By Shannon Farr, CPA•ABV•CFF & Brent McDade, ASA, CBA, BVAL
Step Zero Goodwill Impairment Testing
In an effort to reduce the cost and complexity of performing the first step of the two step goodwill impairment test required under ASC 350, Intangibles – Goodwill and Other, the FASB issued ASU No. 2011-08, “Testing Goodwill for Impairment,” allowing an initial qualitative assessment of goodwill commonly known as step zero impairment testing. The idea of the new, optional procedure is to simplify impairment testing in the situation where it is unlikely that goodwill is impaired. If a step zero impairment test results in the conclusion that it is more likely than not that the fair value of the reporting unit exceeds its carrying value, then no further testing is required.
The new guidance has no effect on the initial measurement of goodwill when a transaction closes; identifiable tangible assets, intangible assets, and goodwill are recorded at fair value. In subsequent periods, on the other hand, step zero may eliminate the more costly step one impairment testing process. The qualitative assessment is optional; an entity can proceed directly to a step one impairment test in any period it chooses to do so.
Step zero is a qualitative assessment of the relevant factors that determine whether the fair value of the reporting unit exceeds its carrying value. It involves determining the value drivers of the reporting unit and examining whether those value drivers are more or less favorable than they were the last time fair value was determined. If it is clear that the changes in these value drivers would not result in a finding of impairment, then it is not necessary to calculate the fair value of the reporting unit.
While step zero impairment testing is an assessment of qualitative factors that affect the likelihood of impairment, it is important to remember that auditors are quantitative people. The bulk of the qualitative factors that inform a step zero impairment test are closely related to quantitative items that can be found either in the company’s financial statements or are available from third party data providers, and this data can support a step zero assessment.
ASU 2011-08 provides several examples of events and circumstances relevant to determining whether it is more likely than not that the fair value of the reporting unit exceeds its carrying value:
- Macroeconomic conditions. For companies sensitive to the economy, the extent to which economic conditions have changed since the last step one impairment test may affect the likelihood that the fair value of the reporting unit continues to exceed its carrying value. In our experience, outside auditors are more likely to agree with a qualitative assessment of economic conditions when that assessment is bolstered by quantitative facts. While management may be correct in the belief that economic conditions are improving, auditors are typically more comfortable when that statement is supported by evidence such as increasing GDP growth rates, decreasing unemployment, and increasing stock prices.
- Industry and market considerations. Step zero impairment testing often involves researching market conditions at relevant dates to see whether third party forecasts of industry performance have changed, to determine whether public company multiples are up or down, to investigate the regulatory environment, etc. Again, auditors are quantitative people, and an argument that “industry conditions are improving” is not as effective as an argument that “my trade association expects industry growth to increase from 2% per year to 6% per year.” “Values in my industry are up,” is not as effective as “The average price/earnings ratio of the comparable companies listed below increased from 6.2x to 10.5x since the last impairment test.”
- Cost factors. In industries where finished goods prices and raw materials prices are not necessarily correlated, expectations regarding raw materials prices might have an impact on value. In addition, if margins are expected to change over time, those changes in expected margin might have an impact on value. The analysis of expected cost and margin changes can provide evidence of whether fair value is increasing or decreasing.
- Overall financial performance. This has always been part of a step one impairment test, and it involves presenting an analysis of the historical financial performance and/or the expected future financial performance of the business. In the step zero environment, the key question is whether overall financial performance has improved since the prior measurement date. If the subject company’s goodwill was not impaired at last year’s step one impairment test, and the company’s financial position and outlook have improved, then there is an argument that it is unlikely that goodwill is impaired at the current measurement date. On the other hand, if the Company is well behind the forecast on which the prior opinion of fair value was based, then overall financial performance might not indicate that goodwill is not impaired. While the qualitative conclusion of the analysis might be that financial performance is improving, that point can be quantitatively supported by a discussion of revenue, margins, cash flow, balance sheet strength, or other financial information.
- Entity specific factors and events. The list of examples provided by FASB in this category includes changes in management, personnel, strategy, or customers; contemplation of bankruptcy; and litigation. A step zero assessment typically includes a discussion of the risks facing the business and how those risks have changed between the two measurement dates. For example, suppose fair value exceeded carrying value a year ago, when the state legislature was considering a bill that would have an adverse impact on the subject business. At this year’s measurement date, we know the bill was defeated, so that risk is no longer immediate.
- Events affecting the reporting unit. If the reporting unit is expected to dissolve, or if an impairment loss has been recognized in a subsidiary of the reporting unit, or if other material events have taken place, then the step zero impairment testing memorandum should explain these events and how they influenced the qualitative assessment.
- The difference between the fair value implied in a previous step one impairment test and the carrying amount of the reporting unit. While the rules no longer allow a reporting unit to carry over a prior step one impairment test, one component of the qualitative assessment can be to consider the extent to which the prior conclusion of value exceeded the carrying amount. If the fair value of the reporting unit exceeded its carrying amount by a significant margin, then it is less likely that minor negative factors identified elsewhere in the analysis would decrease value by an amount sufficient to imply impairment. On the other hand, if the last impairment test was close, then it is more likely that a step one impairment test will be required.
- Other factors. The factors described above are just examples, and any other factors relevant to the fair value of the reporting unit might be considered in a step zero impairment test. We discuss with our clients, and often with their auditors, the value drivers that would be expected to affect the fair value of the reporting unit to make sure that the step zero impairment memorandum discusses the appropriate items. As in any discussion of value, it is important to focus on those items expected to influence the magnitude and timing of the expected future cash flows of the subject, as well as the items expected to influence the risk associated with those cash flows.
Once the relevant factors have been documented, management forms an opinion of whether it is more likely than not that the fair value of the reporting unit exceeds its carrying value. This opinion results from a consideration of the factors that affect value. One common rubric involves listing the various factors considered and determining whether each is positive, neutral or negative. More emphasis is placed on those factors management believes to be more important, and sometimes the degree to which each is positive or negative is assessed.
At DAS, we recommend that our clients create what we call a step zero impairment memorandum, which documents the opinions of management regarding whether it is more likely than not that the fair value of the reporting unit exceeds its fair value, as well as their consideration of the relevant qualitative factors, including appropriate supporting quantitative analysis, that impact their conclusion. Our role in creating this document is to provide data, to help our clients identify the appropriate factors to consider, and to help present the analysis in a form that will be acceptable to an outside auditor.
GAAP does not specifically require the preparation of a step zero impairment memorandum. However, auditors are required to understand the process by which management reached the opinion that a step one impairment test is unnecessary. Further, auditors are required to verify that management’s opinion is reasonable. A step zero impairment memorandum documents the process by which management formed its opinion and supports the reasonableness of that opinion with objective evidence, providing a framework for productive dialogue between management and auditors on the subject of whether a step one impairment test should be performed.
If the company’s auditor decides a step one impairment test should be performed, then the research and analysis that went into step zero will not have been for naught; it will become part of the analysis supporting the ultimate opinion of fair value that results from the step one impairment test.
We Can Help
ASU 2011-08 is effective for annual and interim impairment tests for fiscal periods that being on or after December 15, 2011. If your company is coming up on a goodwill impairment testing date, contact the professionals at DAS to help you document your step zero impairment testing process.
Brent McDade, ASA, CBA, BVAL
Shannon Farr, CPA•ABV•CFF
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