Peeling away financial reporting issues one layer at a time

Goodwill Impairment: I Love a Charade

I have written about initial recognition of goodwill on numerous occasions. I suppose it might be less bothersome if goodwill had the good grace to sit and stay like a good dog on the balance sheet at its opening 'value'; but alas, such is not the case. Not even close.

Goodwill impairment tests chew up good money, and as I am about to describe, they screw up the accounting for just about everything else. Even in the best of circumstances (by which I mean that goodwill could actually be something more than a garbage can for overpayments, mis-measurements and measurement exceptions) the goodwill impairment test is a ludicrous charade.

To Illustrate

Let's start with a simple set of made-up facts, albeit loosely based on a real situation as described to me. The teller of the tale attended a business combinations workshop that I had recently led:

Acquiror Company purchased 100% of the outstanding shares of Target, a consulting company for $1,000. None of Target's liabilities were assumed; the only asset eligible for recognition other than goodwill was a customer-related intangible, with a fair value of $400 million and an expected economic life of 8 years. Therefore, goodwill was initially "measured" (the FASB's misleading term, not mine) at $600 million (=$1,000-$400). Why such a high amount for goodwill? Acquiror viewed Target's assembled workforce to be its most valuable asset, which may not be recognized separately under GAAP (or IFRS).

One-year later, negative events associated with the recession significantly diminished Target's prospects. Principally, the value of the previously recognized customer related intangibles declined significantly; however, their remaining expected economic life still has seven years to run. (The remaining expected economic life of the asset is not particularly relevant to my analysis to follow, but there it is, anyway.)

U.S. GAAP requires that the customer-related intangible be tested for impairment before the goodwill is tested. To make a long story mercifully short, one first assigns the current carrying amount to the smallest cash-generating unit (CGU) for which cash flows can be reasonably attributed. Acquiror determines the CGU to be Target itself, and then determines the expected undiscounted cash flows to be just slightly greater than $350 million (which is the carrying amount of the CGU. Thus, no impairment of the customer-related intangible is recognized, even though its value is surely far below the carrying amount.

Now, it's on to the goodwill; and for the FAS 142 cognoscenti among you, we shall stipulate that Target constitutes a "reporting unit." Cutting to the chase again, GAAP requires that the current fair value of Target be compared to its carrying amount. Let's say that the fair value of Target is determined to be $300 million. Since that's less than Target's carrying amount of $950 million (=$350 + $600), Acquiror must launch itself through the gauntlet of the goodwill impairment test, known as "Step 2."

Step 2 requires Acquiror to pretend that it purchased Target today for its fair value, and to figure out what goodwill would be recorded at today, should that impossible fantasy somehow be the reality. So, let's see: assuming a purchase price of $300 million and a fair value for the customer related intangible of $200 million, the "implied fair value of goodwill" (another fabricated and misleading term to add to one's collection) comes to $100 million.

Thus, a "goodwill impairment" of $500 million (=$600 – $100) must be recorded, even though everyone and their brothers and sisters all know that it is the customer-related intangible that is deep underwater. Acquiror's management knows that the customer-related intangible is worth $200 million less than the amount reported on the consolidated financial statements, but investors don't know that. All they see is a writedown to goodwill; which everyone and their brothers and sisters dismiss as merely the result of an arbitrary recalculation of an arbitrary calculation.

So now you know why issuers don't complain too much about goodwill impairment accounting, even though the charade by which it is calculated can be a gigantic pain in the tuchas. It's just one more line of defense for hiding information about real impairments on any kind of long-lived asset other than goodwill that you can imagine. Nothing actually re-measured, only goodwill actually lost.

Is IFRS Any Better?

No. It's worse and with no prospects of improvement anywhere close to being on the horizon. Unless management elects to separately estimate the "recoverable amount" (higher of net fair value and "value in use"), then all of the goodwill and customer-related intangibles carrying amounts are thrown into the CGU bucket. If the CGU's fair value is less than its total carrying amount, then you will always write down goodwill before you touch any of the other long-lived assets.

Although in this case the GAAP and IFRS answer would be identical, the difference is that under GAAP there is at least some chance that non-goodwill assets would be stated at a more realistic value for them. Moreover, the SEC has demonstrated its awareness of the anomaly and willingness to hold a registrant's feet to the fire. For example, here is one case of an SEC comment letter to a company expressing its incredulity that goodwill was written down while miraculously preserving the carrying amounts of its non-goodwill assets:

Taking into consideration the circumstances that caused you to recognize an impairment charge on the Birmingham market goodwill, tell us whether you first tested your long-lived assets … If you did test your long-lived assets for impairment, explain to us in why an impairment charge was not recognized. If you have not tested your long-lived assets for impairment explain to us why not. Please also tell us how you group your long-lived assets for purposes of testing your long-lived assets for impairment …. [Letter from the SEC to Cox Radio, Inc., dated July 17, 2006]

Don't Worry, Be Happy

Small wonder that goodwill and long-lived asset impairment is not on the rush-rush 2011 convergence agenda, or even anytime thereafter. The financial crisis has clearly demonstrated, asset impairment accounting is a sacred cow that may only be approached in circumstances involving extreme unction. Not very long ago, it was hard enough for the FASB to push through any sort of consistent impairment standard for long-lived assets. Now, with the EU already threatening to jump ship on financial instrument impairment, the only choice the Boards have is to pretend that the shortcomings of impairment standards are not a high priority, not to mention the gaping inconsistencies within and between IFRS and GAAP.

I love a charade.

1 Comment

  1. Reply Aleksey January 20, 2010

    Tom,
    First of all want to thank you for an exciting presentation you made to us on Jan 11-12 in Moscow. I have really enjoyed hearing your ideas and thoughts about “strange” accounting rules that all of us are applying everyday.
    Second – about the goodwill. Don’t you think that goodwill is actually the most intangible from intangible assets and if we see rapid decline in total fair value of the entity ($1000 -> $300) then goodwill should be impaired first before other assets? I believe there is also a good straight logic in US GAAP that the asset should be recoverable (covered by undiscounted cash flow): if the entity is, at least, able to generate cash flows necessary to cover its investments, it is still fine. The only thing I don’t like is the permission to test assets at the level of reporting unit. There should be a presumption that it is possible to make at least one step down. In your example we should find, for instance, a group of customers that left our company or something like that.
    Best regards,
    Aleksey

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