAs (AICPA) which will change the way private companies account for goodwill and intangible assets acquired in a business combination. This change may significantly impact the time and expense incurred by private companies who have acquired a business or are anticipating completing an acquisition in the future. Public companies who may acquire private companies in the future should be aware of this change as well as they would be impacted.
Goodwill represents the residual asset acquired in a business combination after recognizing all identifiable assets and liabilities of an acquired entity. Under the current U.S. GAAP rules, goodwill is subject to impairment testing upon a triggering event and at least annually. The unit of account for goodwill is at the level of the entity referred to as a reporting unit. Prior to 2011, the impairment testing required a company to perform a quantitative analysis to calculate and compare the fair value of a reporting unit to its carrying amount (typically referred to as Step One). If the carrying amount exceeded the fair value, the company would then perform a measurement of the impairment amount. This method is performed in a similar manner as the goodwill was calculated in a business combination in which the company would identify the fair value of all of its assets, including intangible assets, and liabilities of the reporting unit (Step Two). The impairment amount would result in the amount which the carrying value of goodwill exceeded the implied fair value.
This process typically requires a company to hire a third party valuation specialist as the calculations may become complex and require a specific skill set and some audit firms may strongly encourage a company to do so. Additionally, audit firms will add a specialist to their team to review the analysis. These additional specialists become additional costs to the company as well as add time to completing their annual financial statements.
Furthermore, when surveyed by the PCC, users of the financial statements indicated that they disregard non-cash goodwill impairment charges from their quantitative analysis of a private company’s operating performance because they focus on tangible net assets, cash flows, and/or some form of adjusted EBITDA. Some users even noted that an impairment charge may indicate a failure of a business combination but doesn’t predict future failure rather confirms the results of a historical transaction.
In 2011 the FASB amended the impairment testing process to allow companies to perform a qualitative analysis (Step Zero) to determine if it is necessary to proceed to a Step One analysis. This amendment allows companies to potentially avoid hiring a third party valuation specialist on an annual basis if they are able to conclude that there is no qualitative indication of impairment.
The FASB has now approved the proposal by the PCC to allow private companies to amortize goodwill over 10 years or less than 10 years if the entity can demonstrate that another useful life is more appropriate. The private company must still perform an impairment analysis (Step Zero and Step One) if a triggering event occurs to indicate that impairment may exist but the annual analysis will no longer be required; however, the PCC further simplified the goodwill impairment test by eliminating step two of the impairment test, which requires the application of a hypothetical purchase price allocation to calculate the goodwill impairment. Under the alternative method, the goodwill impairment amount would represent the excess of the entity’s carrying amount over its fair value as calculated in Step One of the test.
The alternative accounting guidance for private companies will be applied prospectively for goodwill existing as of the beginning of the period of adoption and for goodwill derived from business combinations entered into during fiscal years beginning after December 15, 2014. Goodwill existing at the beginning of the period of adoption would be amortized prospectively over 10 years or less than 10 years if determined appropriate by the Company. Early adoption would be permitted.
Public companies should consider these changes as well. If a public company were to acquire a private company that has adopted this accounting alternative, the private company’s financial statements would be required to be retrospectively adjusted to account for goodwill in accordance with the standards the public company is required to adhere to.
The FASB is expected to issue an Accounting Standards Update prior to the end of 2013 but since early adoption is permitted it is expected that private companies will adopt the standard in 2013 especially due to potential cost savings. As mentioned above, private companies may be able to reduce costs incurred to third party valuation firms and potentially audit fees as well.
Signature Analytics would be happy to discuss further with you regarding the implications of this accounting change on your financial reporting requirements.
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