Goodwill is an intangible asset recorded when one firm acquires another firm. In 2001 the FASB issued Statement of Financial Accounting Standard (SFAS) 142 which changed the US GAAP treatment of goodwill. Prior to this change, a firm would record a goodwill asset on an acquisition, and then amortize (i.e., expense) this goodwill asset over a period not to exceed forty years. After the adoption of SFAS 142, goodwill assets are still recorded at an acquisition, but are not automatically amortize (i.e., expensed) through the income statement over some extended period of time. Instead, the goodwill asset remains on the balance sheet at original cost, but is subject to annual impairment testing. If the goodwill asset is not impaired, then it continues unchanged; if, however, the goodwill asset is deemed to be impaired, then the firm records a once-off impairment write-off of its goodwill asset(s). Financial accounting information serves a number of different roles, including: (1) providing useful information to investors for valuation purposes, i.e., helping investors value a firm’s debt or equity securities, (2) providing useful information for “stewardship” purposes, i.e., information that is useful for judging how effective management is in running the business (or, how management is providing “stewardship” over the assets of the business), and (3) providing information that can be used for contracting, i.e., information that can be used to write managerial incentive contracts, debt contracts etc. The adoption of SFAS 142 likely impacted the usefulness of US GAAP financial reporting information in fulfilling all three of these roles. In the deliberations that preceded the adoption of SFAS 142, the following issues were raises; please explain each of these arguments/issues.
1) Proponents of the change argued that adoption of SFAS 142 would provide more transparency regarding bad acquisitions made by management (i.e., acquisitions that destroyed shareholder value), thus improving stewardship. Explain how this could be the case.
2) Assuming that the argument in part (1) is correct and the new accounting standard does improve transparency with respect to bad acquisitions, explain who would use this information and how. That is, who would benefit from this enhanced transparency and how?
3) If goodwill write-offs make firms’ bottom-line net income more volatile, how are firms likely to react to this development? What actions might they take?
4) Assume Apex Inc. has substantial goodwill assets on its balance sheet and has a large bank loan that includes (1) a balance sheet-based covenant that specifies that the firm’s debt-to-total assets ratio must not exceed 70% at any point over the life of the loan, and (2) a performance covenant that specifies that the firm’s annual net income must exceed 10% of its balance sheet debt each year over the life of the loan. Violation of either debt covenant would trigger “technical default” on the loan and would force Apex to have to re-negotiate the loan with its bank(s). Explain how Apex Inc. could possibly be adversely affected by the adoption of this new accounting standard for goodwill.