Accounting methods for business combinations, acquired goodwill, and other intangible assets have changed dramatically with the implementation of Statements of Financial Accounting Standards ("Statements") Numbers 141 and 142 issued by the Financial Accounting Standards Board ("the Board"). These two rules supersede APB Opinion Numbers 16 and 17.
Before the issuance of Statement 141 businesses used one of two accounting methods, namely, the pooling-of-interests method (pooling method) or the purchasing method. Use of the pooling method was required when a company met certain criteria; otherwise, the purchase method was used. The use of these two different methods produced dramatically different financial statements for business combinations. This discrepancy made it difficult to compare the financial results of companies and also affected competition for mergers and acquisitions.
Statement 141 removes this discrepancy by prohibiting the use of the pooling method for business combinations initiated after June 30, 2001. The Board now requires use of the purchase method because it records a business combination based on the values exchanged. This standard shows the total purchase price paid to acquire another entity and allows for a more meaningful evaluation of both the acquisition itself and the subsequent performance of the company. In addition, since all businesses are accounted for using a single method, the financial results of entities that engage in business combinations will be more readily ascertainable.
Statement 141 also requires that intangible assets be recognized apart from goodwill if they meet either the contractual-legal criterion or the separability criterion. Under the contractual-legal criterion, an intangible asset must be recognized apart from goodwill if the asset arises from a contractual right. Some examples of these intangible assets include franchise agreements, patent and trademark registrations, and customer contracts. The intangible asset must be recorded apart from goodwill even if the asset is not transferable or separable from the acquired entity. The separability criterion requires that if an intangible asset does not arise from a legal or contractual means but is capable of being separated from the company by sale, transfer, license, rent, or exchange, then the asset must be recorded apart from the goodwill. Recognition of intangible assets apart from goodwill provides more information about the acquired assets and liabilities of business entities. This information will facilitate the assessment of future profitability and cash flows.
Statement 142 corrects financial accounting inaccuracy relating to goodwill and other intangible assets with indefinite economic lives ("goodwill"). Prior to Statement 142, the evaluation of business combinations was inaccurate because the portion of the price paid that related to expected synergies was not accounted for appropriately. The transaction-based approach under APB Opinion Number 17 ("APB 17") treated the acquired entity separately even though acquiring entities usually integrate acquired entities into their operations. Since the acquired company was separate, the total price of the transaction did not reflect the expected resulting synergies. This inaccuracy proved problematic because an acquirer likely paid a greater purchase price for synergies which were not accurately accounted for in the financial statement of the company.
APB 17 also inaccurately accounted for goodwill because goodwill was amortized since it was presumed that goodwill was a wasting asset. APB 17 mandated that the amounts assigned to goodwill be amortized over a maximum period of forty years in order to determine net income. This presumption was erroneous for goodwill that had a useful life of more than forty years or that had an indefinite useful life.
Statement 142 improves the accuracy of financial reporting by setting forth new rules for the accounting treatment and reporting of acquired goodwill. Under Statement 142 if goodwill is determined to be definite, it will continue to be amortized over its useful life but without the forty-year mandatory ceiling. Goodwill that has an indefinite useful life will not be amortized but instead will be tested annually for impairment. The Statement provides a two-part test for measuring goodwill impairment. The impairment test requires that companies compare the fair value of the reporting unit to its net book value (carrying value), inclusive of goodwill. If the net book value exceeds the fair value, then there is indication of impairment. Upon a showing of impairment, the residual method is applied in order to calculate the fair value of the goodwill. The calculated fair value of goodwill is compared to the net book value of goodwill to determine the amount of actual impairment, if any. Once actual impairment is found, the net book value of the goodwill can be adjusted so that a company's financial statement accurately reflects its worth.
Statement 142 also requires disclosure of information regarding goodwill in the years subsequent to its acquisition. Such disclosures include information about the charges in the carrying amount of goodwill from period to period, both in the aggregate and by reportable segment; the carrying amount of all intangible assets (whether or not amortized); and the estimated intangible asset amortization expense for the next five years. These disclosures will provide users with a better understanding of the changes in intangible assets over time and will thereby improve their ability to assess future profitability and cash flows.
Statement 142 is effective in fiscal years beginning after December 15, 2001. Goodwill acquired after June 30, 2001 is immediately subject to the non-amortization provisions of the Statement.
Please consult with legal counsel if you have questions about the new accounting requirements of Statements 141 and 142 and to determine whether your company is in compliance with these rules.
In March 2004, the FASB Emerging Issues Task Force amended these standards to clarify that mineral rights are tangible assets.
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