Impairment Testing: What Bankers Need to Know
August 8, 2016
Impairment testing is designed to give bankers and other stakeholders an early warning sign that the value of a company’s goodwill, brand or other indefinite-lived intangible asset has decreased. Here’s guidance on which intangible assets are subject to impairment, how it’s measured and how the accounting rules about impairment testing are evolving.
A closer look at intangibles
Under U.S. Generally Accepted Accounting Principles (GAAP), businesses report on their balance sheets goodwill, brands and other indefinite-lived assets that they acquire through an asset or stock sale. When a stock transaction is complete, the buyer allocates value to the identifiable assets and liabilities acquired. Any leftover amount is allocated to goodwill.
Conversely, when borrowers create goodwill and other indefinite-lived intangibles internally, they do not appear on the balance sheet. So, the balance sheets of most companies don’t reflect these hard-to-value (but valuable) assets.
Amortization vs. impairment
At one time, borrowers were required to amortize acquired goodwill over its estimated life (up to 40 years) under GAAP. In 2001, however, the rules in Accounting Standards Codification (ASC) 350-20-35 recognized that goodwill and other indefinite-lived intangibles don’t necessarily lose value, except under adverse conditions.
Under the current rules, borrowers that report goodwill and other indefinite-lived intangibles are required to test them at least annually for impairment. This occurs when the fair value of the asset in question falls below its book value.
In 2014, private companies were granted an exception from annual impairment testing, however. Under Accounting Standards Update (ASU) No. 2014-02, Intangibles — Goodwill and Other (Topic 350): Accounting for Goodwill, private companies can now elect to amortize goodwill and certain intangible assets acquired in business combinations over a period of up to 10 years instead of testing them annually for impairment.
Private companies can also forgo recognizing noncompete agreements and customer-related intangibles unless these agreements or intangibles can be sold or licensed independently. If not, they can simply be combined with the value of acquired goodwill under ASU 2014-18, Business Combinations (Topic 805): Accounting for Identifiable Intangible Assets in a Business Combination.
All borrowers, regardless of whether they’re public or private, must test for impairment when a “triggering event” occurs. Examples include loss of key personnel, an adverse change in legal factors or unanticipated competition. Borrowers don’t need to wait until year end to test for impairment if a triggering event occurs.
A two-step process
Impairment testing currently has two steps. First, the borrower compares the company’s fair value (or the fair value of its reporting units) with the book (or “carrying”) value of equity (or the book value of the reporting units).
If book value exceeds fair value, the company must take a second step and calculate the implied fair value of goodwill by performing a hypothetical purchase price allocation as of the date of the impairment test. Impairment equals the excess of the book value of goodwill over its implied fair value.
To simplify matters, in 2011 the Financial Accounting Standards Board (FASB) adopted an optional qualitative impairment test as a screen for companies to assess whether it’s more likely than not that goodwill is impaired before performing the quantitative two-step impairment test. The qualitative test considers such issues as industry conditions, technological obsolescence, legal developments and company-specific factors.
For many borrowers, the qualitative test wasn’t simple enough and the FASB didn’t provide enough practical guidance. So, most companies stuck with the more prescriptive, two-step quantitative test.
In response to concerns over the continued cost and complexity of impairment testing, the FASB recently proposed revising the guidance (again) to eliminate the second step of the impairment test. This change would benefit public companies and private companies that haven’t elected to amortize goodwill under ASU 2014-02. The comment period for this proposal ends in July, and the FASB is currently deliberating on the feedback it received from companies, auditors and investors.
Heed the warning
Keep an eye on the value of goodwill, brands and other indefinite-lived assets when they appear on a borrower’s financial statements. These show up after major asset and stock transactions. If impairment occurs, it may be a sign that the acquisition isn’t living up to management’s expectations, warranting additional investigation.
Watch for impairment in financial statements
How do you know if a borrower’s goodwill, brands and other indefinite-lived assets have become “impaired”? Because most companies develop these assets in-house, financial statements might not reveal any obvious red flags — unless a borrower undergoes a financial statement audit and its CPA raises a warning about the company’s ability to continue as a going concern over the next year.
But if a borrower acquires these assets from outside the company, you have a chance at early detection. An impairment loss reported on the income statement is a major concern that bankers should address immediately. If a borrower reports an impairment loss, visit the company’s facilities and talk to management. Ask questions about what happened and what plans management is taking to turn the situation around.
Above all, avoid making knee-jerk responses. Some proactive, adaptable borrowers can recover from impairment. And bankers who stick beside their borrowers through tough times are often rewarded with long-term customer loyalty.
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