This article was written by Michael L. Binz ASA, ABV & Jake O’Donnell, Senior Consultant, Advisory.
The increasing degree of economic uncertainty and increasing geopolitical risks in today’s business environment have significant financial reporting implications for private companies and not-for-profits with contemplated, pending, or completed business combinations.
The impact of rising inflation, higher interest rates, and continued supply chain challenges have elevated operating and execution risk for many private companies. Companies impacted by the COVID-19 pandemic are now faced with navigating the aftermath. Cash provided through government stimulus programs has been spent while access to additional liquidity is much more expensive.
Inflationary pressure continues to plague many companies even after passing higher input and production costs through to consumers. Profit margins are under pressure as consumer demand shows signs of weakening suggesting the Fed’s hawkish monetary policy is working to slow the economy.
Companies seeking access to debt financing face higher borrowing costs and added scrutiny by lenders as lending standards and tightening and expanded covenant provisions are more frequent to reflect a higher risk environment. Not only has the cost of debt increased, but required returns on equity have increased as equity investors now require higher returns as compensation for higher perceived risk.
These conditions have significant implications for private companies and non-for-profits that elect alternative accounting treatment for business combinations under U.S. GAAP. When the Private Company Council within the (FASB) initiated the alternative accounting election for private companies and not-for-profit entities, its objective was to simplify accounting and financial reporting for business combinations and reduce administrative costs and burden. Under the alternative accounting treatment, private companies can make an election to amortize goodwill and certain customer-related intangible assets and non-compete agreements on a straight-line basis over 10 years.
During 2014, the Financial Accounting Standards Board (FASB) provided additional guidance through Accounting Standards Update 2014-02, Intangibles – Goodwill and Other (Topic 350). Included with this guidance was the announcement of the Accounting Alternative election for Private companies and not-for-profit entities. This alternative accounting election permits the amortization of goodwill, relating to each business combination or reorganization resulting in fresh start reporting, over a straight-line basis over 10 years, or less than 10 years if the entity demonstrates that another useful life is more appropriate.
Goodwill at the entity level or the reporting unit level must be tested for impairment if an “event occurs or circumstances change” that indicates that the fair value of an entity or a reporting unit may be below its carrying amount. Events which “occur” or the “changes in circumstances” are broadly referred to as “triggering events.”
Private companies and not-for-profit entities should actively monitor events and circumstances which may trigger an impairment.
Guidance provided by the Financial Accounting Standards Board indicated the following factors can individually and collectively, have a significant impact on the fair value of an entity, reporting unit, goodwill, or intangible asset:
- Deterioration in general economic conditions
- Deterioration in industry or market conditions
- Increased costs that have a negative impact on earnings and cash flow
- Deterioration of financial performance
- Changes in key personnel or customers
- Litigation
- Bankruptcy
- Disposing of all or a portion of an entity (or reporting unit)
- A sustained decrease in share price (in absolute terms or in comparison to peers)
When a triggering event occurs, entities have the option to first assess “qualitative” factors to determine if the quantitative test is necessary. The quantitative test is required only if it is concluded that the fair value of the entity or one of its reporting units is more likely than not less than its carrying amount.
Qualitative assessment typically involve:
- Macroeconomic conditions such as a negative change in general economic conditions, limitations on accessing capital, fluctuations in foreign exchange rates, or other developments in equity and credit markets
- Industry and market considerations such as a deterioration in the environment in which an entity operates, an increased competitive environment, a decline in market-dependent multiples or metrics (consider in both absolute terms and relative to peers), a change in the market for an entity’s products or services, or a regulatory or political development
- Cost factors such as increases in raw materials, labor, or other costs that have a negative effect on earnings and cash flows
- Overall financial performance such as negative or declining cash flows or a decline in actual or planned revenue or earnings compared with actual and projected results of relevant prior periods
- Other relevant entity-specific events such as changes in management, key personnel, strategy, or customers; contemplation of bankruptcy; or litigation
- Events affecting a reporting unit such as a change in the composition or carrying amount of its net assets, a more-likely-than-not expectation of selling or disposing of all, or a portion, of a reporting unit, the testing for recoverability of a significant asset group within a reporting unit, or recognition of a goodwill impairment loss in the financial statements of a subsidiary that is a component of a reporting unit
These examples are not intended to be all-inclusive however, the examples serve as practical guidance to help companies navigate events or developments that may suggest the need for additional analysis and potential impairment testing. In addition, when assessing whether it is more likely than not that the fair value of the entity or reporting unit is less than its carrying amount, the totality of all of the relevant qualitative factors should be considered based on their importance or relative impact on the fair value or carrying value of the entity or reporting unit.
The AICPA Accounting and Valuation Guide – Testing Goodwill for Impairment (“AICPA Goodwill Guide”) provides more examples of events that may require consideration such as (1) market reaction to a new product or service, (2) technological obsolescence, (3) a significant legal development, (4) contemplation of a bankruptcy proceeding, or (5) an expectation of a change in the risk factors or risk environment influencing the assumptions used to analyze the fair value of a reporting unit, such as discount rates or market multiples.
In cases where an entity or reporting unit has a zero or negative carrying value, goodwill will not be impaired, even when conditions underlying the reporting unit indicate that goodwill is impaired. Entities will however be required to disclose any reporting units with zero or negative carrying amounts and the respective amounts of goodwill allocated to those reporting units.
This article addressed several factors for consideration regarding potential impairment triggering events for privately held companies and not-for-profit entities. Our professionals help clients understand the value of their businesses, potential acquisition targets and routinely provide valuation and financial reporting assistance for our clients across a wide array of industries.
If you need further guidance or have any questions on this topic, we are here to help. Please do not hesitate to reach out to discuss your specific situation.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.