A SYNOPSIS OF ACCOUNTING FOR BUSINESS COMBINATIONS, INTANGIBLES AND GOODWILL IMPAIRMENT INTRODUCTION During the 1980’s and 1990’s a great number of business mergers and acquisitions took place. The generally accepted accounting principles to record the initial transaction and to account for the acquired assets during their estimated useful lives this were well established. Over time however, users of financial statements began to question whether those principles and practices accurately reflected the market realities regarding the assets, their useful lives and their contribution to a company’s value.
In addition, intangible assets have become increasingly more important as an economic resource. It was apparent that users of financial statements did not accept that goodwill amortization expense provided useful information. They realized that treating goodwill as a wasting asset whose value deteriorates predictably over a fixed period of time ignored the economic realities. Goodwill, in fact, can be replenished and increased in value; alternatively, the value of goodwill can decrease precipitously in a short period of time.
During the 1970’s the FASB had an active project on its agenda to reexamine the accounting for business combinations and acquired intangible assets. However, action on the project was deferred until, in 1981, the Board removed the project from its agenda entirely, to focus on higher priority projects. In 1986 the Financial Accounting Standards Board (FASB) included the project on business combinations on its agenda. The purpose was to “improve the transparency of accounting and reporting of business combinations, including the accounting for goodwill and other intangible assets. The FASB’s study confirmed that users of financial statements placed greater emphasis on the goodwill asset reported on the balance sheet, rather than an allocation of goodwill amortization expense reported on the income statement. This project resulted in FASB 141 – Business Combinations, and FASB 142 – Goodwill and Other Intangible Assets. This emphasis on asset valuation rather than expense recognition reflected the FASB’s evolving emphasis on fair value measurement of assets and liabilities. The FASB achieved their two stated goals, that: All business combinations be accounted for in the same manner • Goodwill and intangible assets are accounted for in a manner that reflects economic reality. Another reason the Board undertook the project is because “many perceived the differences in the pooling-of-interests method and purchase method to have affected competition in markets for mergers and acquisitions. Entities that could not meet all of the conditions for applying the pooling method believed that they faced an unlevel playing field in competing for targets with entities that could apply that method. This “unlevel playing field” was perceived to extend internationally, as well. “Cross-border differences in accounting standards for business combinations and the rapidly accelerating movement of capital flows globally heightened the need for accounting standards to be comparable internationally. ” Thus the Canadian equivalent of FASB conducted a similar project concurrently with FASB. The FASB’s project culminated in two new pronouncements, SFAS 141, Business Combinations, and SFAS 142, Goodwill and Other Intangible Assets. FAS 141 – Business Combinations
FAS 141 supersedes APB Opinion 16, Business Combinations. Under APB 16, business combinations were accounted for using either the pooling-of-interests method or the purchase method. The pooling-of-interests method was required when twelve specified criteria were met; otherwise the purchase method was required. However, the twelve criteria did not distinguish transactions that were economically dissimilar and thus similar business combinations were accounted for using different methods, and producing dramatically different results.
As a result, users of financial statements could not compare the financial results of entities where different combination methods had been used; users of financial statements indicated a need for better information regarding intangible assets; and company management felt that differences in combination accounting methods impacted competition in markets for mergers and acquisitions. SFAS 141 is based on the proposition that all business combinations are essentially acquisitions, and thus all business combinations should be accounted for in a consistent manner with other asset acquisitions.
FAS 141 begins with the declaration that the “accounting for a business combination follows the concepts normally applicable to the initial recognition and measurement of assets acquired, liabilities assumed or incurred…as well as to the subsequent accounting for those items. ” A “business combination occurs when an entity acquires net assets that constitute a business or acquires equity interest of one or more other entities and obtains control over that entity or entities. ” In a combination effected through an exchange of cash or other assets it is easy to identify the acquiring entity and the acquired entity.
In a combination effected through an exchange of equity interests, the entity issuing the equity interest is generally the acquiring entity. However, in some business combinations, known as reverse acquisitions, it is the acquired entity that issues the equity interests. (Paragraphs 15-19 offer guidance in this complex area. ) Generally, in exchange transactions, the fair values of the assets acquired and the consideration surrendered are considered to be equal, and no gain or loss is recognized.
The total cost of the exchange transaction is then allocated to the individual assets acquired and liabilities assumed based on their relative fair values. “Fair value” is defined as “the amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale. ” The excess of the cost of the acquired assets over the fair value amounts assigned to the tangible assets, the financial assets and identifiable intangible assets is evidence of an unidentified intangible asset or assets, or goodwill.
In determining the cost allocation, the Statement offers guidance for many items, including: ? Receivables at present values, less allowances for uncollectibility and collection costs ? Finished goods inventory and merchandise at estimated selling prices less costs of disposal and reasonable profit allowance ? Work in process inventory at estimated selling prices of finished goods less cost to complete, cost of disposal and reasonable profit ? Raw materials inventory at current replacement costs ? Intangible assets that meet certain criteria are valued at estimated fair value ?
Liabilities and accruals at present value of amounts to be paid ? Other liabilities and commitments – such as unfavorable leases, contracts ad commitments – at present values of amounts to be paid. “An acquiring entity shall not recognize the goodwill previously recorded by an acquired entity, nor shall it recognize the deferred income taxes recorded by an acquired entity before its acquisition. A deferred tax liability or asset shall be recognized for differences between the assigned values and the tax bases of the recognized assets acquired and liabilities ssumed in accordance with FASB 109. ” SFAS 141 also changes how intangible assets are recognized. APB Opinion 16 required separate recognition of intangible assets that could be identified and named. SFAS 141 requires that acquired intangible assets apart from goodwill be recognized if: 1. the intangible arises from contractual or other legal rights, such as patents and trademarks OR 2. the intangible can be separated or divided from the acquired entity and sold, transferred, licensed, rented or exchanged individually, or in combination with a related contract, asset or liability.
Examples of intangible assets that are contractual or separable include: • Contractual – o Customer contracts o Order backlog o Operating leases o License agreements o Royalty agreements o Employment contracts o Trademarks • Noncontractual but separable – o Customer/subscriber lists o Unpatented technology Any intangible asset that does not meet the separate recognition test (such as a trained and assembled workforce) is classified as goodwill. The FAS offers five categories of intangible asset: ? Marketing-related – those assets that are primarily used in the marketing or promotion of products and services. Trade marks, trade names o Trade dress (package design) o Internet domain names o Non-compete agreements ? Customer-related o Customer lists o Order backlog o Customer contracts and relationships ? Artistic-related – these meet the criteria for recognition apart from goodwill if they arise from contractual rights or legal rights such as those provided by a copyright. o Books, plays and other literary works o Musical works o Pictures and photographs o Video material ? Contract-based o Licensing, royalty agreements o Advertising, construction, service or supply contracts o Lease agreements Use rights such as drilling, water, air, mineral, timber cutting and route authorities o Broadcast rights ? Technology-based – relate to innovations or technological advances o Patented technology o Unpatented technology o Computer software o Databases o Trade secrets, formulas, recipes If it should turn out that the fair value of acquired assets exceeds the cost of the acquisition, the acquirer will first reassess whether all acquired assets and assumed liabilities have been identified and recognized, and will re-value the assets and liabilities.
If there is still an excess of fair value of acquired assets over their cost, the excess will be allocated as a pro rata reduction of the amounts otherwise assigned to the acquired assets, except for: ? Financial assets (cash, evidence of ownership in an entity, or a contract that conveys a contractual right to receive cash) ? Assets to be disposed of by sale ? Deferred tax assets ? Prepaid assets relating to pension or other postretirement benefit plans ? Any other current assets.
In addition to the same disclosure requirements described in APB Opinion 16, SFAS 141 requires the disclosure of the primary reasons for a combination, and the allocation of the purchase price paid to the assets acquired and liabilities assumed by major balance sheet caption. Further, if the acquired goodwill or intangibles is significant, disclosure must be made of the amount of goodwill by reportable segment and the purchase price assigned to each major intangible asset class.
FASB believes SFAS 141 improves financial reporting because it better reflects the underlying economics of business combination transactions in that financial statements will: • Better reflect the investment made in an acquired entity, allowing more meaningful evaluation of the performance of the investment • Improve the comparability of financial information and • Provide more complete financial information through expanded disclosure,
The statement applies to all business combinations initiated after June 30, 2001, and for all combinations accounted for using the purchase method for which the date of acquisition is July 1, 2001 or later. However, the statement does not apply to not-for-profit entities. SFAS 142 – Goodwill and Other Intangible Assets OVERVIEW SFAS 142 addresses the financial reporting for acquired goodwill and other intangibles, and supersedes APB Opinion 17, Intangible Assets. It relates o how acquired intangibles other than those acquired in a business combination should be accounted for upon their acquisition, and also addresses how goodwill and other intangibles are accounted for after initial recognition in the financial statements. An acquiring company’s expectations of benefits from synergies are reflected in the premium paid for the acquired entity. Under APB Opinion 17 an acquired entity was treated as if it remained a stand-alone entity, rather than being integrated with the acquiring entity.
As a result, the portion of the premium (goodwill) related to the anticipated synergies was not accounted for appropriately. Opinion 17 treated goodwill and other intangible assets as wasting assets with a finite useful life. Opinion 17 also mandated an arbitrary maximum amortization period of 40 years over which to amortize the asset. SFAS 142 modifies FAS 121 Accounting for the Impairment of Long-Lived Assets by excluding from its scope goodwill and intangible assets that are not amortized.
SFA 142 applies to the costs of internally developing goodwill and other unidentifiable intangible assets with indeterminate lives, and to the costs of internally developing identifiable intangible assets. Under SFAS 142 intangible assets with identifiable useful lives will continue to be amortized over their useful lives, without the imposition of an arbitrary maximum life. Goodwill and intangible assets with indefinite useful lives, however, will no longer be amortized, but will be tested at least annually for impairment.
Further, the annual testing is done at the reporting unit level. This impairment testing will be a two-step process. First, a test is performed to determine if there has been impairment. If certain criteria are met, the second step is performed to measure the impairment. In addition, SFAS 142 imposes additional disclosure requirements such changes in the carrying amount of goodwill and other intangibles, and the estimated intangible asset amortization expense for the next five years. SFAS 142 is effective for fiscal years beginning after December 15, 2001.
It is important to note that impairment losses for goodwill and indefinite-lived intangible assets arising due to the initial implementation of SFAS 142 are reported as resulting from a change in accounting principle. Subsequently, such impairment losses are charged against income from continuing operations. Understand also that SFAS 142 is a one-way street – impairments are written down, but if the value of goodwill or other indefinite-lived intangible assets should increase in future periods, a write-up is not permissible.
As with SFAS 141, this statement also is not applicable to not-for-profit entities. ANALYSIS OF SFAS 142 An intangible asset or group of assets that is acquired, other than in a business combination, shall be initially recognized and measured based on fair value. If a group of assets, the cost will be allocated pro rata based on fair value, and shall NOT give rise to goodwill. The FASB 141 criteria for including in goodwill intangible assets that are not separable or arises from a contractual right do not apply in SFAS 142.
Costs of internally developing, maintaining or restoring intangible assets that are not specifically identifiable, that have indeterminate lives are to be expensed when incurred. An intangible asset with a finite useful life is amortized; one with an indefinite useful life is not amortized. Useful life is to be determined based on an analysis of all pertinent factors, such as: 1. Expected use of the asset 2. Expected useful life of another asset or group of assets to which the useful life of the intangible may relate (such as mineral rights to depleting assets) 3.
Legal, regulatory or contractual provisions or available renewals 4. Effects of obsolescence, demand, competition and other economic factors such as the stability of the industry, known technological advances, legislative action 5. Level of maintenance expenditures needed to obtain the expected future cash flows If no legal, regulatory, contractual, competitive, economic or other factors limit the useful life of the asset, its life is considered to be indefinite. Appendix A of the SFAS gives examples of determining the useful lives of assets under different circumstances.
Once the useful life is determined, the method of amortization is not necessarily straight line – “the method of amortization shall reflect the pattern in which the economic benefits of the intangible asset are consumed or otherwise used up. If that pattern cannot be reliably determined, a straight-line amortization method shall be used. ” In recording amortization, residual value must be considered as well. If an intangible asset being amortized is later determined to have an indefinite useful life, the asset will be tested for impairment, and shall no longer be amortized.
Impairment of an intangible asset that is being amortized is tested in accordance with the provisions of SFAS 121 – Accounting for the Impairment of Long-Lived Assets. An intangible asset that is not subject to amortization is to be tested for impairment at least annually in accordance with SFAS 142. Goodwill is not to be amortized, and it is considered impaired when its carrying amount exceeds its implied fair value. Reporting Units Impairment reviews are to occur at least annually, at the “reporting unit” level. A reporting unit is defined as an operating segment or one level below an operating segment.
As defined in SFAS 131, Disclosures about Segments of an enterprise and Related Information, an operating segment is a business component that earns revenues and incurs expenses, whose operating results are regularly reviewed by management to assess performance and allocate resources, and for which discrete financial information is available. A component of an operating segment is a reporting unit if its assets constitute a “business” in addition to being an operating segment. SFAS 142 permits the aggregation of economically similar components for impairment review purposes.
The definition of reporting units, and the possible aggregation, could have significant future impact, as the business changes over time. Step One – Carrying Amount Comparison The first step compares the “fair value” of the reporting unit to its carrying amount (shareholders’ equity including goodwill). If the fair value exceeds carrying amount, no further testing is required. If however, carrying amount exceeds fair value, there is evidence of impairment, meaning the value of goodwill is less than its carrying value on the balance sheet.
Step one impairment testing must be done at least annually, and can be performed at any time during the year, provided the test is performed at the same time every year. Different reporting units may be tested for impairment at different times. Impairment should be tested between the annual tests if circumstances change that would “more likely than not” reduce the unit’s fair value. Such circumstances include: ? Changes in legal factors or the business climate ? Adverse action by a regulator ? Unanticipated competition ? Loss of key personnel ? Expectation that a reporting unit may be disposed of
Step Two – Impairment Measurement If step one results in the carrying amount of the reporting unit exceeding its fair value, further impairment testing must be conducted. Since goodwill cannot be measured directly, its value is determined as a residual amount after valuing all assets other than goodwill. If Step One reveals an impairment of goodwill, both the tangible and identifiable intangible assets are valued in order to determine the implied fair value of goodwill. It may be necessary to engage the services of experts in valuing machinery and equipment and intangibles.
SFAS 142 requires valuing a company’s recorded and unrecorded intangible assets such as internally generated patents. If the implied fair value of goodwill is less than its carrying amount, its value is impaired, and a write-down is needed. The implied fair value of goodwill shall be determined the same way as for a business combination (SFAS 141); that is, fair value of the reporting unit will be allocated to all the assets and liabilities of the unit, including unrecognized intangible assets, as if the reporting unit had been acquired, and the fair value of the unit was the price paid.
The allocation is done only for purposes of testing the impairment of goodwill – no write-up or write-down of a recognized asset or liability is to occur. Nor should a previously unrecognized intangible asset be recognized as a result of step two impairment testing. Standard of Value SFAS 142 requires the valuation of the reporting unit using “fair value” as the standard of value. This is defined in the standard as: “The amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing arties, that is, other than in a forced or liquidation sale. ” This definition, and the language in the Standard, indicates that the standard of value allows for known parties to the transaction, and that the value of synergies can be taken into account. “Substantial value may arise from the ability to take advantage of synergies and other benefits that flow from control over another entity. ” In fact, the Standard goes on to say, a “control premium may cause the fair value of a reporting unit to exceed its market capitalization. ”
This is no small matter when distinguished with a “fair market value” standard of value, which would disregard the value of potential or actual synergies. Level of Value As described above, the language of SFAS 142 implies that “fair value” is a controlling interest level of value and that, therefore, a discount for lack of control would not be proper. Further, however, a synergistic control value seems to be appropriate, allowing for the recognition of internal synergy enhancements in value not available to a financial buyer. Calculation of Value
If quoted market prices are not available, the estimate of fair value will be based on the best information available. “A present value technique is often the best available technique with which to estimate the fair value of a group of net assets. ” The estimates of cash flow should be based on “reasonable and supportable” assumptions. If a range of possible outcomes is considered, the guidance in Concepts Statement 7 should be followed. Financial Statement Presentation and Disclosure The following should be disclosed in the financial statements: Presentation: At a minimum, all intangible assets shall be aggregated and presented as a separate line item. However, the intangible assets can be grouped by class of asset. ? The aggregate amount of goodwill is to be shown separately ? Impairment losses of goodwill are shown as a separate item before income from continuing operations. ? Amortization expense and impairment losses for intangible assets other than goodwill are shown as charges against income from continuing operations. Disclosure: ? For intangibles subject to amortization – o Total amount assigned to any major intangible asset class o Amount of any significant residual value Weighted average amortization period, in total and by major class o Gross carrying amount and accumulated amortization in total and by major class o Aggregate amortization expense for the period o Estimated aggregate amortization expense for each of the five succeeding fiscal years ? For intangibles not subject to amortization o The amount assigned in total and by major intangible asset class. o Total carrying amount and for each major class ? The changes in carrying amount of goodwill during the year including: o Aggregate amount of goodwill acquired Aggregate amount of impairment losses recognized o Amount of goodwill included in the gain/loss on disposal of a reporting unit ? For each impairment loss recognized related to an intangible asset other than goodwill: o Description of the impaired asset and the facts and circumstances leading to its impairment o Amount of impairment loss and the method for determining its fair value o The caption in the income statement where the loss is aggregated ? For each goodwill impairment loss: o Description of the facts and circumstances leading to its mpairment o Amount of impairment loss and the method of determining the fair value of the associated reporting unit Previously Recognized Intangible Assets The useful lives of intangible assets acquired prior the effective date of the Statement will be reassessed prior to the end of the first interim period of the fiscal year in which SFAS 142 is first applied. Likewise, previously recognized intangible assets with indefinite useful lives shall be tested for impairment in the same time frame, and any resulting impairment loss will be recognized as the effect of a change in accounting principle.
RUSSELL T. GLAZER, CPA, MBA CERTIFIED BUSINESS APPRAISER Horowitz, Waldman, Berretta & Maldow, LLP 1000 Woodbury Road Woodbury, New York, 11797 (516) 364-4567 [email protected] com CERTIFIED BUSINESS APPRAISER, certified by the Institute of Business Appraisers. 1995 to the present – Performing appraisals of interests in privately held companies for buy/sell transactions, mergers and acquisitions, marital dissolution, gift and estate tax purposes and litigation support. Experienced also in conducting forensic accounting examinations for marital dissolution and litigation support.
This experience covers a broad range of industries, including manufacturing, wholesale, retail, service and construction. 1979 to the present – As a Certified Public Accountant, Mr. Glazer has over twenty years of experience as a business advisor and analyst, providing services in the areas of auditing, financial statement preparation and analysis, forecasts and projections, budgeting, cost accounting and product pricing. Industry experience includes manufacturing, construction, wholesale, service, not-for-profit and retail. PUBLICATIONS Assessing the Effect of Taxes on the Valuation of S Corporations,” Business Valuation Review, June, 2002. “A Study of the Discounts Inherent in the P/NAV Multiples of Real Estate Limited Partnerships,” Business Appraisal Practice, Winter 2000-2001, pages 22-28. “Partnership Re-Sale Discounts Narrow Due To Liquidations,” Business Valuation Update, October 2000. “IRS Releases Recommendations on Valuation Policies,” Business Valuation Update, April 2000, page 1. (Part of the curriculum of Current Update in Business Valuations, a one day seminar offered in 2000 by the National Association of Certified Valuation Analysts. “Conducting Valuations with Guiding Fundamental Principles,” article review, Business Valuation Update, December 1999, page 7. “Valuing FLPs For Estate and Gift Planning,” Long Island Business News, October 22, 1999. “Nondistributing Partnerships Show 46% Discount from NAV,” study abstract, Business Valuation Update, August 1999, page 5. SPEAKING/LECTURES Using Valuation Discounts to Benefit Your Clients, a presentation for the Taxation Law Committee of the Suffolk County Bar Association.
Business Valuation, an eight hour course prepared for the Foundation for Accounting Education, the Continuing Professional Education arm of the New York State Society of Certified Public Accountants. “The Basics of Business Valuation,” presented to various organizations. “Statements on Standards for Accounting and Review Services – Old and New,” CPE credit-approved course developed for C. W. Post College’s Tax & Accounting Institute. Adjunct Professor of Accounting, Suffolk County Community College. Courses taught include: ? Cost Accounting ? Managerial Accounting Practical Accounting ? Computers and Accounting ? Business Mathematics Variety of subjects for NYSSCPA-Suffolk “Accounting and Tax Issues for the Building Industry,” presentation for the Long Island Builders Institute, April, 1998 “Business Planning for Entrepreneurs,” presentation for the U. S. Small Business Administration, January 1999. TECHNICAL TRAINING Institute of Business Appraisers ? Valuation of the Closely Held Business – Advanced Theory and Applications ? Report Writing and Analysis ? Discount and Capitalization Rates: Practical and Defensible Derivation ?
Advanced Steps to Take Appraisals from Ordinary to Outstanding ‘statistics in Business Valuation and Litigation Support American Society of Appraisers ? Current Topics in Business Valuations, 10th Annual Conference ? Principles and Ethics Exam ? Preparing a Defensible Business Valuation Work Product Efficiently ? The Potential Effects of Complex Litigation on Shareholder Value ? Keeping Up With The Internet ? Taking The Deal to Market: Identifying & Quantifying Risks to Value ? How To Evaluate An Executive Compensation Plan Economic Outlook: Inflation, Interest Rates and Equity Returns ? Resolving Disputes With The IRS ? The Board’s Approach to Appraisal Issues and Shareholder Value ? Profits and Market Multiples – Some Complications American Institute of Certified Public Accountants ? What’s New and Important in Business Valuation National Association of Certified Valuation Analysts ? Capitalization and Discount Rates ? Tax Angles in Valuations Under IRC Chapter 14 ? Research: Economic, Industry, Legal and Internet ? Valuing Family Limited Partnerships ? Valuing Service Organizations The Valuation of Law Firms  Under the pooling-of-interests method, the carrying amount of assets and liabilities recognized in the statements of financial position of each combining entity are carried forward to the statements of the combined entity. No other assets or liabilities are recognized as a result of the combination, and thus the excess of the purchase price over the book value of the net assets acquired is not recognized.  A business is defined by EITF 98-3 as “a self-sustaining integrated set of activities …conducted and managed for the purpose of providing a return to investors. ”