The challenge of accounting for goodwill - The CPA Journal (2023)

The further development of goodwill accounting

The treatment of goodwill has been a contentious and much-debated topic in accounting for well over a century. (For a detailed history see Hugh P. Hughes,Goodwill in Accounting: A History of the Issues and ProblemsGeorgia State University, 1982.) Historians have noted cycles in US history in which the nation swings in one political direction and then swings back in the opposite direction over time. As a political process, the setting of accounting standards is not free from these cycles. Not unexpectedly, the FASB and its predecessors in establishing GAAP, the Committee on Accounting Procedure (CAP) and the Accounting Principles Board (APB), have all grappled with the initial and subsequent treatment of goodwill and have come to slightly different conclusions. (For more information, see David A. Rees and Troy D. Janes, "The Continuing Evolution of Accounting for Goodwill,"Das CPA-Journal,January 2012,http://bit.ly/2OIZnfj.) Although there have been minor differences in initial measurement as GAAP has evolved into goodwill, the basic concept has remained the same: goodwill is the difference between the price paid for an acquired business and the total fair value Fair value of identifiable net assets . However, post-accounting for goodwill remains a hotly debated topic, as evidenced by the recent ITC.

The treatment of goodwill has changed between the issuance of Accounting Research Bulletin 24 (ARB 24),accounting for intangible assets,in 1944 and the publication of SFAS 142 in 2001. ARB 24 essentially permitted the following procedures for the subsequent accounting of goodwill:

• Perpetual preservation as an asset
• Systematic amortization of profit, retained earnings or capital reserves
• An immediate charge to retained earnings or capital reserves.

While ARB 24 discouraged the practice of discretionary goodwill amortization, it did not prohibit such amortization.

In Chapter 5 of ARB 43,restatement and revision of accounting research bulletins,Published in 1953, CAP prohibited the arbitrary amortization of goodwill and the immediate charging of goodwill against equity. Although ARB 43 still permitted the permanent preservation of goodwill, this approach was not favoured; instead, the systematic amortization affecting net income was the emphasized approach for subsequent goodwill accounting. In 1970, CAP's successor, the APB, issued Opinion 17,intangible assets,This eliminated the retention (asset) approach and the goodwill had to be amortized through profit or loss on a straight-line basis over a maximum period of 40 years unless another method was shown to be more appropriate. APB Opinion 17 also required an ex post write-off review. In choosing to amortize goodwill, the APB noted: “Amortization of the cost of goodwill and similar intangible assets on an arbitrary basis without evidence of finite useful life or reduced value may recognize expenses and depreciation early, but amortization of cost up to a Losses are obvious, the declines can be seen retrospectively.”

In 2001, the successor to the APB, FASB, issued SFAS 142, which replaced APB Opinion 17's requirement for amortization of goodwill with a periodic impairment testing approach. According to SFAS 142, there are two steps in the impairment test:

• First, the entity compares the fair value of the reporting unit to its book value (Step 1).
• Second, if the fair value is lower, the entity must calculate an impairment of goodwill by comparing the implied fair value of goodwill to its carrying amount (Step 2).

If the calculated implied fair value of goodwill is less than its carrying amount, the entity recognizes an impairment loss for the difference. In arriving at this approach, the FASB noted that "amortizing goodwill on a straight-line basis over any period of time does not reflect economic reality and therefore does not provide useful information."

After the issuance of FASB 142, the FASB received feedback from stakeholders indicating that the cost of performing the impairment test outweighed the benefits. The FASB responded by issuing several ASUs to alleviate the burden. In 2011, it issued ASU 2011-08,Intangible Assets – Goodwill and Other (Item 350): Testing of Goodwill for Impairment,which provides an option where an entity can choose to assess impairment based on qualitative factors (Step 0). The entity is not required to perform the two-stage impairment and calculate the fair value of the reporting unit and thus bear the associated costs unless it determines that its fair value is more likely to be less than its carrying amount. To further reduce the cost and complexity of goodwill impairment testing, the FASB issued 2017 ASU 2017-04,Intangible Assets – Goodwill and Other (Item 350): Simplifying the Goodwill Impairment Test,thereby eliminating step 2 of the quantitative two-step impairment test, the calculation of implied goodwill. Instead, entities recognize an impairment based on the excess of the carrying amount of a reporting unit's goodwill over its fair value.

The amendments in ASU 2011-08 and ASU 2017-04 both fall within the scope of the non-amortization approach originally advocated by the FASB in SFAS 142; however ASU 2014-02,Intangible Assets – Goodwill and Other (Item 350): Accounting for Goodwill (A Private Company Council Consensus), contains significant changes in the subsequent accounting of goodwill. Specifically, ASU 2014-02 allows private companies the option to amortize goodwill over 10 years.

In summary, over the past eight years, in response to concerns about the costs and benefits of the non-amortization approach, the FASB has modified and relaxed the original requirements of its non-amortization approach, allowing private companies the option of using the non-amortization approach to be used instead of the impairment test. The pendulum seems to be swinging back towards amortization.

The invitation to comment

In July 2019, due to mixed feedback on the costs and benefits of the current goodwill accounting model, the FASB issued an invitation to comment on Identifiable Assets and Subsequent Accounting for Goodwill. The ITC is seeking input on the costs and benefits of the current goodwill accounting model and whether the FASB -

• change the subsequent accounting for goodwill;
• change the recognition of intangible assets in a business combination; or
• Change information on goodwill and intangible assets.

The ITC makes it clear that the FASB does not seek input on the conceptual basis for the recognition of goodwill or the immediate amortization of goodwill.

With respect to post-accounting for goodwill, the FASB notes that there are two non-mutually exclusive approaches that can resolve the cost-benefit issue: amortizing goodwill or simplifying the goodwill impairment test goodwill. In the ITC, the FASB states: "Assuming that there is a cost-benefit issue in subsequently accounting for goodwill, one approach to solving the issue would be to amortize goodwill for PBEs [Public Business Entities ] to be reintroduced.” In addition, the ITC is asking for feedback on the appropriate payback period. The ITC notes that goodwill amortization methods generally have at least one of the following characteristics, and these characteristics affect the costs and benefits of alternative depreciation approaches:

• A default period
• A cap (or maximum) on the payback period
• A reasonable estimate
• Justification for the period.

The ITC also seeks information on the length of any downtime that the FASB may require, noting that some stakeholders support amortizing goodwill over a 10-year downtime. While the ITC notes that the FASB is only soliciting input and has made no decisions, the extensive focus on amortization, the filing of other issues, and the discussion of the pros and cons of various amortization approaches seem to indicate that the FASB is on the way the directive to require or allow the possibility of depreciation for public companies.

As this article went to press, the FASB had received 89 comments on the ITC, with 48 letters supporting the goodwill amortization, 37 opposed, and four with mixed views. Most respondents in favor of depreciation were accountants and preparers, while most users, academics, and rating firms were mainly opposed.

Potential impact of depreciation on the financial statements

The FASB's decision to reconsider the accounting for subsequent measurement of goodwill comes as goodwill balances on public company balance sheets are at record levels. Recent studies have found that more than $1 trillion in goodwill was included on the balance sheets of publicly traded companies in calendar years 2015-2017, a significant increase compared to previous years (for more details see the2016,2017, and2018 U.S. Goodwill Impairment-Studienvon Duff & Phelps,http://bit.ly/2Bdm3wm). In addition, another recent study found that the amount of purchase price allocated to goodwill has increased in recent years, from an average allocation of 36% in 2016 to 40% in 2017 (for more details see thePurchase price allocation study 2017von Houlihan Lokey, 2018,http://bit.ly/33wZGhr). If the FASB were to revert to a model that systematically amortizes goodwill, the analysis below shows that the impact would likely be material on many companies' financial statements and key financial measures.

exhibition 1presents an industry-wide summary of goodwill as a percentage of a company's total assets for S&P 500 members reporting a non-zero goodwill balance for 2018. Overall, goodwill amounts to 20.3% (18.1%) of total assets on average (median). In the services and manufacturing sectors, goodwill accounts for the largest share of total assets (median 33.9% and 23.7% respectively). In the finance, insurance and real estate group, on the other hand, goodwill makes up a median of less than 4% of total assets.

exhibition 2presents a list of the S&P 500 companies with the largest goodwill balances. Historically, these are very acquisition-heavy companies with goodwill balances ranging from $31.3 billion to $146.4 billion and total goodwill balances in excess of $1.1 trillion. For example, the largest goodwill balance in the sample belongs to AT&T, which acquired Time Warner and Direct TV in recent years, each at a significant premium to the total fair value of identifiable net assets ($38.6 billion and 34. allocated US$4 billion). to goodwill). While the companies listed inexhibition 2have the largest dollar-sized goodwill balances, however, their goodwill balances vary widely as a percentage of total assets, ranging from 1.8% to 45.0%.

exhibition 3presents a list of S&P 500 companies with the highest proportion of goodwill to total assets, ranging from 51.0% to 61.3%. Of the 20 companies in the list, most offer technology-related products and services (commonly associated with the two-digit SIC codes 35, 36, and 73). As the proportion of a company's goodwill to total assets increases, its earnings-based financial measures would become more sensitive to a potential accounting change where subsequent measurement of goodwill includes amortization.

exhibits 4,5, and6summarize the impact that reintroducing goodwill amortization would have on the S&P 500.exhibition 4presents an analysis of the key balance sheet ratios for each industry group and the overall sample. The two metrics selected are Return on Assets (ROA) and Basic Earnings Per Share (EPS) and a comparison is made between the metrics calculated based on the values ​​reported in the companies' financial statements (as reported) and a hypothetical goodwill amortization expense (pro forma) in the figures calculated after adjustment. The goodwill amortization calculations used to determine the pro forma percentages and per share amountsexhibits 4,5, and6assume that goodwill will be amortized on a straight-line basis over 10 years consistent with the guidance in ASU 2014-02. In addition, pro forma percentages and per share amounts are presented inexhibits 4,5, and6Ignore any deferred tax implications that might arise from deals structured as asset purchases under Internal Revenue Code (IRC) Section 338.

For the ROA comparison, the change for the overall sample is an average decrease of 2.6%, from an average of 6.2% (as reported) to an average of 2.6% (pro forma). Likewise, for the EPS comparison, the change for the full sample is an average decrease of $1.20 per share, from an average of $3.84 per share (as reported) to $2.64 per share (pro forma). Overall, an accounting policy change that reintroduces amortization as part of subsequent goodwill measurement would result in the average S&P 500 company reporting 42% lower ROA and 31% lower annualized EPS.

exhibits 5and6further illustrate the impact of reintroducing goodwill amortization on financial metrics.exhibition 5presents an analysis of the impact a goodwill writedown would have on S&P 500 companies with the largest dollar-sized goodwill balances. For these 20 companies, there is a 2.7% decrease in average ROA, from an average of 2.6% (as reported) to an average of -0.1% (pro forma). Similarly, there is a decline in average earnings per share of $3.47 per share, from an average of $2.45 per share (as reported) to an average of -$1.02 per share (pro forma).

exhibition 6contrasted as reported and pro forma ratio calculations, in this case for S&P 500 companies with the largest share of goodwill in total assets. For these 20 companies, the average ROA is down 5.4%, from an average of 6.9% (as reported) to an average of 1.5% (pro forma). There is a comparatively sharp drop in average earnings per share of $3.85 per share, from an average of $5.34 per share (as reported) to an average of $1.49 per share (pro forma).

signs of the future

Since the publication of APB 24 in 1944, the subsequent accounting of goodwill has been constantly discussed and significantly developed. The FASB's recent ITC and the changes made with the recent ASUs underscore the strong possibility of a return to goodwill amortization. A review of the current goodwill carried on the balance sheets of S&P 500 companies shows, as might be expected, that there would be a significant decline in companies' earnings and earnings-based financial measures if the FASB reinstated goodwill amortization. With such a potentially significant impact on the financial statements, the possibility of a return to amortization raised in the ITC is likely to attract intense comment and discussion from preparers, users and auditors.

Luis Betancourt, PhD, CPA is Professor of Accounting and BDO Faculty Fellow at James Madison University, Harrisonburg, Virginia.

James H. Irving, PhD, CPA is an Associate Professor of Accounting and a Keiter Faculty Fellow at James Madison University.