When you start with a bogus asset like goodwill (itself a misnomer), it's hard to find quality in the rules that govern its measurement. The root of the problem is that business combination accounting relies on a fantasy: that an utterly ineffable plug to balance the business combination journal entry must somehow be an asset. The initial measurement of that plug is, at its theoretical best (i.e., assuming that management did not overpay; and all other assets and liabilities are recognized and accurately measured), an amalgamation of assets and liabilities that (unlike every other asset on the balance sheet) can neither be separated from the rest of the entity nor measured directly. Among the broad panoply of misnomers in financial accounting, "goodwill" is among the least subtle.
If goodwill is a bogus asset, then testing it for impairment compounds the madness. But, there is at least some method to it. The propensity of management to overpay for corporate acquisitions is one of the most well-documented and uncontroverted phenomena in academic finance: with disturbing frequency, share price movements send a signal that investors believe that a corporate acquisition destroyed, rather than created, value. If goodwill were recognized as an asset, but not subject to either amortization or impairment, then management would be even more inclined to destroy shareholder value without having to worry that future earnings would suffer from its profligate spending. Since 2001 (see SFAS 142), impairment testing, albeit replete with opportunities for earnings management, has been seen as the less silly of two silly charades. As currently set forth in U.S. GAAP (ASC Topic 350), this is how it is choreographed:
- All of the goodwill currently on the balance sheet has to be assigned to "reporting units," another misnamed artifice, invented solely for the purpose of making the goodwill impairment test flexible and palatable.
- The fair value of each reporting unit has to be assessed at least once a year – a costly undertaking.
- The real mayhem begins if, heaven forbid, your estimate of the fair value of the reporting unit turns out to be less than its carrying amount. You must then estimate the "implied fair value" of goodwill, another artifice devised solely for goodwill impairment testing; and –
- Write goodwill down to the implied fair value, if its carrying amount is greater.
Recently, however, the FASB issued proposed Accounting Standards Update No. 2011-180, which if finalized would grant unfettered discretion to elect to avoid these processes altogether – so long as "qualitative factors" indicate that it is more likely than not (MLTN) that the fair value of a reporting unit is greater than its carrying amount. The option to consider qualitative factors applies to any year and any reporting unit.
The existing goodwill impairment ballet can be a very costly production. While I am sympathetic to cost issues, I have a number of concerns with the way the FASB is addressing them:
More management discretion means more earnings management – The Board ostensibly decided to give entities the discretion to skip any qualitative assessment at any time. The stated intention is to save entities the cost of performing the qualitative test in a period when breaching the MLTN threshold could be self-evident. Allow me to illustrate my skepticism for this explanation with a slight digression – an example of a similar impairment test that I got wind of just this week:
I was contacted by an analyst who was concerned about a foreign energy producer that prepares its financial statements under IFRS. In accounting for its oil and gas field development costs, the company capitalizes the development costs associated with both successful and unsuccessful wells. The question I was asked pertained to a very large reported impairment charge from writing off the capitalized costs allocated to one particular dry well, one component of a block of wells comprising a "cash generating unit." The write off took place even though every other well in the cash generating unit was performing well beyond original expectations.
I explained to the analyst that IFRS (see IAS 36) provides the option to assess impairment at the individual asset level at any time – ostensibly to allow an entity to provide more timely information regarding impairments. But, ulterior motives may have been at work: With oil prices (and revenues) so high lately, the entity likely had more than enough accounting profit to absorb impairment losses this year, and still meet earnings projections. Hence, the entity apparently elected to pave the way for higher future earnings by taking an impairment charge in the current year with the main effect being reduced future amortization of development costs.
One of my philosophies of financial reporting – and a major theme of this blog – is that discretion in financial reporting invariably leads to abuse. In criticizing the proposal that entities may use the qualitative assessment at their own discretion, am I being too cynical? Or, is the Board being disingenuous? As you decide these questions for yourself, consider that a qualitative assessment in no-brainer circumstances shouldn't cost that much in the first place. Also, while there are already plenty of opportunity for earnings management in the FASB's extant goodwill impairment standard, there will certainly be times when entities will want to write off goodwill before issuing its financials, but can't because the MLTN threshold prevents it.
The "more-likely-than-not" probability threshold is not auditable – I have conducted seminars on financial reporting to thousands of practicing accountants; and my own impression, which is corroborated by a colleague who has done even more of this kind of work than I, is that CPAs are not well-equipped, nor are they excited about, making probabilistic judgments. Yet, the latest fad among standards setters is to require them to do so (and in some cases – leases, loans, revenue recognition – to generate entire probability distributions). Again, my philosophy that discretion leads to abuse is directly applicable.
Moreover, who shall review the 'reasonableness' of these probabilistic judgments? In the most important cases, it will be the "independent" auditors of large public companies, who are paid millions of dollars via checks bearing the signature of the company's CEO. I can see it now: two weeks before the Form 10-K is due at the SEC, a newly-hired auditor who still takes his job too seriously will question the reasonableness of the MLTN determination. Should the auditor require a re-assessment, the company won't have enough time to conduct its goodwill impairment test. Guess who gets inserted between a rock and a hard place?
Non-existent cost-benefit analysis – Federal law requires the SEC to justify a new regulation with rigorous and transparent cost benefit analyses, generally with hard data and quantitative assessments. I find it strange that both the IASB and the FASB (essentially the SEC's agent when it comes to making accounting rules) can trumpet the rigor and extensiveness of their "due process" without the same. In ASU 2011-180, the FASB is proposing, without even acknowledging any potential negative consequences, to allow reporting entities to side-step a series of rules that clearly were intended to mitigate shareholder value destruction.
More convergence nonsense – The Board mentions that it considered a number of other alternatives for changing goodwill impairment accounting. I won't get into the details here, but some of those alternatives make a lot more sense that the proposed rule changes. Irritatingly, much of the Board's rationalizations are based on their concern that a revised goodwill impairment standard should move U.S. GAAP closer to IFRS. But in point of fact, the goodwill impairment rules under IFRS are already as different from U.S. GAAP (with no plans for convergence) as night is from day. Under U.S. GAAP, the last long-lived asset to be tested for impairment, and written down, is always goodwill; but under IFRS, all long-lived assets are tested together, and the first asset to be written down is generally goodwill (subject to earnings management options that are currently not in U.S. GAAP).
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Financial accounting costs too much because it is too darn complex. I am sympathetic towards efforts to reduce the costs of financial reporting, but in most cases, improvements are only slightly incremental and they come with too much baggage. The latest proposal for modifying "goodwill impairment" accounting is a case in point.