In July 2001, the Financial Accounting Standards Board (FASB) issued statements 141, Business Combinations, and 142, Goodwill and Other Intangible Assets. The statements raise significant accounting and valuation issues for companies that have been, or plan to be, involved in mergers and acquisitions.

Pooling Eliminated
The new standards provide for a single method of accounting — the purchase method — for transactions initiated after June 30, 2001. Previously, some business combinations were eligible for the pooling-of-interests method, under which the combining companies’ assets, liabilities, and equities were combined at their historic book values. Many companies preferred this method, when available, because no goodwill was required to be recorded and amortized, resulting in higher net income.

Under the purchase method, the buyer would record the seller’s book value on its balance sheet and any premium paid beyond book value would be recorded as an intangible asset, such as goodwill. Since goodwill was amortized over its economic life, this approach had the effect of diluting the new entity’s earnings.

The FASB’s rationale for eliminating pooling was that "similar business combinations were accounted for using different methods that produced dramatically different financial statement results."

Goodwill No Longer Amortized
At the same time, the FASB recognized that goodwill and other intangibles aren’t necessarily wasting assets, and therefore the new standards provide that goodwill is not to be amortized. Instead, it’s tested annually for impairment and written down only if its carrying amount exceeds its fair value.

Amortization of goodwill will cease upon adoption of Statement 142 (January 1, 2002, for calendar-year companies). The change applies to new transactions, as well as to unamortized goodwill from previous transactions.

Other Intangible Assets
Acquired intangibles are to be recognized as assets separate from goodwill if they arise from contractual or other legal rights, or if they satisfy separability requirements outlined in the new standards. Examples of items that generally will be treated as recognized intangible assets include:

• Trademarks and tradenames
  
  
• Copyrights
  
  
• Technology, both patented and unpatented
  
  
• Trade secrets
  
  
• Customer lists and relationships
  
  
• Software
  
  
• Licenses and permits
  
  
• Leases and mortgage servicing rights
  
  
• Noncompete agreements
  
  
• Creative intangibles, such as books, musical compositions, and photographs
  

Recognized intangibles with finite lives will be amortized over their useful lives. (Note: The 40-year cap on amortization of intangibles has been eliminated.) Recognized intangibles with indefinite lives will be tested annually for impairment.

Testing Goodwill for Impairment
The new standards require affected companies to perform a transitional impairment test within six months of adoption. The measurement date is the date of adoption, not the date the test is performed. Any impairment loss resulting from the transitional test should be recognized and treated as a change in accounting.

Goodwill should then be tested for impairment at least annually — more often if circumstances indicate possible impairment. Such circumstances may include legal developments, regulatory actions, increased competition, loss of key staff, etc. Testing can be done at any time during a company’s fiscal year, provided the timing is consistent from year to year. Different dates can be used for different reporting units.

Impairment testing consists of two steps:

• Step 1: Identify potential impairment by comparing the fair value of each reporting unit to its book value. A "reporting unit" is defined as an operating segment or, in some cases, an individual business within an operating segment. If book value is less than fair value, no impairment exists, and the second step isn’t necessary.
  
  
• Step 2: If impairment is indicated by Step 1, compare the implied fair value of goodwill to its carrying amount. The implied fair value of goodwill is computed by subtracting the fair value (with certain exceptions) of the reporting unit’s recognized net assets from the reporting unit’s fair value. An impairment loss must be recognized if the carrying amount of goodwill exceeds its implied fair value.
  

It isn’t necessary to recompute a reporting unit’s fair value each year, if the following requirements are satisfied:

• The reporting unit’s assets and liabilities haven’t changed significantly since its fair value was last computed.
  
  
• The reporting unit’s fair value, when last computed, exceeded its carrying amount by a substantial margin.
  
  
• There’s no evidence that the reporting  unit’s current fair value has fallen below its carrying amount.
  

Importance of Valuation
Companies required to comply with the new accounting standards would be well-advised to work with a qualified independent valuation professional in conducting the transitional impairment test and in planning new business combinations. The impact of the new standards will depend on the selection of reporting units and the allocation of goodwill and other assets among them, and companies have some flexibility in how this is done (provided the methodology is reasonable and supportable). A third-party appraiser can be invaluable in this process.

A valuation professional can also determine and support the fair value of reporting units and their assets, both tangible and intangible. The FASB defines fair value as the amount at which an asset (or liability) could be bought or sold in a current transaction between willing parties (i.e., other than in a forced or liquidation sale). Although a number of different valuation techniques may be used, the FASB warns that "Estimates of fair value shall be based on reasonable and supportable assumptions and projections" and that "The weight given to the evidence shall be commensurate with the extent to which the evidence can be verified objectively."