The Proper Accounting Treatment of Intangible
Assets Currently Accounted for
in a Business Combination as Goodwill
America's Community Bankers (ACB) appreciates the opportunity that you and the Members of the Committee have given our membership to participate in this roundtable discussion on the proper accounting treatment of intangibles that are acquired in a business combination and that are currently accounted for under generally accepted accounting principles as goodwill. ACB represents the nation's community banks of all charter types and sizes. ACB members pursue progressive, entrepreneurial, and service-oriented strategies in providing financial services to benefit their customers and communities.
Because of the ongoing consolidation in the broader financial services sector, ACB is highly conscious of the importance of the issues to be addressed in this roundtable discussion and seeks to provide the particular insights of a highly competitive but regulated industry that is central to the functioning of a market economy. The views expressed in this statement are adapted from comments that ACB's previously submitted to the Financial Accounting Standards Board in response to its Exposure Draft on Business Combinations and Intangibles.
Goodwill Impairment Review
ACB supports the approach advocated by Chairman Gramm, and identified as an option by FASB, of adopting the purchase method as the sole (or virtually sole) method of accounting for business combinations, but removing the automatic presumption that goodwill is a wasting asset. The revised approach would require the same type of impairment review to be performed on goodwill as is applied to all other identified intangibles acquired in a combination transaction. This approach would potentially address the problem of ‘earnings drag' although an additional onus would be put on valuation methods. This valuation and guidance issue would gain still more force if FASB actually adopts the approach advocated by Chairman Gramm
If impairment review rather than automatic amortization becomes the rule, it seems reasonable to commence the review for possible post-acquisition impairment in the subsequent year's financials. It also seems feasible to perform that review annually thereafter. ACB suggests that this review be required periodically of all entities with these assets rather than relying on the occurrence of obvious impairment events. ACB anticipates the likelihood of technical debates within an entity and between an entity and its auditor over whether a specific impairment indicator has been triggered. If the review were universal, where adverse changes have not occurred, it should not take much documentation to show that recoverability has not deteriorated and thus no real burden has been imposed.
If this overall approach is not taken, the impairment review triggers under the approach of the FASB Exposure Draft must be more sharply defined. For example, the second item whereby a decline in the market price of the stock relative to the overall market is taken as a danger signal is unclear as to whether the decline is relative to some broad index of market or to a more specific ‘peer group'. Not all market indices move in tandem, nor are all indices weighted the same way. The Dow-Jones is an unweighted average of prices of major corporations. The S&P 500 is a weighted average of a larger group of large corporations. Other stock indices all differ in their construction and their universe.
ACB also notes that there may remain substantial potential for massage of the financial results via the impairment/recoverability review. If an entity seeks to perform a rapid write-off for the goodwill item, it could simply provide a rather long list of influences on the value of the item. This would enhance the probability of an adverse change in some item on that list, an item that could be disproportionately emphasized to enable the desired speedy write-off/-down. An entity seeking a more leisurely amortization could give only a short list of vague elements so that it would be harder to reach a definitive conclusion that the conditions supporting the value of the goodwill asset had worsened. No obvious solution to this possible problem comes to mind, but, if in fact it is a problem, it is of a kind handled routinely by independent financial auditors.
Recognition of Goodwill as an Asset and Its Amortization Period
The FASB Exposure Draft carefully distinguishes ‘core goodwill' from the acquisition premium over the book value of the purchased entity and provides a useful six element conceptual subdivision of that premium. The step-by-step flow chart procedure of paragraph 76 of the Exposure Draft used to determine the existence of identifiable intangible assets and the guidance of paragraph 77 of the Exposure Draft on the appropriate useful lives for these items, if conscientiously applied, should better allocate the purchase price away from goodwill. (These procedures deal with the second item in the six element list: the first is simply the discrepancy between book and fair value of tangible assets that, for various reasons, has not been recognized on the books of the acquired entity.)
The last two items on the acquisition premium component list, overvaluation of the consideration for the purchase and overpayment for the acquired entity, are clearly not assets. Rather, they are economic /measurement missteps, but as the background analysis notes, these elements will supposedly be quickly expunged by the recoverability analysis. It would perhaps make sense to mandate such recoverability/impairment analysis as an initial and ongoing procedure to ensure this result, though certain perverse results could conceivably arise from this mandate.
The FASB Exposure Draft performs a careful taxonomic analysis in defining the middle two elements of the list as core goodwill. This analysis would remain useful if FASB chose to adopt the impairment approach. These middle elements are the two that correspond to regular asset status but are hard to price separately because of the impossibility of detaching them from the overall operations of the entity. To the extent that market valuation should be taken seriously, at least where there is an active market in the obligations and equity of the entity, the current market perception of the value of the goodwill is inherently linked to the discrepancy, if any, between the fair value of all net assets (both tangible and intangible, and financial and non-financial) acquired in the combination and their current carrying value.
Unfortunately, since these market values are not themselves directly observable, the validation of the carrying value of the goodwill asset, and perhaps even its basic status as an asset, is not much advanced. Thus ACB concurred on largely pragmatic grounds with the limitation on the life of goodwill at 20 years and the rebuttable assumption that straight-line amortization is appropriate.
Again from a purely pragmatic perspective, the limitation to 20 years was not likely to have any significant impact on depository institutions since the SEC and the federal banking regulators have generally used 25 and 15 year limits, respectively. (For regulatory capital purposes at the depository institution level, goodwill is subtracted from capital, producing a de facto immediate write-off for this item as an element in deposit insurance pricing and the stringency of operating restrictions placed on capital deficient entities: rapid write-off merely conforms accounting and regulatory measures of capital and net assets.) Furthermore, the 15 year value for the amortization period again happens to coincide with the period under the tax law. If a theoretically precise solution is hard to come by, minimizing implementation complexity can be a worthwhile second-order goal.
More guidance on impairment recognition would be essential if FASB does choose to move away from the automatic classification of goodwill as a wasting asset. If goodwill is not to be deemed a wasting asset, there will still remain the issue of its maximum life. One option would be to retain the 20-year limit previously proposed. The other would be to allow goodwill the same status as other identified intangibles. The latter would probably be more consistent with the rationale for moving to an impairment model.
ACB also concurs with the position adopted by FASB in the Exposure Draft that goodwill be ‘attached' to the line of business obtained in the acquisition. The result is that all, or an aliquot part, of the goodwill booked as part of that transaction must be eliminated in the event of the sale of all or a substantial segment of that acquired line of business.
Accounting for Identifiable Intangible Assets
ACB concurs with FASB's view expressed in the Exposure Draft that it is appropriate to record identifiable intangible assets separately from goodwill and treat these assets consistently, whether acquired in connection with a business combination or in a separate purchase transaction. As the modern economy evolves to a greater dependence on intellectual property rights and knowledge-based operations, such transactions are of increasing significance. Various intangibles have quite active markets and unlike goodwill the owner can test the water by an offering of these items separate from the sale of an entire business. Again, the flowchart in paragraph 76 of the Exposure Draft and the examples in paragraph 77 of the Exposure Draft are useful guidance for handling such transactions.
Because of their separability and the demonstrated durability of important classes of intangibles such as high-profile consumer brands, it is indeed appropriate to allow extensions of the useful life beyond the 20 year limit previously proposed for the goodwill intangible. The establishment of that 20 year value as only a rebuttable presumption will fairly place the onus on any entity seeking to use a longer period for economic life. The same logic applies to the decision on how /whether to amortize the value of the item. Perhaps it should be made clear that the burden of proof is on the entity seeking to move beyond the otherwise binding 20 year limit and amortization over that period. The documentation should be carefully reviewed as a vital part of the systems generating the financial statements by the financial officers of the entity and the outside auditor. The enhanced disclosures generally required by the proposed Statement should provide useful information to users of the financial statements that result.
ACB again notes that the complete reliance on fair value as the yardstick for impairment will impose a substantial burden on the ‘appraisal' process of finding comparables for often unique assets and rights. Often it is the very uniqueness of the item that renders it of value and this standard could prove very complex to implement.
Financial Statement Presentation
ACB supports the presentation of goodwill impairment or amortization as a separate line item, net-of-tax. ACB suggests, however, for consistency's sake, that there be an equivalent income statement line item for the treatment of identifiable intangibles. This will offer a more complete picture of the status of these items and their trajectory since acquisition. Such symmetrical presentation would reduce any perceived advantage, one way or the other, in the allocation of purchase price to these two classes of intangibles.
ACB concurs in the elimination of the previously required pro forma disclosures of operating results. The one-time disclosure of the relative book and fair values of the assets and liabilities involved in the acquisition will be more informative and will give the users of the financials a better grasp of the magnitudes involved in the purchase price allocation.
Exclusion of Insured Credit Unions
The Exposure Draft appears to exclude from its scope not-for-profit entities. ACB strongly disagrees that such an exclusion is appropriate or warranted, however, in the case of credit unions whose deposits are government insured. In particular, the argument is evidently being made by the credit union industry that without such an exclusion the acquisition of financially troubled credit unions by other credit unions would be inhibited. It is most definitely in that situation that no exception from GAAP should exist. Uniform application of GAAP is necessary to avoid the potential for confusion that will mask the extent of a safety and soundness problem and facilitate its spread, making it more likely that the problem will ultimately have to be resolved by taxpayers. Such an exception for insured credit unions, would recreate the so-called regulatory accounting regime that was prohibited for banks by Congress because it was viewed as having masked the extent of the banking and thrift problems of the 1980s. ACB strongly requests that the Committee communicate to FASB that, to avoid the potential for future infusions of taxpayer funds, all federally insured depository institutions should be subject to the same requirements of GAAP.
Method of Accounting for Combinations
It is somewhat easier to contest the application of the purchase method in those rare cases where it is in fact truly impossible to determine which is the acquirer and which is the acquiree. As the Exposure Draft notes in Paragraph 121, "even an inability to identify the acquiring enterprise is not a reason for retaining the cost basis of predecessor companies because the resulting combined enterprise is significantly different from its predecessors." Parenthetically, it might be worth bearing in mind in these cases where it is hard to determine who is buying whom that an acquirer has to be designated for federal income tax purposes: obviously, tax accounting is not dispositive for GAAP purposes, but could establish a rationale for the determination.
This set of circumstances might be an occasion for the use of the ‘fresh start' method of reestablishing the basis of all assets and liabilities of the resulting enterprise, but the implementation of a wholly new method for such infrequent and exceptional cases is rejected within the proposed Statement on pragmatic, cost/benefit grounds. ACB supports that decision as a reasonable corollary of the decision to move to a single method of accounting treatment.
The Exposure Draft provides an analysis of the relationship between the overall historical cost method and its use to justify the maintenance of the pooling method. The business combination certainly offers an opportunity for the ‘truing up' of historical cost estimates using the prices implicit in the overall combination transaction, where the acquirer's identity is clear. Of course, the complexity of the remainder of the Statement and of the background discussion makes it quite clear that teasing out and presenting these implicit prices is not a trivial task.
As a final point on the exclusive use of the purchase method, its application to a merger between two healthy mutual-form entities is an issue. These transactions are accomplished essentially by agreement with no cash or stock changing hands. The members of the entities do usually have to vote to approve the transaction, and their ‘share' of the voting power in the combined entity is perhaps theoretically affected, though their basic voting rights usually are not. As an added complicating factor, there is often a limit on the number of votes that may be cast by individual members in both the predecessor and resulting entities so that voting rights do not linearly track deposit balances or other account footings. This is significant since the most substantive economic right of the mutual member, to participate in any subsequent conversion of the entity to stock form, is even more likely to be much the same both before and after the combination. Even in cases where the entities are of divergent asset sizes, these rights are in some sense preserved unchanged. Consequently, perhaps a troubling proportion of the onus to determine the acquirer will be placed on FASB's criteria and management composition of the resulting entity, or alternatively on sheer relative asset sizes.
Because cash or stock consideration does not pass from one entity to the other, concerns have been expressed that this type of transaction may be exceptionally prone to the ‘aberration' of negative goodwill. FASB is itself clearly somewhat uncomfortable with the treatment of this item: the change made to the proposed Statement from prior Board working documents, with an allocation first to identifiable intangibles, then to depreciable non-financial assets, and only thereafter to extraordinary gain booked in the period when the purchase price allocation is completed, indicates legitimate discomfort with ‘gain on purchase'.
Though FASB is probably at least equally discomfited by the prospect of retaining the pooling method to handle mutual entity mergers, it might be helpful to accord a deferred effective date to the application of this Statement to mutual merger transactions. FASB could then determine whether these concerns are well-foundered and prevalent, and, if so, how best to deal with the issue. ACB notes that any concerns about misleading investors are not present here: in the event of a mutual-to-stock conversion transaction, a comprehensive valuation is required and potential stockholders are, in effect, given a look at the entity on a fresh start basis. Alternatively, mutual-to-mutual mergers are a negligible component of business combination volume in today's ‘market for corporate control', and these transactions are conducted under a comprehensive umbrella of federal banking regulation.
Identification of Acquiring Entity
The Exposure Draft offers additional guidance in the determination of the acquirer beyond that in FASB Opinion 16. This is useful. The specific addition is the composition of the board of directors and senior management of the resulting entity. Of course, "all pertinent facts shall be considered" including "the existence of any major voting blocks, unusual or special voting arrangements, and options, warrants, or convertible securities", a list that is quite comprehensive. The one component that might be expected to be present, the market capitalization of the entities, is not specifically mentioned. This may seem paradoxical at first glance. On reflection, however, this dimension will be included in cases where it is a relevant consideration via the impact on voting rights, board, and management. As paragraph 166 of the Exposure Draft indicates, FASB sensibly decided to omit specific reference to market capitalization (and asset size and book valuation) as an item to be considered in all cases. In some significant instances, such as mutuals, privately held entities, and partnerships/proprietorships, there is no observable market capitalization anyway. The overall language mandating the use of all pertinent facts will ensure the consideration of relative market capitalizations where it is relevant.
Mr. Chairman, ACB very much appreciates this opportunity that you have provided to us to express our is pleased to have had this opportunity to express its views.
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