The fate of the pooling-of-interest method of accounting for business combinations was finally decided in mid-2001. In June 2001, the Financial Accounting Standards Board (FASB) issued Statement No. 141 (FAS 141), Business Combinations, which superseded APB Opinion No. 16, Business Combinations, and eliminated the use of the pooling method for all business combinations. The new guidance is effective for all business combinations initiated after June 30, 2001 and all purchase transactions consummated after June 30, 2001. In conjunction with the issuance of FAS 141, FASB issued Statement No. 142 (FAS 142), Goodwill and Other Intangible Assets, which superseded APB Opinion No. 17, Intangible Assets. FAS 142 became effective for companies with fiscal years beginning after December 15, 2001. Accordingly, for financial institutions application of FAS 142 became effective with the filing of the March 31, 2002 Call Report.
While the application of the basic provisions of the purchase method of accounting for a business combination has not changed significantly, the implementation of FAS 141 requires arduous price allocation, reporting unit identification, and separate identification and treatment of intangible assets other than goodwill with definite and indefinite lives. A discussion of all of these tasks is beyond the scope of this article. The purpose of this article is to provide a brief summary of FAS 142 and its implications for financial institutions.
FAS 142 vs. Opinion No. 17
and FAS 121
Reflecting FASB's increased emphasis on measuring the fair value of assets and liabilities, FAS 141 and FAS 142 emphasize asset valuation as opposed to expense recognition. Accordingly, FAS 142 eliminated the amortization of goodwill and indefinite-lived intangibles and focused instead on asset valuation and impairment. Instead of amortization of goodwill over a period not to exceed 40 years, FAS 142 introduced a two-step process to determine if goodwill is impaired and the amount of any impairment loss to be recognized. This assessment must be made annually.
To determine if goodwill is impaired, the fair value of the reporting unit that caused the goodwill to be generated (e.g., the bank that was acquired) is compared to the reporting unit's carrying amount plus the related goodwill. If the fair value is greater than the carrying amount, no further analysis is needed. If, however, the fair value of the reporting unit has dropped below its carrying value plus the related goodwill, goodwill impairment might have occurred. Then, in a more difficult assessment, the implied fair value of the reporting unit's goodwill is compared to the carrying value of the goodwill to determine any impairment. (See the example under "Testing for Impairment.")
Indefinite-lived intangible assets, which appear infrequently in banks, must also be tested for impairment annually. However, the impairment test for indefinite-lived intangibles is more straightforward and should be performed on an asset-by-asset basis rather than on the entire reporting unit.
FAS 142 also requires more extensive disclosure concerning goodwill and other intangible assets. The aggregate amount of goodwill must be presented as a separate line item in the statement of financial position (i.e., balance sheet) and goodwill impairment losses must be reported as a separate line item in the statement of operations (i.e., income statement). Additional narrative and tabular disclosures are also required in the financial statements.
The key differences between FAS 142 and the old rules are summarized below.Comparison of FAS 142 and Prior Rules
|FAS 142||Old Rules|
Goodwill is no longer subject to amortization
Amortization is required under APB No. 17, but for a maximum period of 40 years
Goodwill Impairment Test Guidance
Impairment test, using a two-step process, must be done when events or circumstances occur that indicate that goodwill might be impaired, but not less than annually
Impairment is determined only after the occurrence of certain triggering events, per FAS 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of
Intangible Asset (IA)
IA is amortized over the useful life without the constraint of the 40-year ceiling
IA is amortized over life not to exceed 40 years
IA is separated from goodwill and individually tested for impairment
IA is normally included with goodwill, which is subject to amortization
More disclosure requirements
Less disclosure requirements
Effective Date and
Transition to FAS 142
The provisions of FAS 142 are effective for fiscal years commencing after December 15, 2001. Therefore, goodwill and intangible assets that existed prior to July 1, 2001 would continue to be amortized until December 31, 2001. However, goodwill and indefinite-lived intangible assets that arose after June 30, 2001 would not be amortized, even though the company had not otherwise adopted FAS 142.
All calendar-year companies must adopt FAS 142 beginning on January 1, 2002. The first step of the impairment testthe fair value and book value comparisonmust be performed within six months of the initial adoption of FAS 142. If losses are determined from the first step, the amount of impairment must be calculated using the second step as soon as possible, but no later than by year-end.
Testing for Impairment
Intangibles Other than Goodwill. Amortizable intangible assets, i.e., those with definite lives, will continue to be reviewed for impairment in accordance with FAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Core deposit intangibles are such assets. Indefinite-lived or unamortizable intangible assets will not be subject to impairment testing under FAS 144. Instead, indefinite-lived intangibles must be tested for impairment individually when conditions warrant, but not less than annually. The impairment test is performed by comparing the individual intangible asset's carrying value to its fair value. If the fair value is less than the carrying value or book value, the difference is recognized as impairment loss.
Goodwill. Under FAS 142, goodwill impairment should be tested at least annually at the reporting unit level. For purposes of FAS 142, a reporting unit is an operating segment as defined in FAS 131, Disclosures About Segments of an Enterprise and Related Information, or one level below an operating segment. In general, a reporting unit is the lowest level of a company that earns revenue and incurs expenses, has discrete financial information available, and is reviewed regularly by the chief operating decision maker. Reporting units can be distinguished physically and operationally and for internal reporting purposes from other activities, operations, and assets of the entity. For financial institutions, each bank that files a Call Report would be considered a reporting unit. Nonbank subsidiaries of the holding company and the holding company itself are also reporting units.
The annual test may be performed at any time during the year, but must be performed at the same time each year. In addition, an interim test should be performed if an event occurs that likely would reduce the fair value of the reporting unit below its carrying value.
The two-step process for assessing any impairment of goodwill might occur as follows.
Step 1: Comparing the FV
and BV of the Reporting Unit
If the reporting unit's fair value is greater than its book value including goodwill, no impairment has occurred and the analysis is complete. If the reporting unit's book value including goodwill is greater than its fair value, the goodwill must be assessed for impairment. This calculation can be best illustrated by the example below.
In many acquisitions, the resulting goodwill is recorded on the books of the parent company instead of being pushed down to the acquired entity when the parent company's controlling interest of the subsidiary is less than 80 percent. For purposes of this assessment, the goodwill on the parent company's books related to the acquisition is allocated to the reporting unit.
Step 2: Measuring the
Amount of Impairment
The amount of impairment is determined by comparing the implied fair value of the goodwill and the book value of the goodwill. This is much more complex than step one testing, since all assets and liabilities of the reporting unit must be valued separately. The implied value of goodwill is calculated as the difference between the fair value of the reporting unit as a whole and the sum of the individual fair values of its assets, net of the fair value of its liabilities.
Any impairment must be recognized in the period in which it is identified, and cannot be deferred. If the original goodwill was recorded on the parent's books, the impairment is also recorded on the parent's books and not on the books of the reporting unit.
|The Two Step Impairment Test|
|FV > BV||FV<BV|
|FV of Reporting Unit||$ 325,000||$ 265,000|
|BV of Reporting Unit
(including $35,00 goodwill)
|$ 25,000||$ (35,000)|
|Stop!!||Go to Step 2|
|Sum of FV of Tangible and Intangible Assets||$ 3,000,000|
|Sum of FV of Liabilities||(2,745,000)|
|Sum of FV of Net Assets||$ 255,000|
|FV of Reporting Unit from above||265,000|
|Implied FV of Goodwill||10,000|
|BV value of Goodwill from above||35,000|
|Calculated Impairment||$ 25,000|
Impact on Earnings and
Earnings. During the initial phases of the implementation of FAS 142, companies will likely report higher earnings since goodwill is no longer being amortized. However, future profitability might not be as predictable or consistent given the potential impairment charges that can be affected by many outside factors. Moreover, companies might have to provide additional budget for training and/or consulting fees to ensure an appropriate valuation is performed annually. Nonetheless, the overall financial information provided to stakeholders will be more relevant and reliable.
FAS 142 does not recognize the concept of temporary impairment. Accordingly, if a step-one assessment indicates impairment, no matter how temporary, the step-two assessment must be performed and any impairment must be recognized. In addition, FAS 142 impairment write-downs of goodwill and indefinite-lived assets cannot be recovered in subsequent periods. Therefore, so-called temporary impairments would be reflected permanently in a company's financial statements.
Consider the effects of September 11, 2001. The market capitalization (possibly one indicator of value) of many publicly traded companies plunged below the net book value of their assets. For FAS 142 purposes, any goodwill would likely be determined to be impaired, and would be required to be written down. After the stock markets adjusted to the external events and share prices again rose, the write-downs could not be recovered.
Capital. Since earnings are transferred to capital with closing entries, the impact on equity capital mirrors that on earnings. However, since goodwill is excluded from capital calculations for regulatory capital purposes, regulatory capital would be the same under both the new and old rules, excluding tax implications.
This can be demonstrated by the following example, using the goodwill information from the previous illustration.
Capital Remains the Same:
Goodwill Amortization Versus Impairment
|$35,000/40 years (assume no impairment)||$ 875||0|
(Assumed first year earnings of $40,000 before amortization or impairment)
|Tier 1 Capital||$305,000||$305,000|
|Assume $25,000 impairment||$ 875||$ 25,000|
|Tier 1 Capital:|
(Assume second year earnings of $30,000 before amortization or impairment)
|Tier 1 Capital||$335,000||$335,000|
In addition to transitioning from expense recognition to fair value, one of the primary purposes of FAS 142 is to provide financial statement users with a clearer view of the investments made and the subsequent performance of the investments. Hence, financial statement users can expect to see more extensive financial statement presentation and disclosures related to goodwill and intangible assets, improving transparency and enhancing the utility of the financial statements.
As with any significant change in accounting procedure, many questions remain. For example, under FAS 72, Accounting for Certain Acquisitions of Banking or Thrift Institutions, financial institutions can recognize an unidentifiable intangible asset in the amount that the fair value of liabilities assumed exceeds the fair value of assets acquired. FASB specifically excluded these unidentified intangible assets when drafting FAS 142. However, FASB has agreed to conduct additional research on whether there are issues unique to business combinations of financial institutions that have an excess of the fair value of liabilities over assets that would require different guidance from that provided in FAS 141.
On May 13, 2002, FASB issued an Exposure Draft that would clarify that FAS 141 is the appropriate accounting guidance relating to the recognition of FAS 72 intangibles in a business combination involving stockholder-owned financial institutions. Comments are due to FASB by June 24, 2002.
In addition, some institutions have questioned whether capital guidelines would be adjusted to allow net-of-tax treatment of goodwill (i.e., total goodwill less the deferred tax liability). The federal regulatory agencies are considering this and other issues, and will issue formal guidance later in 2002.
While many acquirers in business combinations may appreciate the potential boost to earnings from the elimination of goodwill amortization, they face a challenge of the rigorous and complex valuation process. In order to comply with the provisions of FAS 142, companies will have to devote additional efforts in developing policies and procedures, providing additional training, and/or engaging outside expertise.
Questions on the application of FAS 141 and 142 for financial reporting purposes should be directed to the company's external auditor or other qualified individual. Institutions supervised by the Federal Reserve Bank of Philadelphia that have questions concerning the appropriate accounting and disclosure treatment for goodwill and other intangible assets for regulatory reporting purposes should contact Eddy Hsiao, Senior Examiner, at (215) 574-3772.
The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.