The Substance of the Standard MAYER HOFFMAN MCCANN P.C. AN INDEPENDENT CPA FIRM TM A publication of the Professional Standards Group February 2014 Changes to the Accounting for Goodwill for Private Companies The Financial Accounting Standards Board (FASB) has finalized the first accounting alternative proposed by the Private Company Council (PCC) related to the accounting for goodwill by private companies; Accounting Standards Update (ASU) 2014-02 Intangibles Goodwill and Other (Topic 350): Accounting for Goodwill (ASU 2014-02). Accounting for Goodwill ASU 2014-02 provides certain accounting policy elections that may be made by a qualifying private company with respect to the accounting for goodwill. Entities that qualify are those that do not fall into one of three categories: a) public business entity as defined under ASU 2013-12(see MHM Messenger 2014-02) b) not-for-profit entity and c) employee benefit plans. ASU 2014-02 contains Contents Accounting for Goodwill...1 Considerations when Adopting ASU 2014-02...6 Implementation Steps...6 For More Information...7 Appendix: Summary of Significant Changes...8 roots TM our run deep In summary: ASU 2014-02 was issued in January 2014 and its provisions may be elected by entities that are not public business entities, not-for-profit entities or employee benefit plans. Through the early adoption provision entities may elect to begin amortizing goodwill as soon as their December 31, 2013 financial statements, for calendar year companies, as long as those financial statements have not been made available for issuance prior to January 16, 2014. See the Summary of Significant Changes for the key differences under ASU 2014-02. three significant components including the amortization of goodwill, the removal of the requirement to conduct an annual impairment test of goodwill and modifications of the impairment test methodology. These three components are described in more detail below. Goodwill Amortization If an entity elects to amortize goodwill, all existing goodwill recognized as a result of a business combination under ASC Topic 805 Business Combinations, fresh start accounting under ASC Topic 852 Reorganizations and goodwill recognized when applying the equity method of accounting under Topic 323 Investments Equity Method and Joint Ventures must be amortized as the election cannot be applied on an individual acquisition basis. The goodwill arising from each individual business acquisition represents an amortizable unit and each unit has its own expected useful life. That amortization period is presumed to be 10 years, unless it can be demonstrated that a period of less than 10 years is more appropriate. As shown in the example below, a period of less than 10 years may be appropriate based on an evaluation of specific facts and circumstances. In most circumstances, it would not be necessary to justify using an amortization period of 10 years. When events occur or facts and circumstances change such that the remaining useful life of goodwill should be changed, an entity should re-evaluate that life. In no event PAGE 1
should goodwill be amortized over a period greater than 10 years. If a change occurs in the expected remaining useful life, the remaining unamortized goodwill should be amortized prospectively over the new life as a change in accounting estimate. Example: ABC Corporation acquires ZXY, LLC on March 1, 2014 for $5 million cash in order to acquire a new medical technology. The identifiable assets and liabilities of ZXY, LLC are recorded at fair value by ABC Corporation resulting in $1.2 million of goodwill. ZXY, LLC s cash flows are derived from the sale of one type of exclusive medical technology. This technology was estimated to be productive for a period of at least 20 years at the time of the acquisition. ABC Corporation had previously elected to amortize goodwill under ASU 2014-02 and at the time of adoption elected to test goodwill for impairment on an entity wide basis (rather than at a reporting unit level). On March 1, 2014, ABC Corporation records $1.2 million of goodwill and begins to amortize the goodwill over a 10-year life, the maximum period allowed under ASU 2014-02. As of December 31, 2014, ABC Corporation recognizes $100,000 of amortization expense for the year and has net remaining goodwill of $1.1 million. On January 1, 2015, ABC Corporation discovers the existence of a new procedure that will make the technology of ZXY, LLC obsolete within five years and as a result the product is not expected to produce cash flows after that time. ABC Corporation performs an impairment test at the entity wide level, and as a result of strong sales in other product lines, no impairment is identified. ABC Corporation estimates a remaining useful life of five years from January 1, 2015 and begins to amortize the remaining balance of goodwill over the revised period. For the year ended December 31, 2015, ABC Corporation recognizes $220,000 of amortization expense and has net remaining goodwill related to ZXY, LLC of $880,000. Circumstances when a Goodwill Impairment Test is Required Under U.S. GAAP, if the accounting alternative of ASU 2014-02 is not elected, goodwill has an indefinite life and, similar to indefinite-lived intangibles, is required to be tested for impairment at least annually. Each unit of goodwill is tested for impairment separately based on its associated reporting unit. A reporting unit is a component of the entity that is an operating segment or one level below an operating segment (see box at right). Components: An operating segment is a component of an entity that has three characteristics: a) it engages in business activities from which it may earn revenues and incur expenses (including revenues and expenses relating to transactions with other components of the same entity) b) its operating results are regularly reviewed by the entity s chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance and c) it has discrete financial information available. A component that is one level below an operating segment has discrete financial information that segment management regularly reviews the operating results of and it has economic characteristics dissimilar from other components. When ASU 2014-02 is adopted, an entity must elect to perform the impairment test for goodwill on an entity wide basis or on a reporting unit basis. An entity that has elected to amortize goodwill will use this elected basis when it performs the impairment test described at right. An entity that elects to amortize goodwill does not perform an impairment test unless events or circumstances indicate that the fair value of the entity (reporting unit) may be less than its carrying value, similar to the requirements for a long-lived asset. Events or circumstances that may indicate impairment exists, also called triggering events, include macroeconomic, industry and market, cost, financial performance and other events. Impairment Test Methodology Existing U.S. GAAP has a three-step methodology to the annual impairment test for goodwill (see box on page 3). With the adoption of ASU 2014-02 and election to amortize goodwill, an entity s impairment test is only performed when a triggering event occurs as discussed above. When a triggering event occurs under ASU 2014-02, an entity can choose to perform a qualitative analysis (step 0) or go directly to a quantitative analysis. A qualitative analysis involves evaluating factors to determine if it is more likely than not that goodwill is impaired (i.e. the fair value of the entity [reporting unit] is less than its carrying value). If it is more likely than not that goodwill is impaired, then the quantitative analysis is performed. The qualitative factors that are considered follow the guidance of a Step 0 impairment test for goodwill as described in ASC 350-20- 35-3C. If an entity elects to bypass or fails the qualitative assessment, the quantitative analysis of impairment is performed PAGE 2
Annual Goodwill Impairment Test Model: Step 0: At the option of the entity, perform an analysis of qualitative factors to determine if it is more likely than not that the fair value of the reporting unit is less than the carrying amount of the reporting unit. Step 1: Calculate the fair value of the reporting unit and compare its fair value to the carrying value of the reporting unit. Step 2: If the fair value of the reporting unit is less than its carrying value, then perform a hypothetical purchase price allocation. The allocation results in the fair value of individual assets and liabilities being determined in order to compute the remainder, which is the fair value of goodwill. If the fair value of goodwill is less than its carrying value, the difference is the amount of impairment recognized. Impairment Model Flow Chart (excerpt from ASU 2014-02) Triggering Event: Has an event occurred or circumstances changed that would indicate that the fair value of the entity may below its carrying amount? (see note 1) Yes Qualitative Assessment: Evaluate relevant events or circumstances to determine whether it is more likely than not that the fair value of the entity is less than its carrying amount (see note 2) at the date of the triggering event, which may be different from the reporting period or the date that the annual impairment tests were previously performed by the entity. When performing the quantitative test of goodwill impairment under either model, the test for goodwill is performed subsequent to any required test of impairment for longlived assets. Thus the carrying amounts of long-lived assets that are determined to be impaired are adjusted prior to performing the impairment test on goodwill. When the quantitative impairment test is performed under the triggering event model there are two steps which differ from the annual impairment test model. The first step in the quantitative analysis is to compute the fair value of the entity (reporting unit) and compare the computed fair value to the carrying value of the entity (reporting unit) including any recognized deferred income taxes and goodwill. Is it more likely than not that the fair value of the entity is less than its carrying amount? Yes Calculate the fair value of the entity and compare with its carrying amount, including goodwill. Is the fair value of the entity less than its carrying amount? No No If the fair value of the entity (reporting unit) is less than its carrying value, the second step is to compute the amount of impairment, which is the difference between the two. When multiple units of goodwill are grouped together for the impairment test for instance when testing goodwill for impairment at the entity level the allocation of the impairment loss is performed on a reasonable and rational basis. If no other reasonable and rational basis for allocation can be determined, it is permissible to allocate the impairment loss on a pro rata basis across all of the units of goodwill. It is not permissible to recognize a loss greater than the carrying amount of goodwill. If an impairment loss is recognized, the adjusted balance of goodwill is its new basis and the new basis is amortized Yes Recognize impairment equal to difference between carrying amount of the entity and its fair value, not to exceed the carrying amount of goodwill. Stop Note 1: An entity may elect to test goodwill for impairment at either the entity or reporting unit level. For simplicity the flowchart refers to the entity level. Note 2: An entity has the unconditional option to skip the qualitative assessment and proceed directly to calculating the fair value of the entity and comparing that value with the carrying amount, including goodwill. PAGE 3
over the remaining life of goodwill. Once recognized, an impairment loss may not be reversed. Example: The Lighting Company, Inc (Company) has determined it has two components consisting of the manufacturing of light bulbs and the manufacturing of light fixtures. When these businesses were acquired, the Company recorded goodwill of $5.0 million and $2.5 million for lights bulbs and light fixtures, respectively. The Company elected to use the accounting alternative permitted in ASU 2014-02 and has elected to test goodwill impairment at the entity level. In March of 2014, the Company determined that there was a significant change in economic circumstances related to its business due to an economic downturn and the entry of new competition into the market place. As a result, the Company performed the quantitative impairment analysis resulting in the following: Carrying value of the Company including goodwill: Fair value of the Company: Impairment loss: $28.0 million 25.5 million $ 2.5 million The Company estimated that the results of the economic changes and new competition would result in a decline in the profitability of the light fixture business of $1 million per annum and of the light bulb business of $250,000 per annum and determined that a reasonable allocation would be based on the relative decline of each business. Therefore, an impairment loss of $2.0 million (80%) was allocated to the light fixtures business and $500,000 (20%) to the light bulb business. Fair Value Measurement The fair value of an entity (reporting unit) is the price that the entire unit would be sold for in an orderly transaction between market participants. It is measured at the date of the triggering event. The fair value of the entity (reporting unit) may be measured using one of several methods depending on the information available and its reliability. The method chosen must be consistent with the objective of measuring the price that a market participant would pay. The computation of fair value for an entity (reporting unit) is typically performed using either a market or income approach. In certain instances a cost approach may be more appropriate, however, such instances are not common.the most commonly applied market approach method include using a quoted market price or a market multiple. When using a quoted market price, the security being valued in this case the equity of the entity or the reporting unit is valued based on the quoted market price in an active market, for example a stock exchange ((i.e. market capitalization). Since a private company would not have traded securities, a quoted market price would not be available. The second market-based fair value method that is commonly used is a market multiple. Market multiples are often based on a multiple of earnings or revenue and are based on the multiples computed based on entities that have been recently acquired that have comparable operations and economic characteristics to the entity (reporting unit). It may be difficult to find multiples that are known for entities of comparable nature, scope or size to the entity (reporting unit) and care must be applied to adjust the market comparables identified to ensure they are truly comparable. An alternative to the market approach is to use an income approach. A commonly used income approach is to estimate the future cash flows of the entity (reporting unit) and apply appropriate discount rates to compute the present value of the expected cash flows from a market participant point of view. When using an income approach to determine the fair value of an entity (reporting unit), consideration must be given to many different assumptions, including growth rates, terminal value and discount rates. The determination of fair value under any model may require the use of a valuation specialist. It is also appropriate to consider control premiums and discounts for purposes of performing the goodwill impairment test. Accounting for Goodwill within an Equity Method Investment When an equity method investment is acquired, there is normally a difference between the cost of the investment and the amount of the underlying equity of the investee. This difference is accounted for as if the investment were in a consolidated subsidiary, which results in differences in the book value of the assets of the investee and fair value at the time of acquiring the investment. This difference normally includes goodwill. When the election permitted under ASU 2014-02 is applied, the goodwill acquired in an equity method investment is amortized following the guidance outlined above. However, there is no separate impairment test for equity method goodwill. Instead, the entire equity method investment is subject to review for impairment as described in ASC 323 Investments Equity Method and Joint Ventures. PAGE 4
Example: On January 1, 2014, ABC Corporation acquires a 25% interest in MN, Inc. for $2,000,000. At the time the investment is acquired, MN, LLC s U.S. GAAP basis financial statements report total stockholders equity of $5,000,000. ABC Corporation computes the difference between the cost of the investment and the amount of its interest in MN, Inc. at its underlying value as $750,000 ($2,000,000 - $5,000,000 * 25%). Acting as if its investment in MN, Inc. were an investment in a consolidated subsidiary, ABC Corporation determines that $500,000 of the difference is related to the value of property, plant and equipment and the remaining $250,000 is related to goodwill. As a result of the acquisition and ABC Corporation s election to use the accounting alternative under ASU 2014-02, it amortizes the goodwill related to its investment in MN, Inc. over 10 years, resulting in $25,000 of amortization in the year ended December 31, 2014. Derecognition of Goodwill When the accounting alternative under ASU 2014-02 is elected and the sale or disposal of a business occurs, the goodwill associated with the disposed business is included in the carrying amount of the assets and liabilities disposed in order to compute the gain or loss recognized. If a portion of a business is disposed (assuming it still meets the definition of a business), the goodwill is allocated to the disposed portion based on the relative fair value of the disposed unit to the retained operations on a pro rata basis. Presentation and Disclosure As with existing U.S. GAAP, goodwill is presented on the statement of financial position (balance sheet) as a separate line item. However, with the election of alternative provided by ASU 2014-02, goodwill is presented net of accumulated amortization. Within the statement of operations (income statement), the amortization or impairment of goodwill is an expense of continuing operations and should be classified within the line items of continuing operations that are determined to be the most appropriate. The amortization or impairment of goodwill would not be considered a component of other expense or an extraordinary item; however, in the event that goodwill amortization or impairment is associated with a discontinued operation, it should be presented in discontinued operations on a net of tax basis consistent with the guidance of ASC 205-20- 45 Other Presentation Matters. When the accounting alternative is elected, an entity discloses in its financial statements for each period presented the following: The gross carrying amounts of goodwill, accumulated amortization, and accumulated impairment loss The aggregate amortization expense for the period Goodwill included in a disposal group classified as held for sale in accordance with paragraph 360-10-45-9 and goodwill derecognized during the period without having previously been reported in a disposal group classified as held for sale. In a period in which an entity initially recognizes goodwill, the following are disclosed: The amount assigned to goodwill in total and by major business combination or by reorganization event resulting in fresh-start reporting The weighted-average amortization period in total and the amortization period by major business combination or by reorganization event resulting in fresh-start reporting. Additional disclosure is required when an impairment loss is recognized by an entity during the period. These disclosures include: 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 entity or the reporting unit (whether based on prices of comparable businesses, a present value or other valuation technique, or a combination of those methods) The caption in the income statement in which the impairment loss is included The method of allocating the impairment loss to the individual amortizable units of goodwill. When an impairment loss is recognized, an entity is not required to disclose the fair value hierarchy level of the fair value measurement of the entity (reporting unit). PAGE 5
Transition The effective date for ASU 2014-02 is for periods beginning after December 15, 2014, which for calendar year entities is the year ended December 31, 2015. Early adoption is permitted, therefore a qualifying entity may adopt the standard for any financial statements that have not been made available for issuance as of January 16, 2014. Upon adoption, this standard requires that the elections provided be performed for all goodwill owned by an entity on a prospective basis. Therefore, the existing carrying balance of goodwill will be amortized over its remaining useful life, not to exceed 10 years, for the entire year in the year of adoption. This may require an entity to determine the acquisition date goodwill associated with any equity method investment acquired. For a calendar year entity adopting ASU 2014-02 for its 2013 financial statements the entity would record amortization expense beginning January 1, 2013. Considerations when Adopting ASU 2014-02 There are various considerations and implementation questions that arise when considering the accounting alternative to amortize goodwill. Some considerations may include: What are the expected cost savings from adopting the amortization of goodwill? The primary savings from adopting goodwill amortization arises from the removal of the required annual impairment test. Estimating the cost of performing the test, including the cost of preparing the test, engaging valuation professionals and the incremental cost of having the impairment test audited or reviewed are all factors that may lead to cost savings. What are the expectations of the users of the financial statements? Owners, lenders, customers or other users of financial statements may have expectations about the accounting for goodwill including potential preferences for the new amortization or the traditional annual impairment testing models. Discussing these preferences prior to adopting goodwill amortization will help ensure a smooth transition. How will the impact of additional amortization expense impact net income, total assets and equity? Are there debt or other covenants which are based on these metrics or ratios that use these metrics? Goodwill amortization may result in an overall decrease in net income and total assets. When an entity is a tax paying entity, this decrease may be partially offset or increased by deferred taxes depending on the tax life and age of the goodwill being amortized. Therefore, covenants based on net income, total assets or equity that were designed without contemplating amortizing goodwill may need to be carefully analyzed before adopting. Covenants based on earnings before interest, taxes, depreciation and amortization (EBITDA) and on tangible net worth should not be impacted. Implementation Steps Every implementation of ASU 2014-02 will be unique, but the following steps can be used to assist in designing an implementation plan: Step 1: Ensure the entity qualifies to make the election in ASU 2014-02 The entity is only eligible to adopt a policy to amortize goodwill if they do not meet the definition of a public business entity provided by ASU 2013-14 (see MHM Messenger 2014-02). Additionally, the option is not available to not-for-profit entities or employee benefit plans. Step 2: Identify all goodwill existing as of the adoption date This includes any goodwill associated with equity method investments. This may involve reviewing the original acquisition information to determine the equity method goodwill acquired on that date. Step 3: Assign a useful life to the existing goodwill Goodwill existing as of the beginning of the period of adoption should be amortized on a straight-line basis as of the beginning of the period of adoption (i.e. January 1 for calendar year-end companies). A period of less than 10 years may be used if an entity can demonstrate a shorter useful life is more appropriate. Entities electing to use a shorter life should have sufficient analysis to support the useful life assigned, which will often include: Identification of the cash flows specific to the goodwill Discussion of the interaction of cash flows specifically identified with the goodwill and other cash PAGE 6
generating units of the entity and why they are included/excluded from the analysis How the estimated useful life was determined Step 4: Finalize accounting policy election with respect to impairment testing Document the accounting policy to perform the goodwill impairment test at the entity level or retain the current practice of performing the analysis at the reporting unit level. After making an election, consider whether there is the existence of a triggering event during the year of adoption to ensure appropriate recognition, presentation and disclosures. Step 6: Ensure financial statement presentation and disclosures are appropriate ASU 2014-02 introduces additional disclosure requirements for entities electing to amortize goodwill. For more information If you have any specific questions or concerns regarding accounting for goodwill, please contact James Comito of MHM s Professional Standards Group or your MHM service professional. James can be reached at 858.795.2029 or jcomito@cbiz.com. Step 5: Ensure amortization expense for the year of adoption is appropriate Amortization expense should be calculated as of the initial day of the financial reporting period and should consider the timing of any impairment losses recorded in the year of adoption. PAGE 7
Substance of the Standard 2014-01 Appendix: Changes to the Accounting for Goodwill for Private Companies Summary of Significant Changes Without the election of ASU 2014-02 With the election of ASU 2014-02 Carrying Amount of Goodwill Not amortized. Amortized over 10 years, unless a shorter life can be demonstrated. The cumulative amortization period cannot exceed 10 years. Goodwill amortization applies to all goodwill, including goodwill associated with an equity method investment. Goodwill Impairment Test Entity (reporting unit) Measurement of Impairment Loss Annual impairment test using the three-step process. Impairment test is conducted at the level of a reporting unit. Impairment loss is measured using a hypothetical purchase price allocation in which all assets and liabilities of the reporting unit are measured at fair value. Impairment test is performed when a triggering event occurs. At the time of a triggering event a qualitative assessment may be performed to determine if it is more likely than not that goodwill is impaired. If the qualitative assessment indicates goodwill is more likely than not impaired or an entity elects to skip the qualitative assessment, a quantitative analysis is performed to measure the impairment loss, if any. An entity must elect to test goodwill at either the entity or the reporting unit level when goodwill amortization is first elected. Impairment loss is measured using the difference between the fair value and the carrying value of the entity or reporting unit. PAGE 8