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Models to measure goodwill impairment.

Article Excerpt
Abstract

Statement of Accounting Standards No. 142 [2001f superseded the former rules of accounting for amortization of goodwill under Accounting Principles Board Opinion No. 17 [1970]. Entities must now recognize annually impairments in the value of the goodwill associated with purchased firms, rather than amortizing such expenses ratably over 40 years. This better matching of revenues and expenses provides for more valid financial statements, but also mandates accountants to select proper models to measure such impairment losses. The authors highlight some reasons for the issuance of this new standard, compare and contrast the effects of the discounted cash flows and residual income methods to measure such impairments, and suggest how to develop a conceptual model to adhere to the new authoritative provisions. (JEL M41)

Introduction

Since 1970, rather than expensing goodwill immediately, entities have written goodwill off over its useful life (that is, up to a 40-year period), in accordance with the provisions of Accounting Principles Board (APB) Opinion No. 17. But, since goodwill loses much of its value in the earlier years of its existence, the Financial Accounting Standards Board (FASB) recently issued Statement of Financial Accounting Standards (SFAS) No. 142. Briefly, entities must now match such declines in goodwill over their useful lives, by recognizing such declining values much earlier in the acquisitions cycle and, in no case, over more than 20 years. This article outlines some major provisions of this new standard and introduces some methods to help ascertain how to value such goodwill.

Under SFAS No. 142, rather than amortizing goodwill, entities should now at least annually test the impairment of the excess prices they paid for such purchased assets, and write off such declines during those periods. This matching of declines in the excess prices paid for such assets with the periods that the declines occurred should produce more relevant financial statements, as when, say, the neighborhood surrounding a highly valued purchased piece of property declines. The FASB calls the carrying amounts less the fair values of such assets as impairments. Various experts [Valdmanis, 2002] expect that such impairments will cause American companies to write off over a trillion dollars of purchased goodwill.

What is Goodwill?

Entities should record goodwill only when they purchase other entire businesses, since goodwill represents the difference between the price paid for the entire business and all specifically identified assets. For example, a real estate developer may purchase a competitor's properties and customers for more than the fair (market) value price of each individual rental unit,...

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