In a bold and dramatic move as part of its closely-watched business combinations project, the Financial Accounting Standards Board (the "FASB") has now decided, at least tentatively, that acquired goodwill should not be amortized. Acquired goodwill is the intangible asset that arises in business combination transactions and represents the excess of the purchase price paid over the fair value of the net assets (excluding goodwill) being acquired. The FASB’s revised position provides that goodwill would be recorded as a permanent asset and would be reviewed periodically for impairment and expensed against earnings only in the periods in which its recorded value exceeded its fair market value. The FASB’s position represents a significant change from current accounting principles which require that acquired goodwill be amortized over periods of up to forty (40) years resulting in charges to earnings that can be significant for companies which have acquired other businesses.

The FASB’s position also represents a significant departure from the guidance proposed in its September 1999 exposure draft, Business Combinations and Intangible Assets (the "Exposure Draft"). The prescribed treatment of goodwill included in the Exposure Draft was to amortize it over a period of up to twenty (20) years.

The FASB’s new position on goodwill and all aspects of the Exposure Draft remain subject to final FASB approval. The FASB issued for public comment its tentative decisions on the accounting for goodwill under an impairment-only approach as a revised exposure draft on February 14, 2001, for a 30-day comment period. While an effective date has yet to be established, the FASB hopes to give its final approval to the business combinations project in June 2001.

Background

The Exposure Draft has generated considerable attention and controversy because of its proposal to eliminate the pooling-of-interest method of accounting, a popular method used by companies to account for certain types of business combinations. Instead, all business combinations would be required to be accounted for using the purchase method of accounting, which is currently required by generally accepted accounting principles for other types of business combinations and is favored by the FASB, which believes that the method more accurately reflects the financial reality of all business combinations. The treatment of goodwill and its attendant effect on earnings lies at the heart of the controversy over the FASB’s proposed mandatory use of the purchase method of accounting. Certain segments of the business community have objected to the Exposure Draft on the basis that the purchase method of accounting discourages business acquisition activity generally. Unlike the pooling-of-interest method of accounting which produces no goodwill amortization, the purchase method of accounting results in goodwill amortization which reduces net income. Moreover, the proposal in the Exposure Draft to reduce the goodwill amortization period from a maximum of forty (40) years to a maximum of twenty (20) years would further exacerbate the negative earnings effects resulting from the application of the purchase method of accounting. Indeed, industry pressure against the Exposure Draft was so significant that two California Congressmen introduced a bill in the U.S. House of Representatives which would have delayed the implementation of the Exposure Draft.

The Proposed Modification

The FASB’s tentative modification to the Exposure Draft should serve to soften some of the resistance caused by concerns over earnings dilution caused by goodwill amortization. Under the modification, goodwill resulting from business combinations would be adjusted on an impairment basis rather than amortized over a period of up to twenty (20) years. Consequently, while charges to earnings resulting from goodwill impairment adjustments would still be possible, there would be no automatic earnings dilution caused by ratable goodwill amortization. The FASB’s shift resulted from a number of factors including:

• a desire to provide more useful information to investors and management;
• a recognition that all goodwill does not "waste," or deteriorate, in value and that goodwill which does waste does not typically do so on a steady basis over time; and
• a determination that perceived difficulties in managing goodwill on an impairment basis, as earlier identified by the FASB, could be addressed in implementation.

The FASB’s modified position on goodwill would require that goodwill be reviewed for impairment when any event or series of events occur which may result in impairment. Goodwill would be impaired, for example, when the fair value of a company’s or its reporting unit’s goodwill is less than its carrying value (see discussion below regarding impairment events). Additionally, an entity would perform "benchmark" testing of goodwill whenever the net assets of the company or its reporting unit are significantly reorganized, or substantially increased because of an acquisition (see discussion below regarding benchmark testing). The FASB’s modification would also change the financial statement presentation of goodwill, including the addition of a requirement that financial statements set forth a reconciliation of the beginning and ending amounts of goodwill.

The scope of the intangible assets portion of the project will address the accounting for goodwill and other purchased intangible assets but not internally developed intangible assets. The FASB’s decision would apply not only to goodwill and intangible assets arising from acquisitions completed after the issuance date of the final statement, but also to goodwill and intangible assets arising from acquisitions completed before that date.

The FASB’s modification to the Exposure Draft is not without its downsides:

• monitoring goodwill for impairment may require additional record-keeping for some entities;
• recording impairment of goodwill could focus investors’ attention on management’s ability to successfully integrate acquisitions; and
• certain financial ratios frequently relied upon by investors may be adversely impaired (return on assets and return on equity).

Impairment Events

Events that might cause impairment of goodwill, thus requiring an adjustment, include, among others:

• a history or projection of operating or cash flow losses;
• a significant adverse change in one or more of the assumptions on which the most recent benchmark testing was based, including:

• the development of a competitive product, technology or service resulting in a significant reduction in market share;
• significant revenue reduction, or deviation from forecast, attributed to changes in technology, customer base, competition or other factors;
• significant operating profit and cash flow reduction, or deviation from forecast, attributed to unplanned cost increases, the inability to realize planned cost reductions or other factors;
• the inability to produce next generation products or technologies on a timely basis to replace significantly reduced sales within a reasonable time period;
• loss of key personnel;
• changes to operating model which significantly depart from the stated assumptions in the most recent benchmark testing; and
• significant adverse changes resulting from legal or regulatory factors;

• a "more-likely-than-not" expectation that the reporting unit with which the goodwill is associated (or a significant portion thereof) will be sold or disposed of.

Benchmark Testing

The FASB’s modified proposal would also require that an enterprise perform periodic "benchmark" tests or assessments of goodwill in certain events. The benchmark assessment would be completed within six months of the triggering event. The benchmark tests would include the following steps:

• document all assets (including goodwill) and liabilities associated with the reporting unit with which the goodwill is associated;
• document the key performance expectations for such reporting unit;
• document the key assumptions to be used to measure the fair value of the assets and liabilities of the reporting unit for the purpose of impairment testing;
• document the model and key assumptions to be used to value the reporting unit for impairment testing;
• measure the fair value of the reporting unit; and
• perform high-level assessment of the reasonableness of the amount of goodwill allocated to the reporting unit.