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Business Combinations - SFAS 141 Issued June 2001

SFAS 141 and 142 issued in 2001 mandated changes to accounting for business combinations and goodwill. SFAS 141 required that all business combinations be accounted for using the purchase method, eliminating the pooling method. This resulted in intangible assets and goodwill being recognized at fair value. SFAS 142 eliminated the amortization of goodwill and instead required annual impairment tests where the fair value of reporting units is compared to book value, with any shortfall requiring a write down of goodwill.

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82 views3 pages

Business Combinations - SFAS 141 Issued June 2001

SFAS 141 and 142 issued in 2001 mandated changes to accounting for business combinations and goodwill. SFAS 141 required that all business combinations be accounted for using the purchase method, eliminating the pooling method. This resulted in intangible assets and goodwill being recognized at fair value. SFAS 142 eliminated the amortization of goodwill and instead required annual impairment tests where the fair value of reporting units is compared to book value, with any shortfall requiring a write down of goodwill.

Uploaded by

Nori Lofindie
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Business Combinations SFAS 141 Issued June 2001

Big takeaway: No more pooling accounting when a firm purchases another firm. Only
use purchase accounting.
Before 2001, companies could choose between the pooling or purchase methods when
accounting for business combinations. It is now mandatory for firms to use purchase
accounting. Under pooling, firms would just record the BOOK VALUE of the equity of
the acquired company, regardless of the purchase price (fair market value). As a result,
no goodwill was created under the pooling method. The purchase method, however, does
lead to a recording of the acquisition at the FAIR MARKET VALUE.
Note that for acquisitions prior to this standard, pooling remains unaffected under GAAP.
Why did was this standard implemented??
Analysts and other users of financial statements indicated that it was difficult to
compare the financial results of entities because different methods of accounting for
business combinations were used.

Users of financial statements also indicated a need for better information about
intangible assets because those assets are an increasingly important economic resource
for many entities and are an increasing proportion of the assets acquired in many
business combinations. While the purchase method recognizes all intangible assets
acquired in a business combination (either separately or as goodwill), only those
intangible assets previously recorded by the acquired entity are recognized when the
pooling method is used (and they are recognized at book value instead of fair market
value).

Company managements indicated that the differences between the pooling and
purchase methods of accounting for business combinations affected competition in
markets for mergers and acquisitions.

If you are analyzing a firm that did use pooling in the past, you have to consider that its
assets are likely understated.
Additionally, since no goodwill arose from the pooling method, incomes of these firms
were nearly always overstated since goodwill amortization wasnt a deduction in
calculating net income. Goodwill is often the largest intangible asset on a firms balance
sheet so the difference between the pooling method and the purchase method is material.
Be sure to see below that goodwill is no longer amortized arising from business
combinations issued after 2001.
Recording Goodwill SFAS 142 Issued June 2001
Big takeaway: Dont amortize goodwill. Test annually for impairment & if impaired
write-down goodwill and record loss on impairment.

Internally created goodwill should NOT be capitalized, as no internally created


intangibles are capitalized. This is really because no objective transaction with outside
parties has taken place so the value of goodwill is very subjective.
Purchase goodwill. Goodwill is recorded only when an entire business is purchased.
Because goodwill is a going concern valuation, it cannot be separated from the
business as a whole. To record goodwill, a company compares the FMV of the net
tangible and identifiable intangible assets with the purchase price of the acquired
business. The difference is considered goodwill. This is why goodwill is sort of a plug
or a gap filler in the journal entry recording the purchase.
Goodwill is NOT amortized as other intangibles are. Companies that recognize
goodwill in a business combination consider it to have an indefinite life and therefore
should not amortize it. The main reason for this is that predicting the actual life of
goodwill and an appropriate pattern of amortization is extremely difficult. Therefore,
companies only adjust its carrying value when goodwill is IMPAIRED.
Impairment of goodwill is a two-step process. The impairment test is done on a reporting
unit level. Consider this to be like a subsidiary of the First, a company should compare
the fair value of the reporting unit to its carrying amount, including goodwill. If the fair
value of the reporting unit exceeds the carrying amount, it does not consider goodwill
impaired. The company does not have to do anything else.
An example: ABC division of Alphabet company
Cash
Receivables
Inventory
PP&E (net)
Goodwill
Less: assumed liabilities (e.g., accounts payable)

$200,000
300,000
700,000
800,000
900,000
(500,000)
$2,400,000

Alphabet determines that the fair value of ABC division is $2,800,000/ As a result, it
does not recognize any impairment, because the fair value of the division exceeds the
carrying amount of the net assets.
However, if the fair value of ABC division is less than the carrying value, or $2.4 million,
then Alphabet performs a second step to determine possible impairment. In the second
step, Alphabet determines the fair value of the goodwill (implied value of the goodwill)
and compares it to its carrying value, $900k. Lets assume that the fair value of ABC
division is $1.9 million instead of $2.8 million.

FV of ABC division
Net identifiable assets (EXCLUDING GOODWILL)
Implied value of Goodwill

$1,900,000
1,500,000
$400,000

Alphabet then compares the implied value of the goodwill to the recorded goodwill to
determine impairment.
Carrying value of goodwill
Implied value of goodwill
LOSS ON IMPAIRMENT

$900,000
400,000
$500,000

The following JE would be made:


Dr. Loss on Impairment (Income statement) 500,000
Cr.
Goodwill (Balance sheet)
500,000

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