Section 4 defined the accounting charge of goodwill as the excess of purchase price over fair value of identifiable net assets acquired in business combinations accounted for as purchases. Goodwill, however, also includes other items such as: brand name(s), patents, some sorts of managerial or professional expertise – and a big ego.
The definition of goodwill and its proper handling in accounting terms has long been a nonregulated entry in the company’s books, which therefore was widely abused. But things have changed both in Europe, with IFRS, and in the United States. Compliant handling of goodwill came first in America, and for this rea- son the present section addresses this, original change.
In June 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 141 (SFAS 141), Business Combinations,
and SFAS 142, Goodwill and Other Intangible Assets. The latter requires business combinations initiated after 30 June 2001 to be recorded using the purchase method of accounting. It also specifies the types of acquired intangible assets that must be recognized and reported separately from goodwill. With SFAS 142:
● Goodwill and certain intangibles are no longer amortized
● Instead they are tested for impairment at least annually, and this is reflected in the firm’s financial statement.
Following the SFAS 142 implementation, starting with fiscal years that began after 15 December 2001, lots of companies experienced their largest write-offs ever. Some entities capitalized on the fact that SFAS 142 permitted them to write off as much goodwill as they wanted in fiscal year 2002 – which after that they had to categorize as goodwill – and account for it at least every year. Said the sen- ior executive of one company participating in research: ‘We regularly review assets that are not carried at fair value for possible impairment indications. If impairment indicators are identified we make an assessment about whether the carrying value of such assets remains fully recoverable.’
Here is an example of how Microsoft commented in its 2003 Annual Report, in connection to its compliance to SFAS 142: ‘SFAS 142, “Goodwill and Other Intangible Assets” ’, requires that goodwill be tested for impairment at the report- ing unit level (operating segment or one level below an operating segment) on an annual basis (1 July for Microsoft) and between annual tests in certain circum- stances. Application of the goodwill impairment test requires:
● Judgment, including the identification of reporting units, assigning assets and liabilities to reporting units.
● Assessing goodwill to reporting units, and
● Determining the fair value of each reporting unit.
‘Significant judgments required to estimate the fair value of reporting units induce estimating future cash flows, determining appropriate discount rates and other assumptions. Changes in these estimates and assumptions could materially affect the determination of fair value and/or goodwill impairment for each reporting unit.’
As the opening paragraphs of this section brought to the reader’s attention, good- will had been a well-known huge loophole in financial reporting practices. Only after Enron filed for Chapter 11 in December 2001 did money managers start to scrutinize the companies’ books as never before, dumping stocks when they
suspected even a hint of bad accounting or abuse. Also because of Enron’s bank- ruptcy, market regulators took a closer look at corporate accounting and goodwill handling practices.
For their part, following FASB’s new reporting standard, many companies felt that taking big write-offs during a recession would keep them from taking smaller ones later on. (That could have distracted shareholders, as the economy revived.) Therefore, many American companies intentionally depressed their results in 2002 which, among other things, could allow them to inflate financial results in 2003 on a year-on-year basis.
JSD Uniphase was the first to take a huge write-off of over $50 billion in late July 2001, the largest ever in US corporate history. Other companies were not too far behind. AOL Time Warner had $126.9 billion in goodwill as of 30 September 2001 and analysts expected it to take up to 50% that amount in write-off in 2002.
Richard Parsons, the company’s then new chief executive officer, suggested his firm wanted to keep its accounting for assets in line with what investors think those assets are worth.
Also, as of September 2001, Viacom had $71.3 billion of goodwill, a huge sum approaching its market value of $78.3 billion. Qwest Communications International had done even better than that. Its $30.8 billion goodwill was swamp- ing its $23.5 billion market value.
AT&T, too, took a large write-off for goodwill, and other companies are expected to do so. Among other entities loaded with goodwill were Verizon, to the tune of
$44.1 billion; WorldCom, at $40.6 billion; and Philip Morris at $33.1 billion.
Notice that the biggest goodwill addicts were found among technology, media, and telecoms (TMT).
When making an assessment of goodwill impairment, well-managed entities compare carrying value to market value. As an alternative, some companies employ the value in use, by discounting expected future net cash flows gener- ated by brand names and other goodwill assets to present value. Determination of the value in use requires management to make assumptions and employ esti- mates which have to be:
● Reasonable, and
● Supportable in the existing market environment.
If the fair value, or value in use, of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not impaired, but it is impaired in
the opposite case. Hence, it becomes necessary to measure the amount of impair- ment loss, comparing implied fair value of the reporting unit’s goodwill with the carrying amount of that goodwill.
For instance, a cable franchise intangible can be determined as the difference between fair value of the cable business and fair value of the cable businesses’
tangible and intangible assets. The value of use of a cable business can be deter- mined using various valuation techniques including discounted cash flow, ana- lyst estimates, and comparable market analyses.
Intangible and other long-lived assets must also be reviewed for impairment whenever events such as product discontinuance, product dispositions, plant closures, or other changes in circumstances indicate that the carrying amount may not be recoverable. In reviewing for impairment, management must com- pare the carrying value of such assets to the estimated undiscounted future cash flows, expected from the:
● Use of the assets, and
● Their eventual disposition.
When the estimated undiscounted future cash flows are less than their carrying amount, an impairment loss must be recognized equal to the difference between the assets’ fair value and their carrying value. Some companies record adverse changes in their planned business operations affecting a reporting business unit, or a significant portion of it, as well as other unforeseen developments as an impairment of their recorded goodwill.
In conclusion, prior to SFAS 142 and IFRS, because goodwill and certain other intangible assets were having, at least theoretically, indefinite lives, they were amortized on a straight-line basis over the periods the firm benefited from them.
What has changed with SFAS 142 is that goodwill must now be tested for impair- ment on an annual basis or between annual tests if:
● An event occurs, or
● Circumstances change that would reduce its fair value below its carrying amount.