FASB Proposals Provide Exceptions for Private Companies for Fair Value Measurements

A help or hinderance?

On July 1, 2013, FASB issued exposure drafts calling for public commentary on three proposals that address private company stakeholder concerns. Two proposals involve accounting for identifiable intangible assets and goodwill acquired in business combinations. In this article, Mark Zyla analyzes the proposed changes, including potential concerns, and their far-reaching impact on the industry, as well as private and (in 2014) public companies.

FASB

A concern in the financial reporting of private companies making acquisitions is the cost benefit of measuring the fair value of intangible assets acquired as part of a business combination.  A related concern of the management of private companies is the usefulness of reporting goodwill on the balance sheet and the testing of that goodwill for impairment in subsequent periods.  Management of private companies question whether or not these accounting requirements provide a benefit, particularly when considering the cost associated with the fair value measurement of these assets.

In order to address the concerns, the Financial Accounting Standards Board (“FASB”) this past July issued exposure drafts for accounting standards updates (“ASUs”) based upon recommendations by the Private Company Council (“PCC”) addressing the accounting for intangible assets acquired by private companies in business combinations.  Last year, FASB formed the PCC as an advisory group to assist the board in improving the process of standards setting for private companies.  The PCC proposed changes to both ASC 805, Business Combinations, and ASC 350, Intangibles – Goodwill and Other, solely for private companies.

Under existing accounting standards, intangible assets acquired as part of a business combination must be recorded at their fair value if they are considered “identifiable.”  An intangible asset is recognized as “identifiable” in a business combination if it meets one of two criteria: 1) it is separable, that is, capable of being separated or divided from the entity and sold, transferred, licensed , rented, or exchanged either individually or together with a related contract, identifiable asset, or liability, regardless of whether the entity intends to do so;  or 2)  it arises from contractual or other legal rights , regardless of whether those rights are transferable or separable from the entity or from other rights and obligations.¹

The PCC proposed changes to ASC 805 where a private company could elect to recognize (but would not be required to do so) only those intangible assets acquired in a business combination that arise from contractual rights with non-cancelable terms or that arise from other legal rights.  If such an election is made, the private company would no longer recognize intangible assets that arise solely from the “transferable” or “separable” criteria.    A private company doesn’t have to make the election, and can continue to prepare financial statements under existing rules.

Comment letters received by the FASB during the exposure period highlighted some concerns about this particular proposal if implemented.  Some examples include:

• The proposals would create two fundamentally different financial frameworks in accounting for business combinations.
• Measurement criteria in the proposal is not consistent with the definition of fair value.  For example, market participants often consider potential renewal terms in contracts.
• If a valuation specialist were to use the Multi-Period Excess Earnings Method to measure the fair value of the primary asset acquired as part of the business combination, the method would require the fair value measurement of all identifiable contributory assets, even if not recognized under the proposal.
• The proposals would perhaps lead to inconsistent measurement of in-process research and development if part of the technology is contractual.
• Measuring the fair value customer relationships in total may be less time consuming and less costly than separating out contractual customer relationships with varying terms.
• The proposal may make eventual convergence with IFRS more difficult.

As such, the FASB has concluded that the proposal, as initially suggested, would not necessarily make accounting for business combinations less costly for private companies.  They have asked the FASB staff to revise the proposals giving consideration to comments received from constituents.  Proposals for ASC 805 are still under consideration by the FASB.

However, on November 25, 2013, the FASB did endorse  the PCC proposal to provide alternative accounting for goodwill by private companies.    Goodwill typically arises from business combinations  as the residual amount remaining after the fair values of all identified assets acquired less liabilities assumed have been subtracted from the acquisition price.

Under the new PCC alternative, private companies can make an election to amortize goodwill over 10 years or for a period less than 10 years, if the entity can demonstrate that a shorter period is more appropriate.  If amortization is elected, goodwill would be tested for impairment only when a triggering event occurs.   Private companies are not required to amortize goodwill.  They can also elect to continue testing goodwill for impairment annually.

Under existing accounting standards, goodwill is tested for impairment annually or whenever certain triggering events occur. Goodwill is tested for impairment under a two-step test at a reporting unit level. 

The first step of the impairment test, the fair value of the reporting unit, is compared to the reporting unit’s carrying amount, or book value. If the fair value of the reporting unit is greater than its carrying amount, the goodwill is not considered to be impaired. If the fair value is less than its carrying amount, then goodwill may be impaired, and a second step is performed to determine the amount of the goodwill impairment.

In the second step of the goodwill impairment test, the fair value of the reporting unit is allocated to the reporting unit’s assets and liabilities in a manner similar to FASB ASC 805’s acquisition method.  The reporting unit’s implied goodwill is the difference between the fair value of the entire reporting unit and the sum of the fair values of all of its tangible assets, intangible assets, and liabilities existing on the measurement date whether or not they were previously recognized in the financial statements.  The fair value of implied goodwill is compared to the carrying value of goodwill. The amount of the goodwill impairment is equal to the excess carrying value of goodwill over its implied fair value.

Under certain circumstances, an entity may bypass the first step of the impairment test altogether by performing a qualitative assessment of the entity’s financial performance.  However, if there is any indication of impairment, the second of the two-step test would be required.

The  recent FASB-endorsed PCC changes to the goodwill accounting standards allow a private company to test for impairment only when a triggering event occurs (since the entity would be already amortizing the goodwill).  The  impairment test would be only a one- step test.  The test can be performed either at the entity level, or the reporting unit level.  The private company would measure the fair value of the entire entity (or reporting unit) and compare the entity’s fair value (or reporting unit) to its respective carrying value.  If fair value is less than its carrying value, the difference would be the amount of impairment.

 Private companies  making acquisitions  that do not  plan to go public in the near future may benefit from these changes.  However, there are  a number of issues that a private company should consider before electing the PCC alternative accounting treatment.  If an entity makes the election and subsequently undergoes an initial public offering (IPO), the entity may have to restate their financials.  The cost of restatements would greatly outweigh any benefit of electing the alternative accounting.  Similarly, an acquisition by a public company or by a private equity firm may also potentially require restatement. 

Constituents should note that after endorsing the proposal to allow  private companies the alternative accounting for goodwill, the FASB added an agenda item for next year to consider the same alternative for public companies So, in addition reconsidering the proposed alternative accounting for private companies in the initial recognition of intangible assets, the FASB is considering extending the election for amortizing goodwill and  simplifying the impairment test for public companies.

The final version of the ASU  of  the recently endorsed proposal  for alternative election by private companies for accounting related to goodwill will be effective for fiscal years beginning after December 15, 2014;  however, early adoption is permitted.  The revised proposal for alternative election by private companies for measuring the fair value of intangible assets should be completed in the first quarter of 2014.

¹ Financial Accounting Standards Board. “Identifiable,”  Master Glossary, http//:www.fasb.org.

Mark L. Zyla, CPA/ABV, CFA, ASA, is managing director of Acuitas, Inc., an Atlanta, Georgia-based valuation and litigation consultancy.  He is author of Fair Value Measurements: Practical Guidance and Implementation,  2^nd ed., published by John Wiley & Sons in 2013. Mark can be reached at mzyla@acuitasinc.com.