The issue related to the year-end goodwill impairment test for a subsidiary that was acquired in a prior year. Specifically the issue was whether the exercise of allocating the fair value of the reporting unit to its assets and liabilities to determine the implied goodwill should include the allocation of value to intangible assets that were not recorded when the subsidiary was acquired.
For several years the reporting unit and the company have been essentially one in the same, and step 1 of the goodwill impairment test (where the fair value of the reporting unit is compared to its carrying amount) had been performed by comparing its common stock market capitalization to its net stockholders’ equity. Step 1 of the goodwill impairment test had never been flunked, but this year the common stock market capitalization of the company was less than its net stockholders’ equity, so it was necessary to proceed to step 2.
Step 2 of the goodwill impairment test compares the recorded amount of goodwill at the test date to the implied fair value of the goodwill at that date. The implied fair value of the goodwill of the reporting unit is determined by assuming that on the test date the reporting unit had been acquired in a business acquisition for its fair value and the purchase cost of fair value was now being allocated to its assets and liabilities in accordance with ASC 805 (SFAS No. 141). See ASC 350-20-35-14 to 17 (SFAS No. 142, paragraphs 20 and 21).
A valuation specialist suggested that a portion of the fair value of the reporting unit should be assigned to certain identifiable intangible assets (e.g., computer software and customer relationships). However, the company believed that no value should be assigned to those assets because no value was recorded for them when the subsidiary was acquired either because the identifiable intangibles did not then exist, or were immaterial at that time. If value was not assigned to those assets in step 2 of the test, the implied fair value of goodwill would be higher. The company pointed to ASC 350-20-35-17 to support its position.
ASC 350-20-35-14 to 17 states that:
(14) – The implied fair value of goodwill shall be determined in the same manner as the amount of goodwill recognized in a business combination was determined. That is, an entity shall assign the fair value of a reporting unit to all of the assets and liabilities of that unit (including any unrecognized intangible assets) as if the reporting unit had been acquired in a business combination and the fair value of the reporting unit was the price paid to acquire the reporting unit.
(15) – The relevant guidance in Subtopic 805-20 shall be used in determining how to assign the fair value of a reporting unit to the assets and liabilities of that unit. Included in that allocation would be research and development assets that meet the criteria in paragraph 350-20-35-39.
(16) – 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.
(17) – That assignment process discussed in paragraphs 350-20-35-14 through 35-16 shall be performed only for purposes of testing goodwill for impairment; an entity shall not write up or write down a recognized asset or liability, nor shall it recognize a previously unrecognized intangible asset as a result of that allocation process.
Thus, value should be assigned to those identifiable intangibles that existed at the test date whether or not value had been assigned to them when the acquisition was initially recorded. We explained that that the essence of step 2 of the goodwill impairment test is to determine what the goodwill would be if the reporting unit had been acquired as of the test date, the purchase price was the fair value of the reporting unit, and that purchase price was allocated to the assets and liabilities of the reporting unit as they existed at the test date in the manner required by ASC 805 (see the second sentence in 14 above).
ASC 305-20-35-17 was not meant to preclude assigning value to assets that were not recognized in the historical balance sheet. Rather that sentence was to remind the reader that the exercise being carried out was solely for the purpose of determining implied goodwill, and no adjustments to the recorded amounts for the reporting unit’s identifiable tangible and intangible assets and liabilities should be made as the result of the calculation
We also pointed to the following in the Wolters Kluwer CCH Accounting Research Manager (emphasis added):
“In the second step (Step 2) of the goodwill impairment test, the fair value of a reporting unit is considered to be its purchase price. That purchase price is assigned to all of the reporting unit’s assets and liabilities as if the reporting unit had been acquired in a business combination. This raises the question of whether in Step 2 of the goodwill impairment test, the purchase price must be allocated to a reporting unit’s identifiable intangible assets that were not recognized apart from goodwill in prior acquisitions.
Paragraph 21 of Statement 142 specifies that “any unrecognized intangible assets” must also have purchase price allocated to them in Step 2 of the goodwill impairment test. In other words, purchase price must be allocated to all intangible assets of a reporting unit, including identifiable intangible assets that were not recognized apart from goodwill in prior acquisitions.”