Financial Reporting for Mergers and Acquisitions

On June 30, 2001, the rules governing the accounting treatment for mergers and acquisitions changed dramatically. On that date, FAS 141 (Business Combinations) and FAS 142 (Goodwill and Other Intangible Assets) became effective, superseding APB No. 16 (Business Combinations) and APB 17 (Intangible Assets) which had been issued in 1971. Under the new rules, pooling of interests accounting is no longer acceptable under any circumstances; the purchase method of accounting for business combinations is now mandatory in order to be in compliance with GAAP. This method of accounting involves allocating the purchase price paid to the assets acquired (tangible and intangible) and liabilities assumed by major balance sheet caption. In this process, intangible assets must be recognized apart from goodwill if they meet one of two criteria: the contractual-legal criterion or the separability criterion. These intangible assets are then amortized over their remaining useful lives.

Goodwill is no longer amortized on a periodic basis, but rather must be tested at least annually to determine whether and to what extent it has been impaired. The acquired assets and liabilities must be assigned to a reporting unit so that subsequent testing can be conducted. If a publicly traded company has only one reporting unit, the company’s stock price usually provides a reliable basis for determining whether and to what extent goodwill has been impaired (Step 1 below). If the acquiring company is privately held or publicly held with more than one reporting unit, then each reporting unit’s goodwill must be tested at least annually in a two-step procedure:

Step 1 of the goodwill impairment test, used to identify potential impairment, compares the fair value of a reporting unit with its carrying amount, including goodwill. If the reporting unit’s fair value is greater than its carrying amount, goodwill is not impaired. If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill impairment test must be performed to measure the amount of impairment loss, if any.

Step 2 of the goodwill impairment test, used to measure the amount of the impairment loss, compares the implied fair value of the reporting unit goodwill with the carrying amount of that goodwill. If the carrying amount of reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess. The loss recognized cannot exceed the carrying amount of the reporting unit’s goodwill. After goodwill impairment is recognized, the adjusted carrying amount of goodwill becomes its new accounting basis.

The implied fair value of goodwill is determined in the same manner as the amount of goodwill recognized in a business combination. That is, the fair value of the reporting unit is allocated to all of the assets and liabilities of that unit (including any unrecognized intangibles) as if the business unit had been acquired in a business combination and the fair value of the reporting unit was the price paid to acquire that reporting unit. The excess of the fair value of a reporting unit over the amounts assigned to its assets and liabilities is the implied fair value of goodwill. This allocation process is performed only for the purposes of testing goodwill for impairment. The entity is not permitted to write up or write down a recognized asset or liability, nor should it recognize a previously unrecognized asset in that allocation process.

Testing for the impairment of long-lived assets, both tangible and intangible, is governed by FAS 144. An impairment loss under FAS 144 is recognized only if the carrying amount of the asset or asset group is not recoverable and exceeds its fair value. Testing under FAS 144 is also a two step process. Step 1 involves an analysis of undiscounted future cash flows that are expected to be realized over the asset or group’s remaining useful life. If the undiscounted cash flows are less than the carrying value of the asset or asset group, then a recognition of impairment may be required. Step 2 of the process involves an analysis of discounted cash flows to determine the asset or group’s fair value. Impairment loss is measured by the difference between carrying value and fair value.

This is a complex process that should be performed by experienced valuation professionals. Wharton’s consultants have extensive experience in the valuation of businesses and intangible assets, as well as the allocation of the purchase price in mergers and acquisitions.