Transaction structures matter in goodwill impairment testing: corporate finance departments need to consider hypothetical transaction structures for each reporting unit early in the process, since they can affect whether goodwill is impaired and the extent to which it is.

• Author: Lynch, Michael
• Position: ACCOUNTING

Goodwill impairment has become an all too common phenomenon recently, as one in five S&P 500 companies recorded an impairment charge during calendar year 2009, according to data from Capital IQ, a quantitative analysis and research provider. Accounting Standards Codification 350 (ASC 350, formerly Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets), states that companies are required to test for possible goodwill impairment at the reporting unit level at least annually, following a two-step process.

Step 1 is used to identify potential impairment and Step 2 measures the amount, if any, of the impairment charge. During the past year, ASC 350-20-35 (formerly "EITF Issue No. 02-13, Deferred Income Tax Considerations in Applying the Goodwill Impairment Test in FASB Statement No. 142"), emerged as an important and sometimes critical consideration in the goodwill impairment testing process.

As a result, corporate finance departments found themselves immersed in discussions of hypothetical transaction structures, deferred taxes and "step-ups" in asset values, For many companies, consideration of ASC 350-20-35 will impact whether goodwill is impaired and the extent of any impairment.

Goodwill impairment tests are performed either as part of the annual requirement under ASC 350 or upon the occurrence of what is known as a "triggering event"--a change in circumstances for the reporting unit that could create a situation where the fair value of the unit is below its carrying value.

For example, triggering events can result from adverse regulatory decisions or a sudden drop in revenue. In 2008 and 2009, many companies experienced triggering events merely as a result of the broad stock market decline and equity valuations dropping with the decline of the global economy.

The Process

The goodwill impairment testing process begins by identifying whether a possible impairment exists. This is accomplished by comparing the fair value of the net assets of a reporting unit to the carrying value of its net assets. Note that the accounting standards are not clear as to the definition of "net assets," and an AICPA Impairment Task Force is currently discussing the issue of whether Step 1 should be performed on an equity or enterprise value basis.

To determine the fair value of the net assets of the reporting unit, traditional income or market-based valuation methods are utilized, depending on the specific facts and circumstances of the entity being valued. Typically, these valuation methods include discounted cash flow analysis, comparable company or transaction approaches or some weighting of these approaches.

Once fair value is estimated, it is then compared to the carrying value of the reporting unit. For public companies with multiple reporting units, a...