Navigating goodwill impairment testing guidance
Observations from the front lines
In 2019 the FASB revised the goodwill impairment testing guidance through its issuance of ASU 2017-04. The intent of ASU 2017-04 was to simplify the overall impairment testing framework and eliminate the legacy “Step 2” quantitative test in the prior guidance.
In recent years, many companies have not had to scrutinize the impairment framework at great length given the state of the equity markets and — with the exception of brief periods of volatility — overall increase in prices. However, the risk of market volatility remains present, particularly as investors weigh international conflicts and global interest rates. Additionally, while not formally written in the current impairment model, in practice we see many auditors require companies to perform a quantitative Step 1 impairment analysis every couple of years.
To the extent that market volatility continues, navigating the goodwill impairment model can be complex, judgmental and often time intensive. Early and ongoing cross-functional coordination between accounting, FP&A, valuation and tax professionals is critical to confirming an effective and efficient impairment analysis.
Companies should take a fresh look at existing processes and controls for assessing asset impairment, as proper identification of triggering events is integral to appropriately measuring goodwill impairment.
Why it matters
The current guidance simplified the goodwill impairment test to address concerns related to the old guidance’s cost and complexity by eliminating Step 2 (see diagram) of the prior goodwill impairment test. Step 2 required a hypothetical purchase price allocation to measure the amount of a goodwill impairment. Under the current framework, a goodwill impairment loss is measured as the amount by which a reporting unit’s carrying amount exceeds its fair value, not to exceed the carrying amount of goodwill. Inherently, the measurement of goodwill impairment (if any) under today’s framework may be materially different from that which would have been measured through a Step 2 hypothetical purchase price allocation.
While many companies may not have had to work through a Step 1 quantitative assessment, there are nuances in how the current impairment guidance interacts with the subsequent measurement of other assets (not goodwill) governed by other accounting standards. These complexities are important for management and stakeholders to understand when applying the current guidance.
Navigating potential impairment testing complexities
Relative to the old goodwill impairment model prior to the issuance of ASU 2017-04, the current goodwill impairment model does not change the sequencing of impairment testing for assets (or asset groups) held and used or held for sale. Getting the sequencing right can help avoid potential errors in assessing impairment. For example, for assets that are held and used, other assets (e.g., inventory, financial assets, etc.), indefinite-lived intangible assets (except goodwill), and long-lived assets are assessed for impairment prior to testing goodwill.
The impairment models for assets other than goodwill may not require an impairment charge to be recognized under certain circumstances, even when the fair value is less than carrying value. As the current single-step approach for assessing goodwill impairment compares the fair value and carrying value of the entire reporting unit, the goodwill impairment charge (if any) may capture fair value declines, below their carrying values, for non-goodwill assets.
Consider the example of a company that has long-lived assets that are recoverable under ASC 360-10: Property, Plant and Equipment — but the fair value of its fixed assets or finite-lived intangible assets have fallen below their carrying amounts. Under the current guidance, the goodwill impairment charge could capture the decline in fair value of the long-lived assets.
Additionally, recognition of the impairment of the long-lived asset that contributed to the goodwill impairment may occur at a later date. Without the more involved calculation that would have been performed when applying Step 2 under the previous model (i.e., the implied fair value of goodwill is no longer calculated), the amount of impairment recognized (if any) would be inherently different under the current standard.
Another example often seen involves companies that hold significant portfolios of financial assets that are carried at amortized cost. In rising interest rate environments, the fair value of these financial assets will often be significantly less than the carrying value, which consequently could lead to the impairment of goodwill to reflect the decrease in the fair value of the reporting unit.
Alternatively, when there is unrecognized appreciation in the fair value of other recognized or unrecognized assets in the reporting unit, the amount of the goodwill impairment charge will be less than under the current guidance.
A closer look at liabilities
In addition to the considerations around an entity’s assets, the fair value of its liabilities, relative to their carrying amounts, may also influence the goodwill impairment analysis. The goal of identifying and assigning assets and liabilities to reporting units is to achieve symmetry between those net assets and the net assets leveraged in the valuation approach. The effect that debt may have on the analysis will be dependent on the valuation approach selected.
Two valuation approaches are typically employed. Under the equity value approach, liabilities (including debt) associated with the reporting unit are assigned to the reporting unit and included in the valuation of the reporting unit. Conversely, under the enterprise value approach, debt is excluded from the liabilities assigned to the reporting unit. US GAAP does not specify the use of an enterprise or equity value approach.
The one-step test performed using an equity value approach can result in a different amount of goodwill impairment than the enterprise value approach. This is specifically relevant to cases in which an entity has a zero or negative carrying amount for any of its reporting units.
Under the current guidance, if the equity value approach is used for a reporting unit with a negative carrying amount, the reporting unit generally will not have an impairment since the reporting unit’s fair value will always be greater than its carrying value. While not a requirement, the FASB has indicated that it might be appropriate to change from the equity premise to the enterprise premise for a reporting unit with a negative carrying amount if it results in a more representative impairment evaluation under the quantitative assessment.
Although the effect of this limitation could be mitigated by employing an enterprise value approach, there are still factors (including corporate level debt that usually does not get pushed down to the reporting unit level) that could impact the calculation and valuation results. It is highly recommended that entities consult with their technical accounting advisors and valuation professionals when assessing the potential effects of a choice in valuation methodology.
Regardless of valuation approach, companies are required to apply their valuation approach consistently from year-to-year and — to the extent applicable — must disclose the amount of goodwill attributable to reporting units with zero or negative carrying amounts which may draw additional scrutiny from investors and regulators.
A note about the tax impact
Another consideration for companies is the income tax effect from any tax-deductible goodwill on the carrying amount of the entity (or the reporting unit). Specifically, if an entity has tax-deductible goodwill, there is the possibility of running into a cycle of impairment due to the decreasing book value of its goodwill as a result of an impairment charge increasing its deferred tax asset. This in turn increases the carrying value of the reporting unit above its fair value. To address the circular nature of the carrying value exceeding the fair value, a simultaneous equation is required to adjust the goodwill impairment and deferred tax impact when tax deductible goodwill is present. In practice, we have seen companies oftentimes overlook the tax implications on the goodwill impairment model. Effective coordination between accounting and tax professionals can help appropriately reflect goodwill and deferred tax balances in the financial statements.
Disclosure considerations
The SEC continues to emphasize disclosures within a company’s critical accounting estimates relating to goodwill impairment. It is not uncommon for the SEC to request additional disclosures for “at risk” reporting units, including:
- The percentage by which fair value exceeded carrying value as of the date of the most recent quantitative test
- The amount of goodwill allocated to the reporting unit
- A description of the methods and key assumptions used and how the key assumptions were determined
- A description of potential events and/or changes in circumstances that could reasonably be expected to negatively affect the key assumptions
The extent and applicability of these disclosures are oftentimes an area of judgment and based on company-specific facts and circumstances.
ASC 350-20-50-2 also outlines required disclosures within the financial statements, including a description of the facts and circumstances leading to the impairment, the amount of the impairment loss and the method of determining the fair value of the associated reporting unit, and fair value disclosures required under ASC 820.
Continued monitoring and early coordination is key
While the overall increase in the equity markets over the past several years has resulted in fewer companies working through the nuances of the current goodwill impairment model, management teams should continue to work with their auditors and monitor the economy for any unforeseen economic turbulence. Early involvement and coordination between cross-functional teams from accounting, FP&A, tax and valuation is critical in order to align expectations and evaluate the financial reporting implications. This includes clearly outlining information and data requirements, as well as key decision points and areas of judgment to effectively test goodwill for impairment and facilitate an efficient audit.
