Determining how to account for the goodwill found in business combinations has been a hotly debated topic for decades. Standards setters have promulgated numerous different approaches over time, and in the past decade FASB has released several pieces of guidance aimed at streamlining the current impairment model. The authors explain how a new proposal has put the spotlight back on the subject and analyze the potential impact a return of the amortization method might have on financial reporting.
Finding an optimal solution to the accounting for business combinations, in particular the treatment of goodwill, continues to challenge accounting standards setters. In 2001, FASB issued Statement of Financial Accounting Standards (SFAS) 141, Business Combinations, which among other changes eliminated the pooling of interests method. Concurrently, SFAS 142, Goodwill and Other Intangibles, replaced the requirement to amortize goodwill with a periodic impairment testing approach. Over the past eight years, several Accounting Standards Updates (ASU) have modified and relaxed the original requirements of SFAS 141 and 142.
In a new invitation to comment (ITC), “Identifiable Assets and Subsequent Accounting for Goodwill,” FASB has sought additional comment and input on whether the benefits of the current goodwill impairment accounting model justify the cost to prepare and audit the information for public business entities, and if not, whether some form of goodwill amortization should be considered. While the ITC raises questions about the current goodwill impairment model, it does not mean FASB has made a definitive decision to return to the amortization approach; rather, FASB has received mixed feedback from users, preparers, and auditors on the current impairment approach and seeks input on whether it should address changes to the current model. This article provides background on goodwill accounting under GAAP, the current issues under discussion in the ITC, and the potential financial statement impacts of a return to the amortization model for public business entities.
The Continuing Evolution 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 Problems, Georgia State University, 1982.) Historians have noted cycles in U.S. history where the nation swings in one political direction and then over time swings back in the opposite direction. As a political process, accounting standards setting is not free from these cycles. Not unexpectedly, FASB and its predecessors in setting GAAP, the Committee on Accounting Procedure (CAP) and the Accounting Principles Board (APB), have all grappled with and come to slightly different solutions on the initial and subsequent treatment of goodwill. (For additional information, see David A. Rees and Troy D. Janes, “The Continuing Evolution of Accounting for Goodwill,” The CPA Journal, January 2012, http://bit.ly/2OIZnfj.) While there have been slight differences concerning initial valuation as GAAP on goodwill has evolved, the basic concept has remained the same: goodwill is the difference between the price paid for an acquired entity and the sum of the fair value of the identifiable net assets. The subsequent accounting for goodwill, however, continues to be a topic of significant debate, as evidenced by the recent ITC.
The treatment of goodwill evolved considerably 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 allowed the following approaches in the subsequent accounting for goodwill:
- Permanent retention as an asset
- Systematic amortization against earnings, retained earnings, or additional paid-in capital
- An immediate charge against retained earnings or additional paid-in capital.
While ARB 24 discouraged the practice of discretionary write-offs of goodwill, it did not prohibit such write-offs.
In Chapter 5 of ARB 43, Restatement and Revision of Accounting Research Bulletins, released in 1953, CAP prohibited the discretionary write-off of goodwill and the immediate charging of goodwill against stockholders’ equity. While ARB 43 still allowed permanent retention of goodwill, this approach was not favored; instead, systematic amortization against income was the emphasized approach for subsequent goodwill accounting. In 1970, CAP’s successor, the APB, issued Opinion 17, Intangible Assets, which eliminated the permanent retention (asset) approach and required goodwill to be amortized against income on a straight-line basis over a period of no more than 40 years unless another method was demonstrably more appropriate. APB Opinion 17 also required subsequent review of amortization. In electing to amortize goodwill, the APB noted, “Amortizing the cost of goodwill and similar intangible assets on arbitrary bases in the absence of evidence of limited lives or decreased values may recognize expenses and decreases of assets prematurely, but delaying amortization of cost until a loss is evident may recognize the decreases after the fact.”
In 2001, the APB’s successor, FASB, issued SFAS 142, which replaced the APB Opinion 17 requirement to amortize goodwill with a periodic impairment testing approach. Under SFAS 142, there are two steps in the impairment test:
- First, the company compares the fair value of the reporting unit to its carrying amount (Step 1).
- Second, if the fair value is lower, the company must then calculate any goodwill impairment charge by comparing the implied fair value of goodwill to its carrying amount (Step 2).
If the calculated implied fair value of goodwill is lower than its carrying amount, the company records an impairment loss for the difference. In arriving at this approach, FASB noted that “straight-line amortization of goodwill over an arbitrary period does not reflect economic reality and thus does not provide useful information.”
After issuing FASB 142, FASB received feedback from stakeholders indicating that the cost of performing the impairment testing exceeded the benefits. FASB responded by issuing several ASUs to reduce the burden. In 2011, it issued ASU 2011-08, Intangibles—Goodwill and Other (Topic 350): Testing Goodwill for Impairment, which provides for an option where a company can elect to assess impairment based on qualitative factors (Step 0). The company is not required to perform the two-step impairment and calculate the fair value of the reporting unit, and thus incur the associated costs, unless it determines that it is more likely than not that its fair value is less than its carrying amount. Similarly, to further reduce the cost and complexity of the good-will impairment test, in 2017 FASB issued ASU 2017-04, Intangibles—Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment, which eliminated Step 2 of the quantitative two-step impairment test, the calculation of implied goodwill. Instead, companies will record an impairment charge based on the excess of a reporting unit’s carrying amount of goodwill over its fair value.
The changes in ASU 2011-08 and ASU 2017-04 both fall within the framework of the nonamortization approach initially advocated by FASB in SFAS 142; however, ASU 2014-02, Intangibles—Goodwill and Other (Topic 350): Accounting for Goodwill (A consensus of the Private Company Council), contains significant change in subsequent accounting for 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 over costs and benefits of the nonamortization approach, FASB has modified and relaxed the initial requirements of its nonamortization approach and allowed private companies the option of using amortization instead of impairment testing. The pendulum seems to be swinging back towards amortization.
The Invitation to Comment
As a result of mixed feedback on the costs and benefits of the current goodwill accounting model, in July 2019 FASB issued an invitation to comment, “Identifiable Assets and Subsequent Accounting for Goodwill.” The ITC seeks input on the costs and benefits of the current goodwill accounting model and whether FASB should—
- change the subsequent accounting for goodwill;
- modify the recognition of intangible assets in a business combination; or
- alter disclosures about goodwill and intangible assets.
The ITC is unequivocal in noting that FASB does not seek input on the conceptual basis for goodwill recognition or the immediate write-off of goodwill.
Concerning subsequent accounting for goodwill, FASB notes there are two non–mutually exclusive approaches that may address the cost-benefit issue: amortize goodwill or simplify the goodwill impairment test. In the ITC, FASB states, “Assuming that a cost-benefit issue exists with the subsequent accounting for goodwill, one approach to addressing the issue would be to reintroduce goodwill amortization for PBEs [public business entities].” In addition, the ITC seeks feedback on the appropriate amortization period. The ITC notes that goodwill amortization methods generally have at least one of the following characteristics, and these characteristics have an impact on the costs and benefits of alternative amortization approaches:
- A default period
- A cap (or maximum) on the amortization period
- A reasonable estimate
- Justification for the period.
The ITC also seeks input on the length of any default period FASB might require and notes that some stakeholders support amortization of goodwill over a default period of 10 years. While the ITC notes that FASB is solely asking for input and has not made any decisions, the extensive focus on amortization, the tabling of other issues, and the discussion of the pros and cons of various amortization approaches appear to indicate that FASB is headed in the direction of requiring or allowing the option of amortization for public business entities.
As this article went to press, FASB had received 89 comment letters on the ITC, with 48 letters supporting goodwill amortization, 37 opposed, and four with mixed views. Most of the respondents supporting amortization were auditors and preparers, while most users, academics, and valuation firms were primarily opposed.
Potential Financial Statement Impact of Amortization
FASB’s decision to revisit the accounting treatment for subsequent measurement of goodwill comes as goodwill balances on public company balance sheets are at record levels. Recent studies found that over $1 trillion in goodwill was added to public company balance sheets during calendar years 2015–2017, representing a marked increase over the years prior (for additional details, see the 2016, 2017, and 2018 U.S. Goodwill Impairment Studies by Duff & Phelps, http://bit.ly/2Bdm3wm). In addition, another recent study found that the amount of purchase consideration allocated to goodwill has increased in recent years, from a median allocation of 36% in 2016 to 40% in 2017 (for additional details, see the 2017 Purchase Price Allocation Study by Houlihan Lokey, 2018, http://bit.ly/33wZGhr). If FASB were to return to a model where goodwill is systematically amortized, the analyses presented below indicate that the impact would likely be material to many companies’ financial statements and key financial ratios.
Exhibit 1 presents an industry-level summary of goodwill as a percentage of a company’s total assets for members of the S&P 500 reporting a nonzero goodwill balance for 2018. Overall, goodwill is 20.3% (18.1%) of total assets at the mean (median). In the services and manufacturing industry groupings, goodwill accounts for the largest proportion of total assets (medians of 33.9% and 23.7%, respectively). On the other hand, in the finance, insurance, and real estate grouping, goodwill accounts for less than 4% of total assets at the median.
Goodwill as a Percentage of Total Assets, by Industry, 2018
Exhibit 2 presents a list of S&P 500 companies with the largest goodwill balances. Historically, these are highly acquisitive companies, with goodwill balances ranging from $31.3 billion to $146.4 billion and an aggregate goodwill balance amounting to more than $1.1 trillion. For example, the largest goodwill balance in the sample belongs to AT&T, which has acquired Time Warner and Direct TV in recent years, each at a significant premium over the sum of the fair value of the identifiable net assets ($38.6 billion and $34.4 billion allocated to goodwill, respectively). While the companies listed in Exhibit 2 have the largest goodwill balances in dollar magnitude, their goodwill balances vary greatly as a percentage of total assets, ranging from 1.8% to 45.0%.
Top 20 Goodwill Balances Reported by S&P 500 Companies by Dollar Magnitude, 2018 (dollars in billions)
Exhibit 3 presents a list of the S&P 500 companies with the largest proportion of goodwill to total assets, ranging from 51.0% to 61.3%. Of the 20 companies in the list, most provide technology-related products and services (commonly associated with two-digit SIC codes 35, 36, and 73). As a company’s proportion of goodwill to total assets increases, its earnings-based financial ratios would become more sensitive to a potential accounting change wherein the subsequent measurement of goodwill includes amortization.
Top 20 Goodwill Balances Reported by S&P 500 Companies by % of Total Assets, 2018 (dollars in billions)
Exhibits 4, 5, and 6 summarize the impact that a reintroduction of goodwill amortization would have on the S&P 500. In particular, Exhibit 4 presents an analysis of key financial statement ratios for each industry group and the total sample. The two ratios selected are return on assets (ROA) and basic earnings per share (EPS), and a comparison is made between the ratios calculated based on the values reported in companies’ financial statements (as reported) and the ratios calculated after adjusting for a hypothetical goodwill amortization expense (pro forma). The goodwill amortization calculations used to determine the pro forma percentages and per share amounts in Exhibits 4, 5, and 6 assume goodwill is amortized on a straight-line basis over 10 years, consistent with the guidance in ASU 2014-02. In addition, the pro forma percentages and per share amounts presented in Exhibits 4, 5, and 6 ignore any deferred tax implications that might arise from deals structured as Internal Revenue Code (IRC) section 338 asset purchases.
Effect of Pro Forma Goodwill Amortization on Key Financial Ratios, by Industry, 2018
Effect of Pro Forma Goodwill Amortization on S&P 500 Companies with the Largest Reported Goodwill Balances, 2018
Effect of Pro Forma Goodwill Amortization on S&P 500 Companies with the Largest Proportions of Goodwill to Total Assets, 2018
For the ROA comparison, the change for the total sample is an average decrease of 2.6%, from an average 6.2% (as reported) to an average 2.6% (pro forma). Likewise, for the EPS comparison, the change for the total sample is an average decrease of $1.20 per share, from an average $3.84 per share (as reported) to $2.64 per share (pro forma). Overall, a change in the accounting guidance that reintroduces amortization as a part of the subsequent measurement of goodwill would result in the median S&P 500 company reporting an ROA that is 42% lower and an EPS that is 31% lower on an annual basis.
Exhibits 5 and 6 further illustrate the impact that a reintroduction of goodwill amortization would have on key financial ratios. Exhibit 5 presents an analysis of the effect goodwill amortization would have on S&P 500 companies with the largest goodwill balances by dollar magnitude. Across these 20 companies, there is a decline in average ROA of 2.7%, from an average of 2.6% (as reported) to an average of −0.1% (pro forma). Similarly, there is a decline in average EPS 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).
Exhibit 6 contrasts as reported and pro forma ratio calculations, in this case for S&P 500 companies with the largest proportion of goodwill to total assets. Across these 20 companies, there is a decline in average ROA of 5.4%, from an average of 6.9% (as reported) to an average of 1.5% (pro forma). There is a comparably steep decline in average EPS 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 Things to Come
Since the issuance of APB 24 in 1944, the subsequent accounting for goodwill has been debated constantly and evolved considerably. FASB’s recent ITC and the changes made with recent ASUs highlight the strong possibility of a move back to amortization of goodwill. A review of the current goodwill carried on the balance sheets of S&P 500 companies finds, as expected, that there would be a noticeable decline in companies’ earnings and earnings-based financial ratios if FASB were to revive goodwill amortization. With such a potentially significant financial statement impact, the possibility of a return to amortization raised in the ITC will likely meet intense comment and debate from preparers, users, and auditors.