The Effect of the New Goodwill Accounting Rules on Financial Statements

By Ronald J. Huefner and James A. Largay III

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Prior practice followed APB Opinion 17, issued in 1970, which called for any goodwill recorded following an acquisition to be amortized over a period not to exceed 40 years. Subsequent observation suggested that many companies adopted the 40-year maximum as the useful life in computing amortization to minimize the periodic earnings effect. Even so, and despite that goodwill amortization is a noncash expense that generally provides no tax benefit, in recent years many companies have felt the need to neutralize these effects by reporting supplementary “pro forma” or “cash earnings.” This misnomer signals a grossly oversimplified “cash earnings” that adds back amortization and depreciation to net income.

Because ending amortization while keeping other factors constant will increase earnings and decrease price-to-earnings (P/E) ratios, there was controversy over the potential effect the new rules would have on stock prices. One money manager stated, “Low P/E ratios could make stocks look cheaper, even if there hasn’t been any change in the company’s profit potential” (The Wall Street Journal, August 21, 2001). Another observer wrote, “And even if an investor doesn’t believe the accounting change should boost stock prices, the thinking goes, he or she should act on the belief that others will” (The Wall Street Journal, January 21, 2001).

The New Accounting Treatment of Goodwill

SFAS 142 made two major changes to goodwill accounting:

• Amortization of all goodwill ceased, regardless of when it originated. Goodwill is now carried as an asset without reduction for periodic amortization.
• Companies are to assess goodwill for impairment at least annually. If goodwill is impaired, its carrying amount is reduced and an impairment loss is recognized.

Companies were required to implement these new standards in fiscal years beginning after December 15, 2001, with early adoption permitted for fiscal years beginning after March 31, 2001. During the first six months following adoption of SFAS 142, companies assessed existing goodwill balances for impairment and reported any such transitional impairment losses as due to a change in accounting principle. Material impairments of goodwill identified after adoption of SFAS 142 are reported as line items above “income from continuing operations.” FASB gave companies a reporting benefit during the transition period by allowing them to report real declines in economic value as the effects of changes in accounting principles.

Some companies used the accounting policy note in their SEC filings to help users understand the implications of the change produced by SFAS 142’s new rules, or to attempt some “spin,” as seen in these examples:

• Note 3 in General Electric’s first-quarter 2002 10-Q filed with the SEC indicates that previously reported segment profit information—which had been charged for goodwill amortization—was restated to exclude that amortization to be consistent with segment information going forward. In those restated periods GE now treats goodwill amortization as a corporate cost instead of a segment cost. This informs users that they need not revise prior period segment profit numbers by adding back previously deducted goodwill amortization, as GE has already done so.
• Note 2 in Kraft’s second-quarter 10-Q informs users that “During the second quarter of 2002, the Company’s reported effective tax rate decreased by 9.2 percentage points… compared with the second quarter of 2001 …. due primarily to …. the Company [being] no longer required to amortize goodwill and indefinite life intangible assets as a charge to earnings.” Kraft’s comment quickly explains the implications of SFAS 142 for a potentially puzzling improvement in this measure of the company’s tax burden.
• Note 3 in AOL Time Warner’s first-quarter 10-Q assures readers that its $54 billion write-off is “nonoperational in nature,” even though it is clearly disclosed as resulting from a change in accounting principle, perhaps to downplay its impact.

As discussed more thoroughly below, although SFAS 121 provided impairment standards for long-lived assets, these standards did not result in the recording of many goodwill write-offs. SFAS 142 provides a new methodology based on the value of the business related to the goodwill, giving improved guidance to the impairment testing process. An illustration of this process below does not address the complications faced when estimating the required fair values.

Goodwill Impairment–Testing Process

To test goodwill for impairment, companies must first assign the recorded goodwill to “reporting units.” These could be the company’s operating segments identified under SFAS 131, or a “component” of a reportable operating segment as defined in paragraph 30 of SFAS 142. In general, companies assign goodwill to each unit by comparing the estimated fair value of the reporting unit as a whole with the fair values of the unit’s identifiable net assets. This process is similar to the process for allocating purchase price differentials among assets acquired, liabilities assumed, and goodwill, in accounting for an acquisition. The sum of these tentative assignments of goodwill to reporting units could exceed the total goodwill recorded by the total entity. When this occurs, the tentative unit assignments are reduced in some reasonable fashion to make the sum equal to the total recorded goodwill. After the goodwill is assigned, at the next impairment testing point the company applies the following two-step process to each reporting unit:

• Step 1: The company estimates the fair value of the reporting unit (UFV) and compares it with the unit’s book value (UBV), which equals the recorded amounts of assets and allocated goodwill less liabilities. When UFV is greater than UBV, there is no impairment, and the test is complete. When UFV is less than UBV, however, goodwill may be impaired, and the company goes to Step 2.
• Step 2: The company estimates the implied fair value (GFV) of the reporting unit’s goodwill by repeating the process performed at acquisition. This requires subtracting estimated current fair values of the unit’s identifiable net assets (INA) from the unit’s estimated fair value (UFV), and comparing the difference with the carrying amount of the goodwill (GBV). When GFV is greater than GBV, goodwill is not impaired and there is no write-off. When GFV is less than GBV, however, the company must record an impairment write-off equal to the difference.

Recognizing Impairment at Transition

Before SFAS 142, companies generally recorded goodwill in total and did not assign it to individual reporting units; that is, they had not completed Step 1. When companies transitioned to the new rules, they assigned their pre–SFAS 142 goodwill to reporting units using the approach described in Step 2. Impairment losses arose when the total pre–SFAS 142 goodwill exceeded the sum of the goodwill amounts assigned to the reporting units.

To illustrate the impairment test when transitioning to SFAS 142, consider the following hypothetical information:

Impairment losses are not reversible. After the transition period, companies go through the two-step impairment test at least annually, treating reporting units’ impairment losses as charges to “income from continuing operations.” After the transition period, the periodic impairment test is not done on an aggregate or portfolio basis; that is, increases in implied goodwill in some reporting units cannot offset impairments in other units.

In the first six months following adoption, companies were to perform the transition review for impairment of goodwill. Paragraph 22 of SFAS 142 states that even if Step 2 is not complete when the first-quarter financial statements are issued, companies must recognize a probable impairment loss immediately and adjust the loss in the next quarter, when Step 2 is complete. Thus, most companies reported the transition impairment write-off in the first quarter of 2002. Some, following the guidance above, reported a preliminary impairment in the first quarter and a further impairment in the second quarter. Other companies, however, did not report any impairment until the second quarter.

Note disclosures. SFAS 142 does not require companies to disclose the methodology used when applying the impairment test. Thus, discussions about methodology found in financial statement notes appearing in the Form 10-Q quarterly reports vary in informativeness, as seen in the following examples:

• Viacom’s first-quarter 10-Q stated that “The first step of the test examines whether or not the book values of the Company’s reporting units exceed their fair values.” Without referencing the second step, Viacom then announced a $1.48 billion write-off of Blockbuster’s goodwill.
• After Tyco’s first-quarter 10-Q mentioned an estimated $4.5 billion impairment charge due to “the decline in the estimated fair value of CIT” (Step 1), it acknowledged Step 2 and stated “The Company will complete this second step analysis in the quarter ending June 30, 2002 to determine if any adjustment to the estimated goodwill impairment charge previously recorded is needed.”
• Raytheon’s second-quarter 10-Q stated that the $360 million first-quarter impairment charge related to AIS “was determined based upon the proceeds received by the Company in connection with the sale of AIS.” In this situation, Raytheon used the transition provisions of SFAS 142 to convert a subsequently realized loss into an accounting principle change. Raytheon’s second-quarter transitional impairment review “utilized a market multiple approach to determine the fair value of reporting units within the defense businesses and a discounted cash flow approach to determine the fair value of the commercial business reporting units.”

Goodwill Database

The authors examined the 100 U.S. public companies reporting the largest dollar amounts of goodwill on their balance sheets as of the end of 2001 (obtained from www.edgar-online.com), before the transition to SFAS 142. The list contains many large companies, such as General Electric, General Motors, and Wal-Mart, and some notorious companies, like WorldCom and Tyco.

Given the potential significance of the change in the accounting treatment of a major asset, the authors expected to observe numerous large impairment write-offs due to implementing the new standard, and large increases in net income due to eliminating goodwill amortization as an expense.

As stated, SFAS 142 was effective for fiscal years beginning after December 15, 2001, with early application permitted. The extent of the above financial statement effects in the first two reporting quarters in 2002 were examined by reviewing the 10-Q reports.

Even though companies accounted for many business combinations over the past 10 years or so using the now discontinued pooling-of-interests method—which records no goodwill at all—there were enough purchase-method combinations to produce large goodwill balances on many balance sheets. In many acquisitions, goodwill amounted to 75% or more of the total price paid. For the 100 companies studied, pre-impairment recorded goodwill ranged from AOL Time Warner’s $127.4 billion to Weyerhaeuser’s $1.1 billion. Total goodwill recorded by the 100 companies amounted to $931.5 billion, nearly 11% of those companies’ total assets.

Impact of the New Standard: Impairment

In the first quarterly reporting period following their adoption of SFAS 142, companies assessed existing goodwill balances for impairment. Some salient results were as follows:

• Collectively, the 100 companies reported $135 billion of goodwill as impaired and written off upon adopting SFAS 142 in 2002. This is about 14.5% of the total goodwill carried, an average of $1.35 billion per company.
• For the 33 companies that recorded the $135 billion of impairment write-offs during the first six months of 2002, these write-offs amounted to 33%, an average of $4.1 billion per company.
• AOL Time Warner reported the largest dollar write-off at $54.2 billion. The largest percentage write-offs were 84% by Qwest, 63% by Clear Channel Communications, 47% by Boeing, 45% by Aetna, and 43% by AOL Time Warner. The smallest write-offs occurred at Dow Chemical, 0.7%, and Alcoa, 0.6%.

The figures cited above may understate the impact of the SFAS 142 goodwill impairment rules, for two reasons. First, several companies made large write-offs in 2001, after the requirements of SFAS 142 became clear but before the official implementation date. Three companies alone—JDS Uniphase, Nortel Networks, and Corning—wrote off an aggregate $61.9 billion of goodwill during 2001. By recognizing the impairments in 2001, these companies fell under the more general long-lived asset-impairment reporting provision of SFAS 121, which requires classification of the write-off as an operating expense. Had they been able to delay the write-off, a more favorable below-the-line treatment would have been available. Second, the transition standards of SFAS 142 allow companies to make the impairment determination anytime during the first year and then retroactively restate the first quarter’s results.

Why were there such large write-offs—nearly $135 billion by 33 companies—in early 2002? Factors certainly include the declining economy and the corresponding declining stock prices. Moreover, the impact of the September 11 terrorist attacks and the numerous accounting scandals reported throughout 2001 and 2002 depressed overall market values. Some acquisitions made during the boom years of the 1990s now appeared overpriced. Furthermore, the new impairment methodology provided by SFAS 142 required companies to specifically focus on goodwill impairment.

The substantial transition write-offs upon adoption of SFAS 142 suggest that the guidance in the prior standard, SFAS 121, did not trigger many goodwill write-offs. Under SFAS 121, goodwill is not tested for impairment directly. Instead, paragraph 12 of SFAS 121 calls for goodwill to be allocated to identifiable assets acquired in the same business combination that are being tested for impairment. Thus, only that portion of the total goodwill balance assigned to the impaired assets was written off when recognizing an impairment loss under SFAS 121.

It is worth remembering that 67 of the 100 companies studied recognized no impairment write-offs in either of the first two quarters of 2002. Their aggregate goodwill balance of some $446 billion was carried forward untouched by the new rules. Therefore, fears of a widespread “big bath” of goodwill write-offs went unrealized, as the aggregate write-off was less than 15% of the aggregate goodwill balance.

Effect on net income. Consideration of the quarter-by-quarter impact indicates that, of the 33 companies reporting goodwill write-offs in the first six months of 2002, 26 companies reported an aggregate write-off of $126 million in their first-quarter 10-Q reports. These write-offs had a major impact on reported net income. Aggregate 2002 first-quarter net income for the 100 companies studied was $7 billion, meaning that the $126 billion in write-offs reduced reported net income by about 95%, from $133 billion to $7 billion. There was little difference between pretax and posttax goodwill impairment amounts. For companies reporting both amounts, the posttax impairment was about 96% of pretax impairment. Twenty-two companies reported first-quarter net losses, including 15 of the 24 companies recording an impairment write-off.

The impact diminished in the second quarter of 2002, when 11 companies (including two that had reported first-quarter impairments) reported an additional $8.6 billion of goodwill impairment. Aggregate second-quarter net income was $30.3 billion, meaning that the $8.6 billion in write-offs reduced reported net income by about 22%. Sixteen companies reported second-quarter net losses, including four of the 11 companies recording an impairment write-off.

Comparison with Fortune analysis. In an April 14, 2003, article, Fortune magazine reported that 2002 was a dismal year for the Fortune 500 companies; revenues declined, by 6%, for only the sixth time in 48 years, and profits dropped 66%, to $69.6 billion, the lowest level since 1993, resulting in a profit margin of a paltry 1%. In addition to economic factors and company scandals, Fortune cited accounting changes—including the new goodwill impairment—as a major factor. It estimated total impairment charges for the Fortune 500 at $235 billion. The analysis above indicates that $135 billion—more than half the annual write-off by all Fortune 500 companies—was concentrated in just 33 companies. The remaining $100 billion is presumably explained by write-offs made by the other 400-plus companies in the Fortune 500, and all write-offs measured in quarters three and four.

Impact of the New Standard: Amortization

SFAS 142 also provides for the discontinuation of goodwill amortization, which partially offsets the income effects of impairment writeoffs and will contribute to higher reported profits in future periods. To aid financial statement users, paragraph 61 of SFAS 142 requires that during the transition period—including the first and second quarters of 2002, which reflect no goodwill amortization—companies are to report pro forma income figures for the corresponding quarters of 2001 (and for any other periods reported), with the amortization effects removed. Some companies provided these data in narrative form whereas others offered more useful tabular formats.

• Philip Morris’ first-quarter 10-Q said simply that “The Company estimates that net earnings and diluted earnings per share would have been approximately $2.0 billion and $0.91, respectively, for the three months ended March 31, 2001, had the provisions of the new standards been applied as of January 1, 2001.”
• Liberty Media’s first-quarter 10-Q provided a table showing how the $152 million net loss reported in the first-quarter 2001 would have been net income of $216 without the amortization!
• Lockheed Martin’s first quarter 10-Q provided this useful table:

The table continues with comparable per-share amounts.

Overall, the 100 companies studied reported goodwill amortization, net of tax, of $5.1 billion and $5.7 billion, respectively, for the first and second quarters of 2001. Projecting these amounts to a full year, reported annual profits under SFAS 142 might be $20 billion to $25 billion higher than under the previous APBO 17 amortization rules. Based on the net incomes reported by the 100 companies for the first and second quarters of 2001, the elimination of $10.8 billion of amortization expense would have increased reported income by about 17%.

Combined Impact

As stated, elimination of amortization partially offsets the income-reducing impact of impairment write-offs. Assuming that 2002 amortization, net of tax, would have been about $6 billion per quarter, the net income impact of SFAS 142 for the 100 companies, and a comparison to the Fortune 500 analysis, appear in Exhibit 1.

To examine the extent to which companies may have benefited from the new rules in the form of higher reported incomes, Exhibit 2 splits the 100 companies between the 24 that reported first-quarter goodwill impairment and the 76 that did not. The 24 impairment-reporting companies reported an aggregate net loss of over $25 billion, and had a 127% reduction in reported profits compared to pre–SFAS 142 reporting. The 76 companies that reported no first-quarter 2002 impairment had aggregate profits in excess of $32 billion and enjoyed a 14% increase under the new standard. Thus, implementation of SFAS 142 enabled most companies to enhance their first-quarter reported results, but among those companies where the first-quarter results were negatively impacted, the impact was very large.

Implications for Users of Financial Statements

The demise of the pooling-of-interests method of accounting for business combinations—which avoided recognizing and amortizing goodwill—and the concurrent replacement of goodwill amortization with periodic impairment testing are major events of great significance to users of financial statements. Probably the biggest concern involves the effects created by the discontinuity in data series created by the new goodwill rules:

• Eliminating amortization raises net income with no corresponding increase in operating cash flow.
• SFAS 142 attempted to mitigate the discontinuity effect of the cessation of amortization by requiring companies to provide pro forma 2001 quarterly income for comparison.
• Impairment write-offs create earnings volatility with no cash flow effects but cannot be ignored, because the write-offs signal a loss in economic value.
• Going forward, the higher net income and discrete write-offs that lower asset and equity balances means that return on assets and return on equity measures should increase.
• The lower asset and equity balances resulting from write-offs will increase debt ratios, such as total liabilities/total assets and debt/equity, creating unfavorable signals.
• Higher reported income (without amortization) will produce increases in interest coverage/times interest-earned ratios that appear favorable, but cash flow coverage remains unchanged.

This study suggests that impairment write-offs produced significant income and asset effects, especially in the first quarter following adoption, for about one-third of the company pool. Elimination of goodwill amortization impacts all companies’ reported incomes by an average increase of about 15% to 20%. The lack of economic effect associated with eliminating amortization should have no effect on firm valuation, but the mechanics of price/earnings ratios could drive stock prices up unless the ratio falls to offset the rise in income caused by the cessation of amortization. Even so, if P/E ratios begin to look “cheap,” prices might rise to compensate for this.