Accounting

Why it’s time to rethink Goodwill Accounting

In July 2019, the FASB issued an invitation to comment on the subsequent accounting for goodwill resulting from business combinations. The FASB performs such evaluations when they expect that “either:

• the expected improvement in the quality of information provided to users—the benefit—justifies the cost of preparing, auditing, and providing that information or
• reduced cost can be obtained in a manner that does not diminish the quality of information.” (excerpt from FASB invitation to comment dated July 9, 2019 File reference number 2019-720

In the case of accounting for goodwill, it is indeed time to reevaluate the current process of treating goodwill as an indefinite-lived asset because the current treatment results in a lag in the recognition of the reduction of the value of goodwill and is thus not as meaningful as potential other methods (i.e. there is an expected improvement in quality of information provided to users). There are also additional considerations resulting in the significant changes in the global business environment which have occurred over the last 20 years, specifically, tech companies are now a signification contribution to the economy which has resulted in start-up companies making up a larger proportion of businesses. As the composition of the economy contains more start-ups and tech companies, which include characteristics such as riskier and more frequent acquisition activity, along with new products and services which behave unlike any other in history, the application of current goodwill assumptions may not be relevant or accurate. This article briefly explains the transparency weaknesses inherent in the current model which is exacerbated by the new start-up environment and proposes an alternative method through the following questions:

1. Is the current impairment test method sufficient to provide transparency to investors regarding the value of the asset?
2. What is the best approach to recognizing reductions of goodwill in lieu of an impairment-only model?
3. Should there be any other considerations given the significant shift in businesses from manufacturing to tech companies?

Question 1 – Is the current impairment test method sufficient to provide transparency to investors regarding the value of the asset?

First, a brief reminder of the current prescribed impairment evaluation process. Goodwill is tested annually for impairment using a “Step 0” analysis, which is meant to allow a company to perform a qualitative analysis to identify whether any impairment indicators exist prior to performing extensive quantitative analyses. If impairment indicators exist, the company is to perform a full impairment test, which essentially consists of assessing whether the fair value of the existing goodwill is below the carrying value and thus requires impairment.

Cashflows related to specific acquisitions are often not identifiable after the first year after the acquisition, as the target is often integrated into the legacy business. For this reason, the impairment tests are performed on a reporting unit level, i.e. in aggregation based on how the company views its operations.

There are three main reasons this process currently leads to results which are not meaningful:

1. The evaluation process is a decidedly judgmental and is subject to a high amount of management bias and valuation assumptions. The result, therefore, is typically that if there is a goodwill impairment, it’s material. It rarely occurs that a goodwill impairment is recognized and not considered noteworthy in the financials. According to the Duff and Phelps 2018 US Goodwill Impairment Study, a small number of companies make up the largest portion of goodwill impairments. This is consistent with findings since 2012. This indicates that goodwill impairments are not a common transaction, but when they occur, they are material. Additional cost from the complexity of the calculations and the increased audit risk is also an issue as noted by the FASB.
2. The evaluation occurs on an aggregated basis due to an inability of determinable cash flows resulting from a single business combination after integration. Further skewing the ability to analyze the results of a goodwill evaluation, if several acquired entities in one reporting unit or the acquiring company itself are over performing compared to original expectations, this can mask an impairment of goodwill of an individual business combination. The aggregated cashflows also include cashflows from assets and unrecorded goodwill created subsequent to the acquisition. There is no guidance which prescribes evaluation of goodwill from an individual business combination, even attempting to estimate the cashflows for each acquisition excluding acquirer cashflows and cashflows from assets created subsequent to the acquisition is not allowed, and would also likely be inaccurate as it would likely be estimated. Conversely, if an impairment is recognized, it may be the result of the acquiring company’s decline in performance, rather than the underperformance of target entities. Overperformance of other entities in a portfolio, inclusion of benefits resulting from assets created subsequent to acquisition, and underperformance of the acquiring entity are two of many examples of situations which lead to an inaccurate review of goodwill from an business combination.
3. Recognition of the usage of goodwill should match the cashflows resulting from that goodwill rather than recognized at a single point in time as an impairment would imply. Theoretically, goodwill represents the additional value of synergies the new management will realize due to additional resources on-hand. There are arguments that synergies exist into perpetuity, thus goodwill is an asset which can conceivably be indefinite-lived. The basis for this is that if management is effective, the acquired entity will increase in value throughout time. This is inconsistent with US GAAP and IFRS frameworks. Goodwill should relate to the value acquired, not hypothetical future value. Goodwill does not represent anything which might be created in the future using future investment. The acquired attributes of the synergies make up the value of the goodwill. Said differently, a company cannot capitalize future assets. What they can capitalize is the current value of future cash flows. Examples of aspects of synergies which erode over time are:

• Management acquired: Management turnover can be quite high after a company is acquired which can lead to knowledge and leadership loss
• Product obsolescence or ennui in the market: Eventually, the cash flows from the product rights acquired diminish as a normal part of the product life cycle
• Sunsetting of acquired processes and workforce due to evolution of the company

A company is always developing, so to make the argument that the company acquired will never change or be developed using the legacy company’s resources is inconsistent with normal economic incentives. It is thus not sufficient to conclude that goodwill is indefinite-lived and a useful life should be determined upon acquisition.

Conclusion 1 – Overall, the result is that goodwill impairments are recognized later than when the decline in value likely occurred as there needs to be a significant decline in the performance of an entire reporting unit before the impairment is detectible. The current impairment process, while more efficient than previous methods, does not result in meaningful results, and may lead to impairments which are recognized long after the indicators of impairment were present. There should be a modification to the current regulation for subsequent accounting of goodwill which more accurately reflects decreases in acquisition values in a way which is also timely and efficient.

Therefore, goodwill needs to be amortized or otherwise expensed prior to impairment in order to reflect the decrease in value in a manner which matches the cashflows resulting from the goodwill.

Question 2 – What is the best approach to recognizing reductions of goodwill in lieu of a impairment-only model?

The classic accounting proposal we should first consider is amortization over a pre-determined useful life, while also testing periodically for impairment in accordance with the rules for other assets.

The FASB Invitation to Comment File Reference No. 2019-720 provides the following suggestions for comment as useful life determination periods in lieu of an indefinite-lived asset conclusion:

1. A default period
2. A cap (or maximum) on the amortization period
3. A floor (or minimum) on the amortization period
4. Justification of an alternative amortization period other than a default period
5. Amortization based on the useful life of the primary identifiable asset acquired
6. Amortization based on the weighted-average useful lives of identifiable asset(s) acquired
7. Management’s reasonable estimate (based on expected synergies or cash flows as a result of the business combination, the useful life of acquired processes, or other management judgments).

When considering the options above, the only logical selection which increases transparency and maintains efficiency for the company is option g. management’s best estimate supported by cash flows and other relevant facts. Due to high audit standards and PCAOB reviews, a high level of preparation and audit work will be required to justify any conclusion, so the most efficient method is to prepare the justification as a part of the initial business combination rather than as an afterthought subject to misstatement conclusions. All the other options will require the same analysis to justify use or rejection of a default of a default option. Using management’s best estimate also increases transparency as every transaction should be assumed to be unique, thus a default period would not likely truly reflect the future benefit of the goodwill recognized.

Conclusion 2 – Valuation work should to be done upon completion of the business combination to determine the useful life. Doing all the valuation work upon acquisition would allow for cost savings from only preparing this evaluation once and only auditing it once (except in cases where impairment indicators are identified). As it is unlikely that any asset is truly indefinite-lived, the burden of proving the indefinite life with more specific cash flows and more critical evaluations of triggers would serve as a deterrent to concluding the asset is indefinite-lived. For example, selecting 20 years as a useful should be more acceptable and defendable under the new guidance than concluding goodwill is indefinite-lived. Although the usage of goodwill may not truly be decline systematically over time, amortizing goodwill straight-line over the best estimate of the useful life is more representative than a one-time impairment (if any).

Question 3 – Should there be any other considerations?

So far, this article has covered why an impairment-only model does not accurately represent the usage of goodwill and has proposed a method for amortizing instead. What the FASB does not request is an evaluation of whether goodwill should be considered an asset in the first place. In today’s new start-up environment, there is very high company over-valuation due to extra cash on-hand from venture capitalists (VC). One only has to consider the fate of WeWork to see how quickly a star can rise and fall. This is not a unique story. There is a myriad of start-ups that get VC funding and then are subsequently acquired by the Googles of the world for millions. The valuations are based on cash flows developed by VC’s in order to sponsor private funding. The nature of these companies is likely 15-20 employees with a good idea and a bit of developed technology, but maybe no product, yet. Consider the FASB guidance defining businesses within the scope of business combination accounting:

“An integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return…” ASC 805-10-20

The guidance further explains in ASC 805-10-55-4 through 55-5 that, specifically, a business must consist of inputs, established processes, and outputs, but most importantly inputs and processes which “are or will be used to create outputs”. The significance is that the business acquired does not need to have a product or service, only the potential of a product or service.

Under the current guidance, an entity consisting of only cost and some kind of on-going process but no product, only a plan for a product, is viewed as a business, and thus can result in goodwill if acquired.

The question is, “Is this goodwill really an asset?”. Are the cashflows really achievable? What additional resources does the new management have which would ensure these new cash flows? What would happen if the start-up founders left the company? If the founders leave, does the developed technology still live up to the potential that was envisioned in the original cash flow projections?

In this light, one can easily imagine a situation where a start-up company with brilliant engineers and a promising new product are acquired. Most of the purchase price is goodwill, as there are very few assets in this small new company. The consideration is contingent consideration to the founders based on an agreement that they stay and ensure the success of the development and launch of the technology. It often happens that founders may leave due to preferring the start up environment to the new corporate environment. Then the development stops. The product is never realized. The contingent consideration is recognized as income due to the release of the liability because the founders left, thus the amounts are no longer payable. The goodwill remains on the ledger without impairment, but the whole business acquisition is a loss. The result is a company which acquired a business that did not provide benefit now as an asset on the books and income on the P&L.

Conclusion 3 – The solution is to create a more rigid definition of a business and incorporate a test to confirm that goodwill qualifies as an asset upon acquisition, i.e. confirm there is stand-alone value which can be measured in case of immediate impairment or if the arrangement is instead compensation. This can be through thorough cash flow analyses which confirm the cash flows are dependent on the success of the acquiring company rather than the target or a more strict definition of a business.

Overall – The intent of the FASB is to provide meaningful information to users of the financials while avoiding over-burdening companies reporting in US GAAP. The most direct way to do this is

1. Create a test to confirm that the business acquisition results in goodwill rather than immediate expense or future compensation arrangements to founders
2. Define goodwill as finite-lived intangibles as all assets inherently have an end value due to developing economies
3. Amortize goodwill over management’s best estimate of the useful life in order to fairly represent the usage of goodwill

Goodwill can be treated like other intangible assets which require confirmation that the amounts represent future benefit and an assessment of the useful life. By treating goodwill like other assets, complexity and inefficiencies are reduced and more meaningful information is available to the users of financials.

Source links:

https://www.duffandphelps.com/-/media/assets/pdfs/publications/valuation/gwi/2018-us-goodwill-impairment-study.ashx

https://www.fasb.org/cs/ContentServer?c=Document_C&cid=1176172950529&d=&pagename=FASB%2FDocument_C%2FDocumentPage

Audits are a necessary part of the accounting process, and, while there are clear benefits resulting from audits, the process also places resources constraints on controlling processes. This analysis focuses on how to manage an audit to require fewer resources while maintaining effectiveness of the audit. This article is meant to provide a framework for financial statement audit preparation in order to allow controllers to efficiently prepare for the arrival of internal and external audit. The controller should build the process for ensuring accurate financial reporting (normally in the order listed):

The controller will find that every audit question fits into one of the above categories. By addressing each point above when preparing GL balances through internal documentation and procedures, the controller prepares to efficiently manage a financial statement audit. Throughout the article, “documentation” means narratives in either word documents or excel. The standard of documentation should be such that a new user can use the documentation to prepare the procedures in a way which is materially correct (COSO 2013).

Policy

The policy development is always the first step. A good policy is very technical and includes discussion of any situation which might occur. One good tool is to discuss why certain complex situations are either not likely or not material and include data which demonstrates this. This will allow the controller to avoid implementing complex processes for immaterial transactions. A good policy also prescribes how the company will execute ASC 606 accounting and ensure financials are materially correct.

Inputs

Inputs are metrics or data which often result from actions from non-accounting departments, for example shipping information entered by the logistics team. Accordingly, it is important to have internal controls on the process of developing inputs or a process for confirming that there is little to no risk that input data will be incorrect or inaccurate. Operational controls should be in place to ensure that the data entered by non-accountants is sufficient and accurate enough for accounting reporting. Testing sample data is a good approach for allowing a controller to ensure the data is accurate.

It is also best to use a data set which will not often fluctuate. This will have implications on future conclusions and assumptions used in accounting as well as call into question past accounting and reporting decisions and ensure data can be locked for past periods to maintain the integrity of the data. Locking data is also necessary for audit purposes as a typical audit procedure is to re-pull the data to confirm the same results.

Assumptions

Assumptions are applied to inputs prior to performing final calculations of GL balances. The fewer assumptions, the better. To paraphrase Occam’s Razor, the fewer the assumptions, the more likely it is that you have the correct result. Each time an assumption is added to the process, there needs to be robust documentation supporting the assumption and an analysis of the sensitivity of the calculation to the assumption. Support for the assumption should use historical data which has been tested internally whenever possible and documented. If the assumption has a significant impact on the calculation, then there needs to be a narrative supporting the basis of the assumption. If the assumption can change within a wide range and not impact the calculation much, normally it is sufficient to document that the calculation is not sensitive to the assumption and leave the documentation simple.

Calculations

Calculations often are applied to inputs and assumptions in order to develop the final GL balance or entry for booking. In some cases, the calculation is as simple as a sum of records, but could also be quite complex, for example, a regression analysis. If the data being used are kept in Excel, then the best approach is to lock calculation cells or pages so that they cannot be edited. The best solution, though, as discussed later, is to configure an ERP or interface to perform the calculations. This allows the audit process to focus on testing the configuration of the system (application controls) which is much more efficient. Clear documentation of the support for the calculation method should be maintained and easily accessible in order to facilitate audit procedures.

Reconciliation

Of course, it goes without saying that in the end of the process, there needs to be a reconciliation from the GL calculations to the general ledger. For excel calculations, the most efficient is to have this in a tab within the calculation. When an ERP or other automated tool performs the calculation, then the controller should build a process to check the subledger data from the ERP to the general ledger. Document within the reconciliation clear, quantitative thresholds for further investigation and amounts which are immaterial and thus do not require additional investigation or consideration. Example of adequate language is “The difference is neither qualitative nor quantitively significant is the causes are not pervasive and the amount is immaterial to the financials per the company’s policy on reconciliation difference.”

Automation

Automation can take many forms. The simplest form of automation is excel models. Building detailed, robust reporting is another form of automation in order to facilitate excel models or GL entry generation. More complex forms include building ERP functions or build-on applications that do automated calculations and GL entries without user intervention. Automating processes and calculations goes a long way to decreasing risk and reducing processing time, thus decreasing cost. It can also significantly decrease audit work performed as audit can then focus on only the few failure risks and rely on the rest of the process. The more manual/error-prone a process is, the more the auditors will question the process and results.

Reconciliations and review procedures can also be automated using tools like Blackline which automatically population GL balances to ensure the proper balance is being reconcilied and also keeps electronic signatures and time stamps of preparation and review for reliable audit evidence that controls are performed.

The Big Picture

Remember to keep it simple. Document the big, most material points. Use data which is reliable and can be locked. Automate processes and draw the auditor’s attention to the reliability of inputs, assumption and most importantly, process.  For any other potential questions on revenue, find a data set and analysis which proves the amount is immaterial, and recalculate the potential amounts quarterly to confirm no further consideration is required.

In the current environment of increasing control and audit requirements, it can prove to be a burden on controllers to ensure ASC 606 is implemented and executed to the degree to which Sarbanes Oxley requires. As audit thresholds decrease, controllers are having to find ways to ensure consistent and accurate application of some very complex elements. This leads to a higher risk of misstatement and a increased accounting resource investments.

In order to address accounting complexity and controls without adding significant headcount or other resources, controllers should consider the following actions:

• Changing business processes which drive revenue transactions in order to lead to simplicity
• Control the data being used by locking and testing data
• Automate accounting for revenue recognition

Change the Business Process

When evaluating the process for recording financial information, a controller might find that the systems and data available are not adequate for tracking the transactions the business offers. It is, therefore, beneficial to consider the products, bundles, discounts, etc. offered to customers in order to simplify the revenue recognition process. A cost-benefit analysis on complex products sometimes shows that the product offerings are not adding to the bottom line because of accounting resources required to track the ASC 606 impacts. The costs of complex product offers can include personnel or systems to track and record the revenue, and extra audit fees from complexity or a history of errors. In extreme cases, the cost is the reputation or valuation of the company from bad news related to misstatements or control weaknesses, e.g. Enron.

One example of a small change which can significantly simplify the accounting process is to require that a discount offered by sales personnel is applied to an entire contract rather than to only one performance obligation within the contract. This reduces the SSP effort later in the process, makes invoicing easier, and creates many other down-stream benefits with no impact on cash flow.

Thoroughly understanding the products and sales process is crucial in order for the controller to influence change, so collaboration with sales leaders results in more meaningful and effective process change recommendations as well as allows for greater chances of a successful implantation of the recommendations.

Control the Data

When evaluating whether the data available will be adequate for reporting and audits, consider the data source on which the company will rely and whether the data can be locked so that it can be consistently pulled in future periods for audit and review purposes. Often, the reliance on operational data creates the risk that the data is not meeting accounting requirements. For example, in some operational systems, if a sale is refunded, rather than showing the refund as an expense in the period in which the sale is refunded, some operational systems reflect this as a reversal of the sale in the period in which the sale occurred, thus changing prior period data.

Another consideration is the stability of the trends and data used in building assumptions. Examples of assumptions are final rebate claims, refunds, warranties, etc. It is best to rely on a data set which will not often fluctuate when this is possible. This will have implications on future revenue as well as call into question past revenue decisions. Revenue is considered an assumption, so if the data set is changing enough to cause revenue to fluctuate significantly, this compromises past recognition conclusions and might lead auditors to assume a past revision is required due to inaccurate assumptions. If direct sales or revenue information is not available, i.e. the sales price requires unobservable inputs, look for a metric which can be linked to revenue with a high level of correlation and data which can be consistently repulled in prior periods.

The level at which data is aggregated also has implications on later steps. Consider keeping data based on some of the following metrics:

• Customer identification number or name
• Customer contract
• Product
• Date of sale
• Duration of contract (start and end date)
• Sales representative
• Amounts billed
• Whether a sale is an initial sale (customer acquisition) or repeat sale (customer retention)
• Other unique identifiers to help with revenue tracking

Automate

Automating processes and calculations also substantially decreases risk and processing time when correctly implemented. It can also significantly decrease audit work performed as audit can then rely on application controls and focus on addressing fewer manual/input risks and rely on the rest of the process. The more manual/error prone to process is, the more the auditors will question the process and results.

Automation includes developing simpler excel models, building reports in the system which are easier to insert into models, and implementing system tools which perform and book ASC 606 calculations.

There are many tools available within newer ERP systems as well as standalone products which can be added to an ERP in order to automate ASC 606 accounting. Some examples are Zuora RevPro and Pro Rata by Chargify. These tools automate SSP determination and contract price allocations as well as deferred revenue recognition. Although it’s possible to keep calculations in excel, normally the data becomes too large and there’s enough risk of human error that it is generally worth it to invest in a system which will automate the accounting for a small subscription fee.

There are also system add-ons available to collect shipping and receiving information through UI directly from vendors, which eliminates the work of tracking shipping terms manually in order to confirm proper revenue recognition and provide an easy source for audit documentation.

Final Recommendation

The possible actions above should be constantly reconsidered. There is always room for improvement, and it is often worth the time to evaluate these elements in order to continue to increase efficiency. Taking these actions will lead to significant cost savings by reducing the time to review and audit revenue and will allow for cost avoidance through internal efficiencies and a strong control environment.