Dataline A look at current financial reporting issue

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1 Dataline A look at current financial reporting issue No November 25, 2013 What s inside: Overview... 1 At a glance... 1 The main details... 1 Contents of the Guide... 2 Concepts and application of ASC Accounting considerations... 3 Qualitative assessment... 5 Measuring fair value of a reporting unit... 7 Questions Testing goodwill for impairment AICPA issues Accounting and Valuation Guide Overview At a glance In November 2013, the AICPA's Financial Reporting Executive Committee (FinREC) issued the AICPA Accounting and Valuation Guide Testing Goodwill for Impairment (the Guide). The Guide, which was developed by the AICPA Impairment Task Force (the Task Force), provides nonauthoritative accounting and valuation guidance and illustrations for preparers of financial statements, auditors, and valuation specialists regarding goodwill impairment testing. The Guide discusses practice issues related to the goodwill impairment test, including the valuation of a reporting unit in accordance with applicable standards. FinREC s new guide illustrates techniques often utilized to measure the fair value of a reporting unit. It also describes and illustrates the framework for performing the optional qualitative assessment. Preparers, auditors, and valuation specialists can use the Guide to better understand goodwill impairment testing and the related valuation techniques, as well as the required and expected disclosures. The main details.1 Given the complexity, sensitivity, and need for significant judgment, companies continue to experience issues assessing goodwill for impairment. The Task Force created the Guide to assist public and private companies in conducting their assessments. The Guide does not amend existing guidance, but instead provides details about the principles in existing standards and provides practical examples that may help illustrate the concepts discussed. National Professional Services Group CFOdirect Network Dataline 1

2 .2 While it is nonauthoritative, the Task Force was comprised of accounting, valuation and industry specialists, and reflects input received from the FASB and SEC. The Guide was also made available for public comment..3 Organized into four chapters, the Guide includes the following: Chapter 1 focuses on fair value measurements and discusses the assumptions and techniques used to value a reporting unit when testing goodwill for impairment Chapter 2 addresses accounting considerations when testing goodwill for impairment Chapter 3 discusses and illustrates the optional qualitative assessment in determining whether or not the first step of the goodwill impairment test should be performed Chapter 4 describes how to measure the fair value of a reporting unit and includes a comprehensive example of the two step goodwill impairment test The appendices include a disclosure example and a summary table that illustrates the relative responsibilities of management and the external valuation specialist. Although the Guide provides comprehensive examples that illustrate an effective goodwill impairment test, companies must tailor the assessment to be responsive to their specific facts and circumstances. Contents of the Guide Concepts and application of ASC Accounting Standards Codification (ASC) 820, Fair Value Measurement (ASC 820), defines fair value and establishes a framework for measuring fair value for financial reporting purposes. Chapter 1 of the Guide provides an overview of fair value concepts, e.g., market participant and highest and best use, and the framework established in ASC 820, which provides background for the remainder of the Guide..5 The Guide reminds entities that fair value is a market-based measurement, not an entity specific measurement, and that the objective of fair value measurement is to estimate the price at which an orderly transaction to sell an asset or transfer a liability would take place between market participants. Fair value and the fair value hierarchy, as well as application guidance and accounting considerations, are discussed in detail in PwC s Global Guide to Fair Value Measurements. National Professional Services Group CFOdirect Network Dataline 2

3 .6 The three valuation techniques described in existing standards used to value assets and liabilities are discussed in the Guide. Those techniques are: The income approach, which converts future estimates of cash flows to a single (discounted) current value The market approach, which uses prices and other information from transactions for identical or similar assets or liabilities The asset approach, which considers the value of an entity to be the sum of the values of each of the assets and liabilities within the entity.7 The income and market approaches are commonly used to value a reporting unit, whereas the asset approach is used only in the earlier stages of a business, before intangible assets and goodwill have significant value..8 When multiple approaches are used to measure the fair value of a reporting unit, the range of values resulting from the different approaches should be considered and a point within that range should be chosen as most indicative of fair value. If different valuation approaches give widely disparate results, care should be taken to understand the reasons for the differences in value. Simply taking an average of the results is generally not appropriate..9 The Guide describes the following process to apply the ASC 820 framework in measuring the fair value of a reporting unit: Determine the unit of account Determine the valuation premise Identify the potential markets Determine market access Apply the appropriate valuation approaches Determine the fair value As described in the Guide, this process provides a way to obtain information or make assumptions about required information when measuring the fair value of a reporting unit. Further discussion of each of these steps can be found in the Guide. Accounting considerations.10 Goodwill is tested for impairment at least annually at a reporting unit level as prescribed in ASC 350 Intangibles Goodwill and Other (ASC 350). Chapter 2 of the Guide discusses and illustrates the requirements of the two-step goodwill impairment test, and includes the flow chart contained in ASC 350 which illustrates the optional qualitative assessment (discussed further in chapter 3 of the Guide) and the two step goodwill impairment test..11 Step 1 of the goodwill impairment test identifies potential impairment, and step 2 measures the amount of the impairment (if any) to be recognized. Under step 1, if the fair value of a reporting unit (including goodwill) exceeds its carrying amount, the goodwill of National Professional Services Group CFOdirect Network Dataline 3

4 the reporting unit is not considered impaired and step 2 is not applicable. If, however, the fair value of the reporting unit (including goodwill) is less than its carrying amount, an entity must proceed to step 2 to determine the amount of the impairment loss, if any..12 If the carrying amount of a reporting unit is zero or negative and it is more likely than not (that is, a likelihood of more than 50 percent) that a goodwill impairment exists, step 2 of the goodwill impairment test should be performed to measure the amount of impairment loss, if any..13 Step 2 of the goodwill impairment test compares the implied fair value of a reporting unit s goodwill with the carrying amount of the goodwill. The implied fair value of goodwill is determined by performing a hypothetical purchase price allocation. An entity assigns the fair value of a reporting unit determined in step 1, to all the assets and liabilities of that reporting unit (including any unrecognized intangible assets) as if the reporting unit had been acquired in a business combination. If the carrying amount of goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to the excess..14 The Guide discusses that an entity needs to consider and consistently apply assumptions developed in step 1 that would be applicable in performing step 2 (e.g., whether the reporting unit would likely be bought or sold in a nontaxable or taxable transaction)..15 Goodwill is tested for impairment at the reporting unit level. The identification of reporting units is unique to each entity and begins with that entity's identification of its operating segments. The Guide describes the process of identifying reporting units and determining the appropriate level at which to test goodwill for impairment..16 Assets and liabilities must be assigned to a reporting unit to determine the appropriate carrying amount to test. A reporting unit s carrying amount may be based on an equity approach, where all liabilities including debt are available for assignment, or based on an enterprise approach, where debt is excluded from the liabilities available for assignment. Assets and liabilities that are assigned to a reporting unit should be the same net assets that are considered in determining the fair value of that reporting unit. Because the authoritative accounting literature does not mandate a specific approach for calculating the carrying amount of a reporting unit, the Guide does not promote a particular approach..17 The Guide describes how to assign operating assets and liabilities to multiple reporting units, illustrating the assignment method both for when the asset or liability is shared by reporting units and when it is not. The Guide also describes the considerations for determining whether to assign corporate debt, deferred taxes, cumulative translation adjustment, and contingent consideration arrangements to reporting units..18 The Guide provides a detailed example illustrating the above allocations. The example describes four different methodologies to assign value, including those most frequently observed in practice..19 All goodwill acquired in a business combination should be assigned to one or more reporting units using a reasonable and supportable method consistently applied. When a reporting unit consists of a subsidiary of a parent that is less than wholly owned, it is necessary to differentiate and separately track goodwill related to the controlling interest and goodwill, if any, attributable to the noncontrolling interest (NCI). The existence of an National Professional Services Group CFOdirect Network Dataline 4

5 NCI does not impact the testing of goodwill, but if an impairment is identified, it needs to be separately attributed to the parent and the NCI..20 The Guide provides two examples demonstrating how to measure the goodwill attributable to the NCI both when there is no discount for lack of control (minority interest discount) and when there is a minority interest discount..21 The Guide discusses a number of other accounting matters, including: How to reassign goodwill when an entity reorganizes its reporting structure How impairment testing at the subsidiary level may differ from the parent entity s test Determining the amount of goodwill to be allocated when an entity disposes of a portion of a reporting unit The timing of annual and interim impairment testing Changing the annual impairment test date Determining the order of impairment testing for goodwill and other assets Determining the implied fair value of goodwill in step 2 The above and other complexities in the accounting for goodwill are discussed in detail in chapter 11 of PwC s Global Guide to Accounting for Business Combinations and Noncontrolling Interests ( PwC Business Combination Guide ). Qualitative assessment.22 ASU No , Intangibles Goodwill and Other (Topic 350): Testing Goodwill for Impairment, created an optional qualitative assessment that could be utilized to determine if step 1 of the goodwill impairment test is necessary. Chapter 3 of the Guide discusses and illustrates the accounting requirements of the qualitative assessment. Considerations related to the qualitative assessment are also discussed in chapter 11 of the PwC Business Combination Guide. It gives guidance on the selection of reporting units for the qualitative assessment, consideration of prior fair value measurements in the qualitative assessment, including when to refresh a reporting unit s fair value, as well as guidance on the qualitative assessment for a reporting unit with zero or negative carrying value..23 The objective of the qualitative assessment is to identify and evaluate relevant events and circumstances to conclude whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. Although there may be other approaches to performing the qualitative assessment, the Task Force outlined the following process, which it believes will meet the objective: National Professional Services Group CFOdirect Network Dataline 5

6 Identify relevant drivers of inputs and assumptions that most affect fair value Identify relevant events and circumstances that may have an impact on those drivers of fair value inputs and assumptions Weigh the events and circumstances Conclude on the totality of events and circumstances.24 Entities should consider the methods as well as inputs and assumptions used in the last quantitative test to determine whether they are still relevant or may have changed. More weight should be given to the key inputs and assumptions that can most affect the outcome of the qualitative assessment..25 In addition to the examples of events and circumstances that are included in ASC , the Guide includes the following more specific examples of events and circumstances that should be considered in determining if step 1 of the goodwill impairment test should be performed: Market reaction to a new product or service Technological obsolescence A significant legal development Contemplation of a bankruptcy proceeding An expectation of a change in the risk factors or risk environment influencing the assumptions used to calculate the fair value of a reporting unit, such as discount rates or market multiples.26 The Guide indicates that the qualitative assessment may not be cost-effective for a reporting unit whose fair value approximated its carrying amount in a recent fair value calculation because it may be difficult to conclude, based solely on a qualitative assessment, that it is not more likely than not that the fair value of the reporting unit is less than the carrying amount..27 All available evidence, both positive and negative, should be considered to determine whether, based on the weight of that evidence, it is more likely than not that the fair value of a reporting unit is less than its carrying amount. The Task Force believes that, all else equal, the weight given to the potential effect of positive and negative evidence needs to be commensurate with the extent to which it can be objectively verified. Therefore, the more negative evidence exists, the more positive evidence would be necessary and the more difficult it would be to support a conclusion that it is not more likely than not that the fair value of a reporting unit is less than its carrying amount..28 If an entity determines that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, then the entity is required to perform the first step of the two-step goodwill impairment test. If, however, after performing the qualitative assessment, an entity concludes that further goodwill impairment testing is not necessary, the entity should make a positive assertion about its conclusion and the events and circumstances taken into consideration to reach that conclusion. The Task Force believes that the extent of documentation of considerations should be commensurate with the level of judgment and qualitative analysis involved in supporting the positive assertion. National Professional Services Group CFOdirect Network Dataline 6

7 .29 In addition to describing the optionality of the qualitative assessment, the Guide discusses several other aspects of assessing goodwill impairment, including interim evaluation and qualitative assessment, comparison of the sum of the fair values of the reporting units to the entity s market capitalization, and the consideration of supporting or corroborating quantitative assessments such as sensitivity analyses..30 The Guide includes an example of an analysis of the qualitative factors considered in arriving at a conclusion for each of three reporting units regarding whether the first step of the two-step goodwill impairment test should be performed. These examples are intended to be illustrative and demonstrate one possible way to perform and document the qualitative assessment. Engagement teams and clients may want to refer to Dataline , FASB issues guidance that simplifies goodwill impairment test and allows for early adoption, and chapter 11 of the PwC Business Combination Guide for further discussion regarding the qualitative assessment. Measuring fair value of a reporting unit.31 ASC 350 states that the fair value of a reporting unit is the price that would be received to sell the reporting unit as a whole in an orderly transaction between market participants at the measurement date and that quoted market prices in active markets are the best evidence of fair value. Chapter 4 of the Guide discusses how to measure the fair value of a reporting unit..32 While quoted market prices provide the best evidence of fair value, quoted market prices will not be available for many reporting units..33 The Task Force indicates that it is not appropriate to measure the fair value of multiple reporting units together and then allocate the fair value of the combined reporting units to the individual reporting units, (i.e., a top-down approach). Rather, an entity should measure the fair value of each reporting unit individually and may assess, for each reporting unit, the benefit, if any, arising from synergies created by reporting units working in combination, (i.e., a bottoms-up approach)..34 The Task Force observed that the top-down approach would be viewed as combining reporting units for testing which is not permitted, while the bottoms up approach is consistent with the guidance in ASC 350 and market participant considerations..35 As described in ASC , substantial value may be recognized through synergies or other benefits that arise from a combination with another entity. As a result, the quoted market price may need to be adjusted to take into consideration these market synergies. The Guide includes an example illustrating the impact on fair value when a cost synergy is available to market participants. Synergies could be present in a business combination that would increase revenues, or decrease costs and the cost of capital. It is important to consider that such synergies might not be available and that a control premium is not always appropriate. Careful consideration and documentation of synergies that would be available to an acquirer of the reporting unit is an important part of estimating and documenting a control premium. National Professional Services Group CFOdirect Network Dataline 7

8 .36 The Guide discusses the effects of NCI when measuring the fair value of a reporting unit. Whether the existence of NCI impacts the fair value of a reporting unit may depend on whether the NCI is present above the reporting unit, within the reporting unit, or both. Because the fair value of a reporting unit refers to the price that would be received to sell the unit as a whole, when the NCI exists above the reporting unit, both the controlling and noncontrolling interests are sold together. As a result, the Task Force believes that the sale of the reporting unit would likely give the same value per share to the controlling shares and the NCI. Alternatively, when the reporting unit consolidates an entity that is partially owned, the reporting unit could be sold without selling the noncontrolling interest in the reporting unit s subsidiary. In this situation, the Task Force believes there may be a difference between the fair value per share for the controlling shareholders and the NCI. This could be due to the inclusion of a control premium in the fair value of the controlling interest in the reporting unit or the inclusion of a discount for lack of control in the fair value of the NCI..37 The Guide describes valuation techniques and provides schedules that illustrate fair value measurement techniques often used to measure fair value of a reporting unit. Specifically, the discounted cash flow method (an income approach), the guideline public company method (a market approach), and the guideline company transactions method (a market approach) are discussed and illustrated. The schedules included in the Guide provide a comprehensive example that is helpful in demonstrating how to perform a valuation analysis and the key components to be included. These schedules are for illustrative purposes and entities should consider their own relevant facts and circumstances when performing a valuation analysis..38 The discounted cash flow method (income approach) discounts to present value the future estimated cash flows during a defined projection period and also discounts to present value a terminal value which represents the fair value of all cash flows beyond the projection period. The terminal value can be computed using financial formulas or with market derived multiples which assume a hypothetical sale of the business after the projection period. Cash flows used in the discounted cash flow method are the responsibility of management and usually start with management's strategic plan..39 The above income approach can be used to estimate a market price when no active or observable market exists for the reporting unit being valued. The income approach is often based on entity-specific assumptions that should to be adjusted to be consistent with the assumptions a market participant would use to price the reporting unit..40 The Guide discusses adjustments to an entity s prospective financial information that may be required to arrive at market participant assumptions and/or to ensure consistency with the valuation objective of estimating fair value of the reporting unit. Examples of adjustment discussed in the Guide include those that may be necessary when there is planned acquisition activity, or to account for working capital, deferred revenue, nonoperating assets and liabilities, depreciation and amortization, share based compensation, or different income tax rate, among others..41 The risk related to the cash flows used in a discounted cash flow must be reflected in the discount rate. A discounted cash flow can be performed using projected cash flows which are expected or they can be performed using cash flows that are conditional on the National Professional Services Group CFOdirect Network Dataline 8

9 outcome of a specific event. If the projected cash flows are conditional on a specific event (for example, a successful patent application), the discount rate should incorporate an additional risk factor to reflect the uncertainty in whether the condition will occur. As the risk related to the cash flows increases, the discount rate will increase and the computed present value of the cash flows will decrease..42 Expected cash flows can be reflected in one set of cash flows that represents the weighted average of all outcomes or a number of discrete cash flow forecasts for different scenarios. These scenarios can be used in discounted cash flow analyses and weighted according to the probability of each event occurring..43 The comprehensive example in the Guide includes schedules which demonstrate the calculation of a weighted average cost of capital used as the discount rate in the discounted cash flows as well as the weighted average cost of capital used to determine the fair value of cost saving synergies. These schedules demonstrate that since the risks of achieving synergies may be different from the risks of the overall business, the discount rate used to determine the fair value of each may be different..44 ASC 350 requires that an entity determine whether the reporting unit being valued could be bought or sold in a nontaxable or a taxable transaction. In making the determination, an entity should consider whether the assumed structure results in the highest economic value to the seller, whether the assumption is consistent with those that a market participant would consider, and the feasibility of the structure..45 An example in the Guide compares the measurement of fair value of a reporting unit assuming it would be sold in a nontaxable to that determined in a taxable transaction. The Task Force discusses factors to consider when deciding to assume the reporting unit could be bought or sold in a nontaxable or a taxable transaction..46 The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets, liabilities, or a group of assets and liabilities, such as a business. Two commonly used market comparable methods for measuring the fair value of a reporting unit are the guideline public company method and the guideline transaction method. The guideline public company method compares the stock prices of public companies to the reporting unit being tested. Performance metrics are calculated for each public company and these metrics are then analyzed, adjusted if appropriate, and applied to the reporting unit's performance metrics. The guideline transaction method is similar, but it uses recent merger and acquisition transaction data for acquisitions of target companies that are similar to the reporting unit being tested..47 When applying the guideline public company method, the Guide discusses a number of important considerations, such as how active the market for the guideline company selected is, what makes a company comparable from a valuation standpoint to the reporting unit, as well as the number of guideline companies selected..48 The Guide also includes schedules illustrating the use of the guideline public company and the guideline transaction methods. In illustrating the use of these valuation methods, the Guide discusses, among other things: Operational and financial characteristics to help determine which companies are comparable to the reporting unit being valued Financial and nonfinancial metrics that may be calculated from the guideline public companies Adjustments that may be necessary to convert the financial data National Professional Services Group CFOdirect Network Dataline 9

10 .49 Once the guideline companies are selected, a determination needs to be made about which multiples to use and how to calculate them. Further discussion on applying the guideline public company method can be found in the Guide. Market multiples may be calculated on a historical basis or forward looking basis. The determination of whether to use historical or forward looking multiples should be made based on which measure is considered to be most indicative of a normalized level of operation on a go forward basis..50 Most of the considerations that apply to the guideline public company method also apply to the guideline transaction method but there are a few additional considerations in applying the guideline transaction method discussed in the Guide. For example, when applying the guideline transaction method, limited data may be available on guideline transactions or they may not be relevant based on the time that has passed..51 When measuring fair value of a reporting unit, multiple valuation techniques are often used and are weighted to determine the selected fair value for the reporting unit. For entities with publicly traded securities, it is best practice to perform a reconciliation between the aggregate fair values of the reporting units and the observable market capitalization. Any difference in value should be identified and explained..52 As a final step, the Guide illustrates the second step of the goodwill impairment test in both a nontaxable and a taxable transaction and how to measure the amount of the goodwill impairment. The Guide also includes example disclosures of the requirements of ASC 350 as well as those of Item 303 of Regulation S-K for a public company. The Task Force observed that the SEC s staff continues to focus on the accounting policies and related judgments made by management regarding their assessment of goodwill for impairment and the details of the recognized goodwill impairments. The example disclosure may be helpful for entities in considering the adequacy of their financial statement disclosures..53 Further discussion of each of these topics can be found in the Guide which is available for sale on the AICPA website..54 Additional guidance on testing goodwill for impairment can be found in chapter 7 (Valuation) and chapter 11 (Accounting for Goodwill Postacquisition) of the PwC Business Combination Guide. Questions.55 PwC clients who have questions about this Dataline should contact their engagement partner. Engagement teams that have questions should contact the Business Combinations team in the National Professional Services Group ( ). National Professional Services Group CFOdirect Network Dataline 10

11 Authored by: Lawrence Dodyk Partner Phone: Elly Barrineau Senior Manager Phone: Richard Billovits Director Phone: Datalines address current financial-reporting issues and are prepared by the National Professional Services Group of PwC. They are for general information purposes only, and should not be used as a substitute for consultation with professional advisors. To access additional content on financial reporting issues, register for CFOdirect Network ( PwC s online resource for financial executives PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see for further details.