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Back in April 2002, CFO.com's Stephen Taub
referred to it as "the good, the bad, and the very ugly,"
(1) when he reported on Qwest's announcement that its
net income would increase by approximately $900 million per year
as the result of the implementation of new rules governing goodwill
accounting. Mr. Taub went on to report Qwest's disclosure that it
would be taking a charge of between $20 billion and $30 billion
to write down the value of assets as a result of the impairment
tests required by the new accounting standards. And Qwest was not
alone. AOL Time Warner, JDS Uniphase, and other corporations have
disclosed that they have reduced amortization expense in 2002 and
have or will be recording substantial charges from writing down
the value of recently acquired assets.
In the summer of 2001 the Financial
Accounting Standards Board ("FASB") released two new Statements
of Financial Accounting Standards ("SFAS") dealing with
the valuation and accounting for businesses and their intangible
assets. SFAS 141, Business Combinations, replaces Accounting
Principles Board Opinion 16 of the same title ("APB 16").
SFAS 142, Goodwill and Other Intangible Assets, replaces
Accounting Principles Board Opinion 17, Intangible Assets ("APB
17"). Both of these new standards are having an enormous impact
on companies' financial statements and on how we read and interpret
those statements.
The two standards are long and
complex. The purpose of this article is to give the reader an overview
of some of the more substantive changes required by SFAS 141 and
SFAS 142.
Application to Reorganizations
and Fresh Start Accounting
American Institute of Certified Public Accountants
Statement of Position 90-7, Financial Reporting by Entities in Reorganization
Under the Bankruptcy Code ("SOP 90-7"), required that
so called "Fresh Start" accounting applied to a qualifying
company emerging from bankruptcy should be applied in conformity
with the requirements of APB 16 and APB 17. With SFAS 141 and SFAS
142 superceding APB 16 and APB 17, the application of Fresh Start
accounting must conform to these new statements. One provision of
SOP 90-7 specifically addressed in SFAS 142 relates to the rather
bulky term, "reorganization value in excess of amounts allocable
to identifiable assets." As specified in SFAS 142, "reorganization
value in excess of amounts allocable to identifiable assets"
will be captioned "goodwill" on the reorganized company's
balance sheet.
SFAS 141, Business Combinations
In many respects accounting for business
combinations and acquisitions of minority interests following the
rules specified in SFAS 141 will be no different than the accounting
under APB 16. Where the rules differ, however, the differences are
significant.
Pooling eliminated
Perhaps the most significant of the changes
is the elimination of "pooling." Recording a business
combination under the pooling rules essentially entailed adding
together the balance sheets of the acquiree and the acquiror at
their historical cost bases. Under SFAS 141, the only acceptable
method of accounting for a business combination is the purchase
method of accounting. The purchase method sets the cost basis of
the acquired enterprise at the more evident of the value of the
consideration given or consideration received plus transaction costs.
More guidance for identifying
the acquirer, intangibles, etc.
In an exchange of equity interests or in
roll-up transactions, SFAS 141 still uses a judgmental determination
for identifying the acquirer. Applying APB 16 usually resulted in
treating the largest forming company or the entity with whose stockholders
owned the larger portion of voting rights as the acquirer. SFAS
141 requires consideration of all facts and circumstances, not just
the relative size of the combining companies or the survival of
majority voting rights.
Under SFAS 141, the purchase price
allocation to identifiable intangible assets is subject to a higher
standard of identification. Under APB 16, if an asset could be identified
and named, value could be assigned to it. Now, value will only be
assigned to an intangible asset if the asset is obtained through
a legal or contractual right or is separable from the entity's assets.
Negative goodwill eliminated
Under APB 16 if an entity was acquired for
less than the value of its current assets, the remaining residual
credit after writing the non current assets down to zero was recorded
on the balance sheet as "negative goodwill." Negative
goodwill was amortized into income over a reasonable period of time.
There has been a number of bankruptcy cases over the last ten years
where the reorganization value in comparison to the assets and liabilities
of the reorganized entity has resulted in negative goodwill. Ames
I (filed 1990) and Zales (filed 1992) are two such cases that come
to mind. Under FSAS 141, after non current assets (with a few exceptions)
are reduced to zero the remaining residual credit is recognized
in income immediately as an extraordinary gain.
SFAS 142, Goodwill and
Other Intangible Assets
Unlike the relationship between
SFAS 141 and APB 16, SFAS 142 and APB 17 have very little in common.
Perhaps the single consistent accounting treatment between the two
statements relates to the accounting for internally generated intangible
assets. Both APB 17 and SFAS 142 require companies to expense as
incurred costs related to internally generated intangible assets.
Amortization versus impairment
Goodwill has been amortized over
periods not to exceed 40 years since Richard Nixon was in the White
House (and Arthur Burns was chairman of the Fed.) The chosen period
over which to amortize goodwill and the very presence of amortization
expense in a company's income statement have been controversial
ever since. Among other controversies, the Securities and Exchange
Commission has regularly challenged registrants' use of the full
40-year amortization period and company management, and stock analysts
have regularly complained that investors don't understand the profitability
of companies because they don't understand goodwill amortization.
SFAS 142 replaces the concept that
goodwill is a depleting asset that should be amortized with recognition
that some intangible assets, including goodwill, have indefinitely
useful lives. Such assets should not be amortized against income
but should be periodically tested for impairment. As a result, SFAS
142 replaces the requirement to amortize goodwill with specific
guidance on annually evaluating goodwill for impairment.
Although the accounting model has
long recognized the concept of asset impairment, APB 17 did not
specifically articulate the requirement that goodwill, although
subject to amortization, should also be evaluated for impairment.
As a result of the lack of guidance in this area, the recognition
of excess carrying value of goodwill through a charge in the statement
of operations has not often been reported because the general standard
against which to evaluate impairment was not specifically tied to
value. As an example of the looseness in the rules under APB 16
and APB 17, one large construction related company acquired another
complementary operation a few years ago. At the time of the acquisition,
the acquiror forecast that it would record approximately $45 million
of goodwill on the purchase price of approximately $200 million.
Within the one-year adjustment period following the acquisition,
the acquiror discovered unrecorded contract losses that took the
net identifiable assets acquired from approximately $155 million
to approximately a negative $75 million. (The acquiror ended up
purchasing no net assets, rather it assumed net liabilities of approximately
$75 million.) The $230 million of contract loss accruals resulted
in the acquiror recording total goodwill of approximately $275 million
on the transaction. As the acquiror filed for bankruptcy approximately
two years later, at least partly as a result of the acquisition,
it continued to carry the amount of the acquisition goodwill, net
of subsequent amortization, on its balance sheet. Under SFAS 142,
the acquiror would likely have been required to charge off the excess
goodwill that essentially represented a capitalization of contract
losses.
Evaluating impairment
Until SFAS 142, a one-step undiscounted cash
flow test would have been performed at the acquired business level
to assess the impairment of goodwill. Under SFAS 142, a two-step
fair value impairment test at the reporting unit level is required
at least annually and on an interim basis if conditions or events
indicate that an interim evaluation is warranted. Under the new
rules, the acquiror must allocate the goodwill from the acquisition
to its appropriate reporting unit level. A company's reporting units
are based on the company's organizational structure. The reporting
unit to which the goodwill is assigned depends on how the acquired
company is integrated into the acquiror. The first step of the goodwill
impairment test compares the fair value of the reporting unit with
its carrying value, including goodwill, on the company's financial
statements. If the carrying value exceeds the fair value of the
reporting unit, the second step, comparing the implied fair value
of the reporting unit goodwill with the carrying amount of that
goodwill, is performed. If the implied value of the reporting unit
goodwill is less than the carrying value of that goodwill, impairment
exists and an impairment loss must be recognized as a charge against
income. The charge should be presented as a separate line item before
the subtotal "income from continuing operations" or similar
caption, unless the impairment loss is associated with a discontinued
operation.
More guidance related to
other intangible assets, disposal of businesses
SFAS 142 provides more guidance than APB17
related to accounting for the effect on goodwill of disposing of
all or a potion of a business. Additionally, SFAS 142 specifically
addresses other types of intangible assets that may have indefinite
useful lives and the appropriate accounting for these assets.
Disclosure
SFAS 141 and SFAS 142 expand upon
the necessary disclosure related to business combinations and intangible
assets, including goodwill. Particularly those disclosures required
by SFAS 142 should expand the financial statement reader's understanding
of the company's assessment of the value of its businesses and the
circumstances and events that effect that assessment of value. Among
the information a company must disclose are changes in goodwill
carrying amounts by reportable segment, the events and circumstances
leading to any impairment, the amount of the impairment loss, the
method used to determine the fair value of the associated reporting
unit, and whether the loss recognized is based on an estimate rather
than a full valuation and the reasons why.
Impact on other reporting
Concepts such as EBITDA must be reevaluated
with the effective date of SFAS 142. A substantial portion of the
"A" in EBITDA is being replaced by what is expected to
be irregularly occurring charges against income for impairment losses.
Being based on current fair value assessments, such charges do not
have the same character as amortization expense. While management
may seek to have such charges excluded from covenant calculations,
lenders must reevaluate the purpose of those covenants and determine
whether such charges should be excludable from covenant reporting
or whether such charges will serve as a leading indicator of emerging
problems for the company.
(A) Substantial portions of this
article previously appeared in American Bankruptcy Institute Journal
(1) " FAS 142 Strikes Again!"
Stephen Taub, CFO.com April 2, 2002
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