How to Survive the SEC’s Second Guessing

New rules for recording goodwill and intangibles may inadvertently produce more restatements.
Craig SchneiderJune 29, 2001

Some senior financial executives may get more than they bargained for with the adoption of new accounting standards for goodwill and intangible assets in business combinations.

Amid the switch from amortization of goodwill to a complex impairment test exists what some experts see as a breeding ground for Securities and Exchange Commission inquiries and required restatements — an unintended consequence of the Financial Accounting Standards Board’s new rules.

For starters, the standards require companies to perform impairment tests in a new reporting unit, develop valuation methodologies for those units, and subjectively value identifiable intangible assets.

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The reporting unit definition takes the familiar “segment level” term from FAS Statement 121 but also introduces a segment “one level below” it. “That’s still a little fuzzy as to whether you’ll know one when you see it,” says Norman Strauss, Ernst & Young’s director of accounting standards.

“The SEC is often asking companies, ‘You disclosed three segments, why aren’t you disclosing five?’” adds Strauss. Now there’s another layer open for debate.

But experts say the allocation of purchase price to the reporting units and intangibles will receive the brunt of scrutiny because it offers ways for companies to potentially shield themselves from future goodwill impairment. “The SEC is already making very [loud] public noise that we are going to be on this like you wouldn’t believe,” says Mark McDade, partner in PricewaterhouseCoopers’s transactions service group.

John Steuart, CFO, says the new standard “opens you up to the same types of shenanigans that companies can do with one-time charges.” In other words, after a bad quarter, management says, “Let’s clear the balance sheet of the bad stuff so we appear more profitable in future periods.” Steuart adds, “It will encourage companies to do the same when they do their impairment work. I’m sure that will be the hot item in the future.”

For example, assume one of your reporting units is doing well and one is doing poorly. “If you assign as much goodwill as you can to the one that’s doing well and it’s increasing in value, you won’t have an impairment loss in the near-term future,” explains Alfred King, chairman of Valuation Research. Why? The fair value of a reporting unit must fall below its book value for it to be considered impaired.

Of course, since any impairment loss recognized as a result of completing the transitional impairment test will be treated as a change in accounting principles instead of a loss later on, companies may decide to link as much goodwill as supportable against the poorly performing unit and disclose a potential impairment loss in the first fiscal year.

Moreover, certain identifiable intangible assets such as patents will require amortization over their useful life, whereas goodwill only requires the impairment test under the new rules. So, the SEC also wants to prevent companies from undervaluing the identifiable intangibles in the purchase price allocation simply to keep down amortizable items.

CFOs should also be aware that the regulatory body could also examine the reporting unit values derived during the initial benchmark assessment for the impairment test, including the highly subjective identifiable intangibles, most of which have never been valued before.

To mitigate any potential SEC line of questioning, one must consider the following tips:

  • “Whatever methodology is needed, make sure it’s very well documented,” warns Jim Schnurr, senior partner in Deloitte & Touche’s M&A group. “If [management is] using a discounted cash flow, they have to make sure the assumptions are consistent with whatever strategic plans and other materials [they present] to the board of directors. You can’t have one [set of assumptions] for goodwill impairment and another set to run the business.”
  • Pick a conservative valuation methodology and hire reputable independent appraisers to determine the values.