Valuations, goodwill and impairments investigations

November 2019  |  TALKINGPOINT | FINANCE & ACCOUNTING

Financier Worldwide Magazine

November 2019 Issue

FW moderates a discussion between Andrew Fargason, Jasmeet Singh Marwah, Jason Muraco, Jeremy Krasner and Matt Clark at Stout on valuations, goodwill and impairments investigations.

FW: Could you provide an overview of the main trends and developments across the goodwill valuation landscape in recent times? Once written-off as an expense, how is business goodwill defined today?

Fargason: Currently, for public companies, goodwill in a financial reporting setting is just the excess of the amount paid in a business combination over the values booked for all other assets net of liabilities, reduced by any impairments taken since acquisition. For private companies that have elected the private company alternative, goodwill may include the value of certain assets, customer relationships and agreements not to compete, for example, that would be broken out separately otherwise, and is reduced by amortisation as well as any impairments.

Krasner: In other words, goodwill is a simple residual amount – the difference between the purchase price and the fair value of all assets. In my mind, the general landscape of goodwill valuations has not changed materially recently. However, several significant variations have arisen. In other words, the definition of goodwill remains the same, but some of the accounting has been simplified. Prior to 2014, all companies had to record intangibles and goodwill resulting from an acquisition on its financial statements. Intangible assets were amortised over an estimated life of the asset, while goodwill remained at a fixed amount and did not change unless impaired. Companies were required to test for impairment at least on an annual basis using a two-step process. Today, private companies can elect to amortise goodwill and do not have to individually identify all assets in an acquisition. Although public companies still must identify and separate intangible assets and goodwill, the two-step process has been simplified to allow for an initial qualitative assessment of goodwill and then, if warranted, determining the fair value of the company. The fair value is compared to the carrying value and if fair value is lower, then the difference is taken as a goodwill impairment.

Muraco: Since 2001, goodwill recognised in an acquisition is capitalised on the balance sheet under US Generally Accepted Accounting Principles (GAAP). The practice of capitalising goodwill is also consistent with current International Financial Reporting Standards (IFRS).

Clark: For at least as long as I have been a valuation practitioner – over 30 years – goodwill has never been written off as a true expense. It was, at one point, amortised over a period of time that was typically fairly long, ‘not to exceed 40 years’. To minimise the impact on earnings, it was generally expected and accepted that most companies would choose an amortisation period of 40 years. Currently, goodwill is not amortised but, rather, remains on the balance sheet for an indefinite period and is tested at least annually for potential impairment. There is currently discussion of changing the accounting for goodwill for public companies to possibly return to amortisation over a finite period of time. Such treatment is already allowed under private company accounting guidance.

Marwah: Goodwill’s initial measurement and impairment testing has been a hot discussion topic at the Financial Accounting Standards Board (FASB) and among financial reporting experts and various accounting circles for the last two decades.  Most recently, the FASB issued an invitation to comment on 9 July 2019, with comments due by 7 October 2019, soliciting feedback from users, preparers and practitioners regarding identifiable intangible assets acquired in a business combination and subsequent accounting for goodwill related to public business entities.

FW: How would you characterise the complexities involved in calculating goodwill, in comparison with a company’s tangible assets such as machinery and property? Where do the principal risks reside?

Krasner: The valuation of goodwill itself is not complex, as it is a residual value. However, determining the right residual is highly complex and requires the valuation of intangible and tangible assets. The valuation of intangible assets generally involves thinking about the business in a unique perspective. Company management often discusses capital needs and issues involving customers, but they rarely talk about the assets people do not see and touch all the time. The vast majority of today’s assets are likely not on the books because so much of today’s value is generated from internally developed assets that companies are not required to record. Only those from acquired businesses are recorded as assets. So, when a valuation professional is asked to value intangible assets, and hence goodwill, it usually requires a fair bit of discussion and thinking about different parts of the business where there are less financial metrics. As a result, a lot of assumptions often underpin the valuation. Making sure these assumptions are documented and well-founded with quantitative data gives rise to the principal risk. If an underlying assumption is loosely supported but used to value an intangible asset, then goodwill could be materially mis-stated if that assumption is wrong.

Muraco: The key risks of valuing goodwill reside in both accurately determining the appropriate value of the overall business – which is not always identical to the stated purchase price in a transaction – and the value of each of the business’ individual assets and liabilities. Because valuing goodwill ultimately requires expertise in valuing all assets and liabilities as opposed to being a specialist in one asset category, estimating the value of goodwill is more complex than valuing one specific asset group.

Clark: The complexities around goodwill measurement come with the requirement to test goodwill at least annually for potential impairment. Again, goodwill will always be the difference between a company’s overall value and the aggregate value of all of its other assets. But without the benefit of a clearly observed, objective acquisition purchase price that establishes the overall value, one must derive an overall value for the company based, at least in part, on subjective assumptions. In my mind, this subjective, or less than fully objective, starting point is the principal risk.

Marwah: In my opinion, the complexity in assessing value for goodwill lies in the definition of goodwill – goodwill is an asset representing the future economic benefits arising from other assets acquired in a business combination. Goodwill in an acquisition does not arise on its own; it is dependent on a business’ combined productivity from other assets. Further, since goodwill is neither a tangible asset, such as machinery and equipment or real property, nor separately identifiable, like brands or technology, one has to value the total business enterprise value and deduct all other assets to derive the value of goodwill. This is one of the reasons why a goodwill impairment exercise involves valuation of the company’s or the reporting unit’s enterprise value. Since goodwill is typically considered to be the most risky asset of a business, it reflects the primary risk of the business not performing or being expected to earn lower projected cash flows than the levels envisioned at the time of the acquisition. This causes goodwill to lose value at a faster pace in a downturn than any of the tangible assets. As a data point, based on the market data from S&P Capital IQ for US companies with market capitalisation greater than $1m, in the great recession in 2008, the total amount of goodwill impairment in the US was more than $169bn versus an average of $39bn of goodwill impairment from 2009 to 2018.

FW: What are the main methods used to calculate goodwill? In what scenarios should a simple multiple approach, whole company approach or revenue approach be adopted?

Fargason: We suggest avoiding the idea of ‘valuation of goodwill’ altogether. As goodwill is a residual amount that falls out of the valuation of other assets, and either the price or value of a business, goodwill is not directly ‘valued’ in this setting.

Clark: For goodwill impairment testing, we are really looking at the value of the overall business and not a calculation of goodwill specifically. It is best practice to derive valuation indications for the overall business from multiple methods whenever possible. Broadly, one should consider the three traditional approaches to value: the income approach, the market approach and the cost approach. For goodwill impairment testing, we most commonly rely on some combination and weighting of a discounted cash flow analysis, the income approach, a guideline public company analysis, the market approach, and a guideline transaction analysis, the market approach. Practitioners and auditors tend to frown upon a single indication of value as it does not allow for corroboration from other accepted methods.

Marwah: In 2011, the FASB provided a qualitative test option to companies performing goodwill impairment measurement, where a company can avoid performing detailed calculations if it believes and documents that there is more than 50 percent likelihood that the goodwill is not impaired. If a company performs the quantitative goodwill impairment test, it would involve the valuation of the company or reporting unit where goodwill resides. Typically, in a goodwill impairment measurement exercise, if a business’ cash flows could be forecasted with reliable accuracy, the DCF method would result in a more reliable answer. However, in cases of recent acquisition of the concerned business or reporting unit, the implied multiple from that transaction can be used as a reliable basis to determine the business’ value, if overall expected cash flows have not materially changed. The decision to utilise a valuation methodology could also depend on the materiality of impairment passing cushion.

Muraco: When determining the value of the individual assets and liabilities of a business – which is required to value goodwill – the appropriate valuation approach is based on several factors, including the nature of the asset or liability and the availability of market data. Ultimately, all assets and liabilities are valued via an income approach, market approach, cost approach, or some combination thereof.

Krasner: The asset approach is generally not used, unless a holding company or other unique circumstances. Ideally, the income approach and market approach should be used to value the entire company and both should reconcile. Neither one should be vastly different than the other. Facts and circumstances specific to each situation will dictate whether all or some of these approaches are ultimately used.

FW: To what extent are regulators increasing their scrutiny of goodwill impairment? How do auditors and regulators value goodwill as opposed to companies’ estimations?

Clark: Scrutiny by auditors and regulators of goodwill impairment testing continues to increase but not necessarily with respect to the actual value, per se. Remember, the goodwill impairment test is essentially a threshold test – a determination as to whether the fair value exceeds the carrying value. Of course, assumptions used in the valuation must be supported and documented. So there is an emphasis there. But auditors and regulators, especially regulators, typically do not derive their own independent value. Their roles are to review the assumptions and the processes undertaken by the company or third-party valuation firm to arrive at their value. In the past three to four years, significantly more focus and scrutiny has been placed on companies’ processes, documentation and internal controls related to goodwill impairment testing, particularly as it pertains to exercising professional scepticism when evaluating prospective financial information.

Marwah: Goodwill impairment measurement and impairment testing have been at the forefront of the FASB’s agenda in the last few years. Further, the Public Company Accounting Oversight Board (PCAOB) and in turn, auditors, have been heavily scrutinising goodwill impairment procedures. In our experience, auditors would typically involve in-house valuation specialists to review the goodwill impairment test prepared by management and management’s advisers. In many cases, finance and accounting teams are already pressed for time and do not maintain the third-party resources required to support inputs and assumptions to the goodwill impairment testing analysis. While strong from an accounting and finance skill set, many reporting entities do not maintain the specialised skill set pertaining to business valuation. Considering the foregoing, many companies consider involving a valuation specialist in performing goodwill impairment measurements.

Muraco: The increased level of scrutiny from the various regulatory bodies has trickled down into the valuation community whereby valuation specialists are consistently being challenged to more rigorously support key assumptions within a fair value analysis, including assumptions related to prospective financial information. In fact, a new credential was recently designed within the valuation community, the Certified in Entity and Intangible Valuations (CEIV) credential, to enhance consistency and transparency in the fair value measurement process. In situations where a valuation specialist is not relied upon, it has been my experience that audit teams are even more rigorous on challenging key assumptions made by company management.

Krasner: One thing to note is that regulators have increased scrutiny on a lot of areas in general, some of which end up touching goodwill impairment. For example, the scrutiny on a company’s financial forecast, or prospective financial information (PFI), has significantly increased by regulators. This has a ripple effect on just about all valuation-related matters, including goodwill impairments. A more thorough process of pulling together the PFI is necessary, as well as a deeper understanding of the process and inputs by company advisers, such as auditors and valuation experts, is essential. Hopefully, the resulting higher level of checks and balances minimise the risk of differences in goodwill estimations from the company and expectations of the goodwill estimations by auditors and regulators.

Fargason: Auditors and other regulators view goodwill through the same accounting lens as registrant companies. There has been a general tightening of audit scrutiny from many of the large accounting firms in recent years, across a wide range of audit areas including impairment testing for public companies. However, the rules have loosened somewhat for private companies through the establishment of the private company alternatives. One of the ways in which auditors have increased their scrutiny of the fair value work underlying goodwill measurements is to request that companies provide evidence of management having challenged the assumptions used and methodologies applied by their outside valuation consultants.

FW: With goodwill valuation involving high levels of subjectivity, what essential advice would you give to companies on improving their calculation and impairment review processes?

Muraco: The two areas where I often see companies having issues in their internal calculations and reviews relate to market data and PFI. Having market data to support key assumptions and benchmark resulting calculations will not only strengthen the accuracy of results but should also expedite the audit review process. While market support is certainly critical in supporting PFI, being able to clearly reconcile PFI to historical results, prior budgets and original acquisition models is a vital step in the impairment review process. One of the biggest missteps is to rely on an internal forecast that inherently includes assumptions that may not align with actual expectations, for example an aggressive forecast built to support management incentive goals or conservative forecast used to secure financing.

Krasner: Although valuation involves a high level of ‘science’, a significant component relies on ‘art’. Generally speaking, all practitioners utilise a consistent process and approaches to value goodwill. However, application varies widely, and how underlying assumptions are incorporated can result in drastic differences in conclusions. Consequently, having a well-documented process in place is essential for companies. Beyond hiring a valuation expert, companies should have strong internal review processes. They need to understand the basics of the analysis, and be able to talk to major assumptions and conclusions intelligently. Companies should not simply take a valuation report from their provider and hand it over to auditors and regulators. An in-depth internal review should be undertaken and documented. Having a strong set of internal controls surrounding any external expert’s work can make a big difference when being reviewed. Ultimately, analysis is the company’s ownership, not external advisers.

Fargason: It is becoming increasingly important that management and outside valuation consultants track discussions regarding the development of key assumptions and methodologies used in fair value work. It is much easier to track these discussions as the work progresses than to recall them later when asked during an audit.

Marwah: Generally speaking, if a reporting entity performs an analysis internally, it raises the professional scepticism that the external auditor and their valuation review team bring to the process. In many cases, the time and expense related to this ‘extra’ review time can exceed the cost of outsourcing, and this is before considering the ‘opportunity costs’ associated with the reporting entities’ internal staff time. If management conducts the impairment testing internally, we would recommend utilising the DCF method as one of the primary valuation methods. Further, management needs to prepare long-term forecasts and a rate of return that corresponds to the underlying risk in those forecasts. Finally, management should consider gathering pricing multiples and other financial metrics for the comparable companies, in order to perform the GPC method.

Clark: There are a handful of best practices that tend to consistently dictate how smoothly the goodwill impairment testing exercise goes. And more times than not, it is more about the process than it is the actual valuation assumptions. Communication, planning, consistency of approach and proper documentation go a long way. Companies are well-served when they start early and have an open dialogue between and among themselves, their auditors and their outside valuation specialists. The annual testing date is known. Far too many companies wait until the last minute to begin their annual testing, which puts unnecessary time pressure on the valuation specialist and the auditor. It allows less time for auditor review and thorough documentation, which often leads to more scrutiny and problems during the regulatory review process.

FW: How do you expect the goodwill valuations landscape to develop in the years ahead? At the same time, how do you foresee the evolution of reporting and measurement rules and regulations pertaining to goodwill?

Krasner: A few years ago, I would have likely envisioned little to no change in the goodwill landscape. However, over the past few years some relatively big alternatives have been implemented that definitely make me wonder about the next several years. There is a comment letter out asking whether goodwill accounting should be effectively eliminated. Investors can garner value from current disclosure requirements on goodwill. They provide insights into a company’s acquisition acumen. An investor gains insights into a company’s past ability to achieve success which can be used to assess future success. For example, a company that has several impairments may imply it overpaid for past acquisitions, or was not able to achieve the strategic goals for the acquisition in the first place. Maybe it was too aggressive in its price which resulted in higher goodwill levels. Even though goodwill, and intangibles, are non-cash impacts on financial statements, they do provide insights into management’s acumen. So, although there is likely going to be some changes in the coming few years, my hope is not wholesale changes.

Marwah: Though we do not expect valuation methodologies to change in the years ahead, the annual impairment testing requirements for publicly-listed companies may change. Specifically, similar to private companies, some users have argued that goodwill should be amortised, rather than tested annually for impairment. We hope that the FASB considers the viewpoints of all users of financial statements in its decision regarding the initial calculation of goodwill and impairment measurements. For instance, by amortising goodwill as per US GAAP, financial statements for US companies can become inconsistent compared to the financial statements of foreign companies. Lastly, if the annual impairment testing requirement is eliminated for the publicly-listed companies, one can expect relatively larger total goodwill impairment in the next near-term recession, compared to the significant total goodwill impairments observed in 2008.

Fargason: It seems unlikely that fair value accounting will go away, given the broad move into this area over the past few decades. However, a general movement toward inclusion in goodwill of some intangible assets currently being booked separately may mean somewhat larger goodwill balances.

Clark: It is always difficult to predict the regulatory environment as it is not always based on best business practices. There is a lot of discussion on this topic right now and the outcome could dramatically change how goodwill is measured, recorded and tested. Some potential changes being discussed strike me as very inconsistent with the messaging we have been hearing over the past decade or more with respect to the increased need for greater financial statement transparency. Current discussions and debate by the FASB to potentially do away with the segregation of intangible assets from goodwill will not lead to more transparency in financial reporting. It will lead to less. And it will also result in inconsistencies with IFRS reporting standards, which underwent a process not all that long ago to ensure more consistency with US GAAP.

Muraco: Several of the questions raised within the FASB’s invitation to comment relate to the current measurement and reporting of goodwill, and whether certain changes should be made to simplify or even eliminate many of the current procedures in place, which could lead to divergence between US GAAP and IFRS. While changes are not necessarily imminent, the existence of the invitation to comment is an early indication that regulations pertaining to goodwill could shift in the foreseeable future. It will be interesting to see if this perspective changes at all during the next economic down cycle when goodwill impairments become more prevalent again.

Andrew Fargason is a managing director in the valuation advisory group. He has extensive experience domestically and internationally in valuation and mergers & acquisitions. His asset and business valuation experience encompasses a broad range of industries. He has valued equity, debt and derivative securities, as well as a variety of intangible assets, for numerous purposes including purchase and sale advisement, financial and tax reporting, fairness and solvency opinions and other corporate, tax and litigation-related matters. He can be contacted on +1 (404) 369 1117 or by email: afargason@stout.com.

Jasmeet S. Marwah is a director in the valuation advisory group. He has more than 10 years of experience providing valuation analysis for clients globally for financial reporting, mergers & acquisitions, litigation and tax restructuring purposes under US generally accepted accounting principles (GAAP), IFRS and Indian GAAP. His experience includes corporate finance advisory, business and equity valuations, valuation of intangible assets, portfolio valuations and business plan reviews. He can be contacted on +1 (248) 432 1263 or by email: jmarwah@stout.com.

Jason Muraco is a managing director in the valuation advisory group at Stout. He has nearly 20 years of experience providing a broad range of business valuation and financial advisory services for public and large private enterprises. He specialises in the valuation of debt and equity instruments, intangible asset valuations and enterprise and legal entity valuations for financial and tax reporting purposes, as well as corporate strategic planning matters. He can be contacted on +1 (216) 373 2989 or by email: jmuraco@stout.com.

Jeremy Krasner is a managing director in the valuation advisory group at Stout. He has over 20 years of finance-related experience providing business valuation and advisory services for Fortune 500 companies, middle market corporations, early-stage, growth companies and private equity controlled entities. Experienced in a wide array of industries, his responsibilities include engagement management in the areas of intangible and business valuations for numerous purposes. He can be contacted on +1 (703) 848 4959 or by email: jkrasner@stout.com.

Matt Clark is a managing director in the valuation advisory group at Stout. With over 30 years of financial advisory and valuation experience, he performs financial consulting assignments related to M&A, corporate decision analysis, valuations of businesses and securities for a variety of purposes, and dispute resolution. His clients have included some of the largest global telecom carriers, infrastructure providers and equipment manufacturers, as well as technology and software companies. He can be contacted on +1 (214) 389 3487 or by email: mclark@stout.com.

© Financier Worldwide

THE PANELLISTS

Andrew Fargason

Jasmeet Singh Marwah

Jason Muraco

Jeremy Krasner

Matt Clark

Stout