New Rules for Business Combinations Intangibles and Goodwill Accounting

<i>Oct. 31, 1970</i>—New accounting rules require that all goodwill recognized in
business combinations must be amortized over a period not to exceed 40 years.

</p><p><i>June 30, 2001</i>—New accounting rules require that goodwill acquired after this date
will no longer be subject to amortization. Companies will also cease amortizing
goodwill acquired before June 30, 2001, upon adopting the new rules.

</p><p>What a difference 30 years makes.

</p><p>This summer, the Financial Accounting Standards Board (FASB) released two new
Statements of Financial Accounting Standards (SFAS) dealing with valuing and
accounting for businesses and their intangible assets. SFAS 141, Business
Combinations, replaces Accounting Principles Board Opinion 16 of the same title
(APB 16). SFAS 142, Goodwill and Other Intangible Assets, replaces
Accounting Principles Board Opinion 17, Intangible Assets (APB 17). Both
of these new standards will have an enormous impact on companies' financial statements
and on how we read, interpret and set financial covenants on those statements.

</p><p>The two standards are long and complex. This article will give the reader an
overview of some of the more substantive changes required by SFAS 141 and
SFAS 142.

</p><h3>Application to Reorganizations and Fresh-start Accounting</h3>

<p>American Institute of Certified Public Accountants Statement of Position 90-7,
Financial Reporting by Entities in Reorganization Under the Bankruptcy Code (SOP
90-7), required that so called "fresh-start" accounting applied to a qualifying
company emerging from bankruptcy should be applied in conformity with the requirements
of APB 16 and APB 17. With SFAS 141 and SFAS 142 superceding APB
16 and APB 17, the application of fresh-start accounting must conform to these
new statements. One provision of SOP 90-7 specifically addressed in SFAS 142
relates to the rather bulky term, "reorganization value in excess of amounts allocable
to identifiable assets." As specified in SFAS 142, "reorganization value in excess
of amounts allocable to identifiable assets" will be captioned "goodwill" on the
reorganized company's balance sheet.

</p><h3>SFAS 141, Business Combinations</h3>

<p>In many respects, accounting for business combinations and acquisitions of minority
interests following the rules specified in SFAS 141 will be no different than the
accounting under APB 16. Where the rules differ, however, the differences are
significant.

</p><h3>Pooling Eliminated</h3>

<p>Perhaps the most significant of the changes is the elimination of "pooling."
Recording a business combination under the pooling rules essentially entailed adding
together the balance sheets of the acquiree and the acquiror at their historical cost
bases. Under SFAS 141, the only acceptable method of accounting for a business
combination is the purchase method. The purchase method sets the cost basis of the
acquired enterprise at the more evident of the value of the consideration given or
consideration received plus transaction costs.

</p><h3>More Guidance for Identifying the Acquirer, Intangibles, etc.</h3>

<p>In an exchange of equity interests or in roll-up transactions, SFAS 141 still
uses a judgmental determination for identifying the acquirer. Applying APB 16
usually resulted in treating the largest forming company or the entity with whose
stockholders owned the larger portion of voting rights as the acquirer. SFAS 141
requires consideration of all facts and circumstances, not just the relative size of
the combining companies or the survival of majority voting rights.

</p><p>Under SFAS 141, the purchase price allocation to identifiable intangible assets
is subject to a higher standard of identification. Under APB 16, if an asset
could be identified and named, value could be assigned to it. Now, value will only
be assigned to an intangible asset if the asset is obtained through a legal or
contractual right or is separable from the entity's assets.

</p><h3>Negative Goodwill Eliminated</h3>

<p>Under APB 16, if an entity was acquired for less than the value of its
current assets, the remaining residual credit after writing the non-current assets down
to zero was recorded on the balance sheet as "negative goodwill." Negative goodwill
was amortized into income over a reasonable period of time. There have been a number
of bankruptcy cases over the last 10 years where the reorganization value in
comparison to the assets and liabilities of the reorganized entity has resulted in
negative goodwill. <i>Ames I</i> (filed 1990) and <i>Zales</i> (filed 1992) are two
such cases that come to mind. Under FSAS 141, once non-current assets (with
a few exceptions) are reduced to zero, the remaining residual credit is recognized
in income immediately as an extraordinary gain.

</p><h3>SFAS 142, Goodwill and Other Intangible Assets</h3>

<p>Unlike the relationship between SFAS 141 and APB 16, SFAS 142 and
APB 17 have very little in common. Perhaps the single consistent accounting
treatment between the two statements relates to the accounting for internally generated
intangible assets. Both APB 17 and SFAS 142 require companies to expense
incurred costs related to internally generated intangible assets.

</p><h3>Amortization vs. Impairment</h3>

<p>Goodwill has been amortized over periods not to exceed 40 years since Richard
Nixon was in the White House (and Arthur Burns was chairman of the Fed.) The
chosen period for amortizing the goodwill and the very presence of amortization expense
in a company's income statement have been controversial ever since. Among other
controversies, the Securities and Exchange Commission has regularly challenged
registrants' use of the full 40-year amortization period, and company management and
stock analysts have regularly complained that investors don't understand the profitability
of companies because they don't understand goodwill amortization.

</p><p>SFAS 142 replaces the concept that goodwill is a depleting asset that should
be amortized with the recognition that some intangible assets, including goodwill, have
indefinite useful lives and should not be amortized against income, but should instead
be periodically tested for impairment. As a result, SFAS 142 replaces the
requirement to amortize goodwill with specific guidance on annually evaluating goodwill
for impairment.

</p><p>Although the accounting model has long recognized the concept of asset impairment,
APB 17 did not specifically articulate the requirement that goodwill, although
subject to amortization, should also be evaluated for impairment. As a result of the
lack of guidance in this area, the recognition of excess carrying value of goodwill
is not often reported because the general standard against which to evaluate impairment
was not specifically tied to value. As an example of the looseness in the rules
under APB 16 and APB 17, one large construction-related company acquired another
complementary operation a few years ago. At the time of the acquisition, the acquiror
forecast that it would record approximately $45 million of goodwill on the purchase
price of approximately $200 million. Within the one-year adjustment period following
the acquisition, the acquiror discovered unrecorded contract losses that took the net
identifiable assets acquired from approximately $155 million to approximately -$75
million. (The acquiror ended up purchasing no net assets; rather it assumed net
liabilities of approximately $75 million.) The $230 million of contract loss
accruals resulted in the acquiror recording total goodwill of approximately $275
million on the transaction. As the acquiror filed for bankruptcy approximately two
years later, at least partly as a result of the acquisition, it continued to carry
the amount of the acquisition goodwill, net of subsequent amortization, on its balance
sheet. Under SFAS 142, the acquiror would likely have been required to charge
off the excess goodwill that essentially represented a capitalization of contract losses.

</p><h3>Evaluating Impairment</h3>

<p>Until SFAS 142, a one-step undiscounted cash flow test would have been
performed at the acquired business level to assess the impairment of goodwill. Under
SFAS 142, a two-step fair value impairment test at the reporting unit level is
required at least annually and on an interim basis if conditions or events indicate
that an interim evaluation is warranted. Under the new rules, the acquiror must
allocate the goodwill from the acquisition to its appropriate reporting unit level. A
company's reporting units are based on the company's organizational structure. The
reporting unit to which the goodwill is assigned depends on how the acquired company
is integrated into the acquiror. The first step of the goodwill impairment test
compares the fair value of the reporting unit with its carrying value, including
goodwill, on the company's financial statements. If the carrying value exceeds the
fair value of the reporting unit, the second step, comparing the implied fair value
of the reporting unit goodwill with the carrying amount of that goodwill, is
performed. If the implied value of the reporting unit goodwill is less than the
carrying value of that goodwill, impairment exists, and an impairment loss must be
recognized as a charge against income. The charge should be presented as a separate
line item before the subtotal "income from continuing operations" or similar caption,
unless the impairment loss is associated with a discontinued operation.

</p><h3>More Guidance Related to Other Intangible Assets, Disposal of Businesses</h3>

<p>SFAS 142 provides more guidance than APB17 related to accounting for the
effect on goodwill of disposing of all or a portion of a business. Additionally,
SFAS 142 specifically addresses other types of intangible assets that may have
indefinite useful lives and the appropriate accounting for these assets.

</p><h3>Disclosure</h3>

<p>SFAS 141 and SFAS 142 expand on the necessary disclosure related to
business combinations and intangible assets, including goodwill. Particularly those
disclosures required by SFAS 142 should expand the financial statement reader's
understanding of the company's assessment of the value of its businesses and the
circumstances and events that affect that assessment of value. Among the information
a company must disclose are changes in goodwill-carrying amounts by reportable segment,
the events and circumstances leading to any impairment, the amount of the impairment
loss, the method used to determine the fair value of the associated reporting unit,
and whether the loss recognized is based on an estimate rather than a full valuation
and the reasons why.

</p><h3>Impact on Other Reporting</h3>

<p>Concepts such as EBITDA must also be re-evaluated with the effective date of
SFAS 142. A substantial portion of the "A" is being replaced by what is
expected to be irregularly occurring charges against income for impairment losses. Being
based on current fair value assessments, such charges do not have the same character
as amortization expense. While management may seek to have such charges excluded from
covenant calculations, lenders must re-evaluate the purpose of those covenants and
determine whether such charges should be excludable from covenant reporting or whether
such charges will serve as a leading indicator of emerging problems for the company.

</p><hr>
<h3>Footnotes</h3>

<p>^{<small><a name="1">1</a></small>} The views expressed in this article are solely those of the author and not necessarily his firm. <a href="#1a">Return to article</a>

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