New Governance and Accounting Rules Concerning Goodwill and Intangible Assets

Hot companies, inflated stock prices and aggressive acquisition strategies will most likely result in a lot of goodwill being carried on the books of the acquiring company. Since traditional goodwill was defined as the excess of the purchase price over net assets, it could also include purchase price overpayments, anticipated but unrealized synergies, and other intangible assets having an estimated life much shorter than the traditional 40-year amortization period.

Only when there was a problem with the investee company, did an initial overstatement of goodwill or a subsequent impairment of it come to light-too late for investors and creditors. For example, Nortel Networks Corp., JDS Uniphase Corporation and Qwest Communications International Inc. all reduced goodwill values by billions of dollars in the last two years.

As a result of new accounting rules both in Canada and in the United States, traditional purchased goodwill will be whittled down by allocating it, where applicable, to a variety of previously unrecognized intangible assets such as non-compete agreements, customer contracts, customer relationships, etc., as well as the more traditional intangibles such as patents and trademarks. Since intangibles are to be amortized over their useful lives (unless considered indefinite) income statements will reflect as an expense a portion of their purchase price over time.

The remaining goodwill under the new rules will not be amortized, but will be tested at least annually for impairment. If goodwill is found to be impaired, a portion or possibly all of it will be written off. This will impact both the acquirer's balance sheet and income statement. Simple purchase price overpayments and unrealized synergies should therefore come to light much sooner and post-acquisition events that result in impairment will be reflected in financial statements on a timelier basis.

Financial statements should now provide investors with current information to enable them to analyze management's acquisition decisions. Management and the board of directors will need to understand the implications of the new rules at both the point of acquisition and at each annual reporting date.

This article provides an overview of the governance and financial reporting issues arising out of recent initiatives, including new generally accepted accounting principles (GAAP) rules concerning accounting for goodwill, auditor's independence and the enhanced role for independent directors and audit committee members.

What's different?

There are new governance and accounting rules for goodwill and intangibles. A recent roundtable discussion was held at which these rules were discussed with Jonathan Lampe of Goodmans LLP, Doug Cameron of Ernst & Young LLP, John Hughes of the Ontario Securities Commission, and Stephen Cole of Cole & Partners. Highlights of this discussion can be found in the "New Governance in Accounting Rules Concerning Goodwill and Intangibles (The Annual Impairment Test)" article, published in the October/November 2000 Volume 14, No. 6 issue of Fairvest's "Corporate Governance Review" (Fairvest article):

• Upon any merger or business acquisition, GAAP now require the allocation of the purchase price to all the tangible and intangible assets acquired.
• New categories of acquired intangible assets are to be recognized separately from goodwill, including customer relations, proprietary but unpatented systems, people subject to employment contracts and restrictive covenants, backlog, etc., in addition to the familiar intangible asset categories such as patents, brands and trademarks.
• Goodwill value on the balance sheet is to be the excess of the fair value of the reporting unit less the fair value of net identifiable assets: goodwill is therefore a residual calculation. By default, it will include intangible values, such as the value of an assembled workforce of "at will" employees who are not bound by a contract and, in large part, anticipated synergies.
• All assets, other than goodwill and identifiable intangible assets with indefinite useful lives, will need to be depreciated or amortized over their "useful life".
• The useful life and fair values of goodwill and other intangibles (which are not amortized because they are regarded as having indefinite useful lives) need to be assessed annually pursuant to an annual impairment test.
• CEOs and CFOs for Securities and Exchange Commission purposes now need to certify, personally, the fairness of the financial information released.

How will goodwill be valued?

It won't be. It's what's left over. The valuation of goodwill on the balance sheet for purposes of the annual impairment test is what is left over after properly valuing everything else:

How will goodwill be vaued?

When is an independent valuation opinion required?

Where there is significant intellectual property or goodwill associated with a business, it will become common practice for companies to retain independent valuation specialists to review management's reports and give opinions (or second opinions) in the following instances:

• Allocating the purchase price immediately following acquisition.
• Reviewing, developing or assisting in the development of the procedures to be undertaken by management.
• Where there is, or may be, a material impairment and analysts, shareholders, lenders or other stakeholders place particular reliance on intangible asset values.
• Where the company does not have personnel who are experienced in business valuation matters.
• Where management, the audit committee or board want a second opinion because the matter is controversial, because more specialized skills or independence is required or simply out of an abundance of caution.

In most cases, the auditors alone will assess management's annual impairment test as a necessary step of the financial statement audit. As part of that process, the auditors will review the valuation work of management, but will not originate valuation findings.

Under the U.S. Sarbanes-Oxley Act of 2002 and the new independence standards proposed by The Canadian Institute of Chartered Accountants (CICA), auditors are precluded from providing valuation services where the valuation involves matters that are material to the financial statements and the valuation involves a significant degree of subjectivity.

Responsibility and liability.

Broadly, liability for addressing goodwill falls with the same individuals or groups that have responsibility for the financial statements. There's nothing really new here. The board of directors has to approve the financial statements. It does so on the recommendation of the audit committee, which looks to management. All of these groups, to varying degrees, look to the assurance provided by auditors.

There will be greater liability and concern, because reported goodwill will not be subject to a formulaic approach (i.e., amortization), but will be subject to more variable and subjective assessment with potentially greater impact on the financial statements.

Practically speaking, the following table highlights who is responsible for what:

From the ground up.

The independent valuator will not need to reinvent the wheel. Except as discussed earlier, it will almost always be appropriate to work co-operatively, though independently, with management and with the auditors to ensure timely and economic results. Without losing objectivity, the knowledge base of management and the auditors is invaluable and should be leveraged by the independent specialist.

Planning and documentation.

Proper planning should help to ensure there are no earnings or balance sheet surprises and the process is both efficient and cost effective. Doug Cameron states in the Fairvest article:

In Canada there is no formal requirement for robust systems and internal control. With the Sarbanes legislation there is a requirement for both internal and disclosure controls, which is why the certification is easily inserted into their system and not ours.

Good internal controls and processes are integral to discharging the Board's role of overseeing, just as are other internal controls. It is essential that management document both the processes and the resulting valuation reports and that the Board and the Audit Committee approve them so that when John comes along and says, 'Why did you write that off in the third quarter and not the second quarter?' the reporting issuer ideally will be able to trot out the models that they use and say, 'Well, you know, we went over the edge in Q3'.

Competing interests.

In many cases, there will be competing interests to be aware of:

• To increase earning per share one would want to allocate value to goodwill and other assets with an indefinite life-avoid allocating value to those that are depreciable or amortizable.
• If the acquirer was a private company at acquisition and had aspirations of doing an initial public offering (IPO), then the best of both worlds would be to allocate value to those assets that are depreciable or amortizable, but amortize them quickly for accounting purposes so that the post-IPO earnings per share did not suffer this cost, but the cash flow would enjoy the tax benefit.
• If banking and leverage covenants are an issue, candidly discuss the issues and ensure the matching of covenants and margin ratios.

What about volatility?

Impairment refers to what is expected to be a permanent impairment-something that is temporal can be ignored. Purely cyclical changes will not be occasion for write-offs. The foreseeable future should include one full business cycle. Discounted cash flow (DCF) analysis may well include more than one cycle depending on the industry. One will have to have the confidence and maturity to know when it is reasonable to expect value, when it is coming back in the foreseeable future and when it is not.

"It is going to be interesting-especially depending on where we go with certification issues and liability issues-to see how gutsy CEOs, CFOs and boards are about saying that we really believe a cycle is going to repeat itself. This may be another reason that we see some 'big hits' to the value of intangibles. We may see 'lumpy' write-downs. If there is an impairment in goodwill, a company may want to take a conservative position and get more of the 'overhang' out of the system," states Jonathan Lampe in the Fairvest article.

Fair market value or fair value?

The question is not what an asset will fetch on the open market, but what it is worth to the particular acquirer, based on market expectations. A detailed DCF model should be most frequently used to determine fair value. Mergers and acquisitions, and corporate finance street knowledge, plus traditional business valuation theory, are needed to ensure that the valuation balances both market realities and the subtleties of the specific business.

Flags.

Flagging potential impairment situations is likely to be the most important new area of focus for the board, audit committee, management and the auditors. Failure to recognize a potential problem that then comes home to roost may result in inaccurate reporting.

Internal controls and reconnaissance are necessary so as to identify that the flags will be focused both outside and inside the entity. It will include, but not be limited to, the following concerns:

• Changes in the competitive landscape.
• Loss of key personnel.
• Current operating losses or cash flow losses that may be continuing.
• Material difference between pre-acquisition budget and post-acquisition results.
• Anticipated sale or disposal of a business unit.
• Changes in the extent or manner in which an asset is used (or intended to be used).
• Changes in legal factors or the business climate that could affect the value of an asset or adverse action or assessment by a regulator.
• Others with similar assets or in similar businesses have recognized impairment.
• Changes in corporate structure that could affect how business units are defined.
• Over the long term, changes in valuation parameters.

Who sets the standard?

The Canadian Institute of Chartered Business Valuators (CICBV) and the American counterpart organizations prescribe standards and procedures for formal valuation opinions, informal and second opinions and procedural reviews. They reflect generally accepted valuation principles and practices. They address the disclosure and style required in a valuation report, substantive content and methodologies, and scope of work to support the opinion and related professional matters. There is a large body of supportive publications and jurisprudence bearing on these areas.

Private vs. public issuers.

With most valuation issues, it takes 20 per cent of the time to get the right ballpark answer and the other 80 per cent to document and communicate it to all the stakeholders. It follows that good work can be done for a reasonable cost for private firms provided there are shared intentions and no time consuming politics.

These concerns will apply to a non-public company, particularly where they have significant outside equity investors or institutional debt. Those parties are going to be saying, 'We would like similar protections in terms of controls and systems of red flags that are being put in place by other companies,' states Lampe in the Fairvest article.

As John Hughes also states in the article, "This debate will be a very hot one. Should it be one size fits all? Very theoretically, one could accept a kind of lower standard of governance for smaller companies, but that would be part of the trade off for not investing in something bigger. The cost will be that governance doesn't offer the same rigour, predictability and oversight. It would be uncertain but not unreasonably so."

Speaking before a Senate committee in Ottawa in October 2002, David Brown, chairman of the Ontario Securities Commission, agreed with advocates of slightly different rules for small Canadian companies, saying that "we needed a made-in-Canada solution, one that takes into account our unique circumstances, such as the large proportion of small companies." In particular, he suggested that there will probably be different rules in Canada than in the United States when it comes to the independence of members of boards of directors. However, he also indicated his consultations support certification of financial results by CEOs and CFOs. He did not specifically address matters pertaining to goodwill.

So what will be different?

• "Financial statements don't have some kind of magical accuracy. Everything is always the reflection of a range of possibilities and there is a high side and a low side and you crunch it the best you can," states Hughes in the Fairvest article.
• "Realistically, this is going to be another issue that will be layered on to, and make demands of, the audit committee in particular. It won't be as easy as dealing with amortization of goodwill, and the amounts in issue may be very significant. An open question for me is, given the potential magnitude and subjectivity, is this another item that gets 'backed out' as the market assesses relative financial performance?" states Lampe in the Fairvest article.
• "Issuers will have greater transparency and immediacy and whether they pay conservative amounts or exaggerated amounts for acquisitions in the future, I think these changes in reporting will serve us better. The focus on goodwill reinforces the fair value concept. I like it. It is informative. It has an immediacy. As to historical cost, who cares?" states Cameron in the Fairvest article.

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Andrew J. Freedman, CA.IFA, CBV, ASA, and Paula G. White, CA, CBV, are partners at Cole & Partners in Toronto, a firm specializing in business valuations, litigation support and corporate finance.