2.4 Quantitative Assessment (Step 1)

The fair value of a reporting unit is determined in accordance with ASC 820. ASC 820-10-20 defines fair value as “[t]he price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” Accordingly, fair value is an exit price. To meet the “exit price” measurement objective, an entity is required to develop assumptions that market participants would use to determine the price of an asset, liability, or equity instrument in an orderly transaction as of the measurement date. ASC 820-10-20 defines market participants as “[b]uyers and sellers in the [entity’s] principal (or most advantageous) market for the asset or liability” that are (1) “independent of each other,” (2) “knowledgeable,” (3) “able to enter into a transaction for the asset or liability,” and (4) “willing to enter into a transaction for the asset or liability.” As noted in ASC 820-10-35-9, an entity “need not identify specific market participants” but should “identify characteristics that distinguish market participants generally.” The assumptions that market participants would use when measuring fair value are relevant in the determination of the inputs to the fair value measurement. An entity may not substitute the assumptions of market participants with its own assumptions that differ from those of market participants.

ASC 350-20 does not prescribe a specific valuation approach or technique (“approach” is a broader category than “technique”) for measuring the fair value of a reporting unit, but the approach or technique an entity selects should be based on the principles of ASC 820. ASC 820-10-20 defines the three valuation approaches as follows:

• Market approach — “A valuation approach that uses prices and other relevant information generated by market transactions involving identical or comparable (that is, similar) assets, liabilities, or a group of assets and liabilities, such as a business.”
• Income approach — “Valuation approaches that convert future amounts (for example, cash flows or income and expenses) to a single current (that is, discounted) amount. The fair value measurement is determined on the basis of the value indicated by current market expectations about those future amounts.”
• Cost approach — “A valuation approach that reflects the amount that would be required currently to replace the service capacity of an asset (often referred to as current replacement cost).”

An entity typically measures the fair value of a reporting unit by using either a market approach or an income approach (or both) rather than a cost approach. The entity then selects one or more techniques “that are appropriate in the circumstances and for which sufficient data are available.” The technique selected should maximize the use of observable inputs while minimizing the use of unobservable inputs. ASC 820-10-35-24B states:

See Section 5.2.6 for disclosure requirements related to fair value measurements and Deloitte’s Roadmap Fair Value Measurements and Disclosures (Including the Fair Value Option) for more information about measuring fair value in accordance with ASC 820.

A control premium represents the amount a buyer is willing to pay for the synergies and other potential benefits that would be derived from controlling another entity. For example, incremental value could be associated with a controlling interest in a publicly traded company. The incremental value, or control premium, would represent the amount a buyer may be willing to pay in excess of the market capitalization of the publicly traded company (i.e., the product of the number of outstanding shares and the quoted price per share) to obtain a 100 percent ownership interest in that public company.

See Section 10.10.3.2 of Deloitte’s Roadmap Fair Value Measurements and Disclosures (Including the Fair Value Option) for further discussion of the impact of a control premium on measuring the fair value of a reporting unit.

Neither ASC 350-20 nor ASC 820 specifies which premise an entity should use. Paragraph BC26 of ASU 2017-04 states:

Further, paragraph BC4 of ASU 2010-28 states, in part:

On the basis of the above paragraphs, while no one approach has been prescribed for determining a reporting unit’s carrying amount, the approach an entity selects should be consistent with that used for determining the reporting unit’s fair value.

When no debt has been assigned to the reporting unit, the carrying amount of the reporting unit will be the same under either an equity premise or an enterprise premise. In addition, when the carrying amount of debt approximates its fair value, use of either premise would not have an effect on the quantitative impairment test.

The SEC staff frequently refers to an entity’s market capitalization when commenting on the entity’s testing of goodwill for impairment. When an entity’s book value is greater than its market capitalization, questions may be raised about whether goodwill should be tested for impairment (see Section 2.3.3.6 for guidance on assessing the impact of a decline in the quoted market price of an entity’s equity securities) or, if goodwill was tested, whether goodwill at one or more reporting units is impaired. Entities should be able to explain how having a greater book value than market capitalization affected their judgments regarding the testing of goodwill for impairment.

In a speech at the 2008 AICPA Conference on Current SEC and PCAOB Developments, Robert Fox III, then a professional accounting fellow in the SEC’s Office of the Chief Accountant, addressed the SEC staff’s view on determining the reasonableness of control premiums:

While the speech states that “[i]n some cases, . . . it would be more reasonable to look at market capitalization over a reasonable period of time leading up to the date at which you are testing for potential impairment,” it does not clarify the meaning of a “reasonable period.” In practice, a reasonable period has been interpreted as being relatively short, but its length might vary depending on the entity’s specific facts and circumstances. An entity should be prepared to use entity-specific factors (e.g., volatility in the entity’s stock price) to support any range of dates used to determine its market capitalization. For example, it may not be appropriate to incorporate prices into the average share price in periods before the occurrence of discrete events (e.g., earnings releases) that negatively affected the entity’s share price because of the entity’s performance rather than overall market volatility. However, while it may be appropriate to use an average in volatile markets, it may not be appropriate when the entity’s stock price is in decline, since the SEC staff has said that registrants should not ignore a recent decline in market capitalization. Further, we believe that an entity should not incorporate stock prices after the goodwill impairment measurement date into its average share price.

In his speech, Mr. Fox went on to say:

In certain situations, a market capitalization reconciliation may be more complicated. For example, some entities may not test all of their reporting units for impairment on the same date, may have reporting units with no assigned goodwill that are therefore not tested, or may choose to perform a qualitative assessment for one or more reporting units to determine whether it is more likely than not that the fair value of the reporting unit is less than its carrying amount. Paragraph BC34 of ASU 2011-08 states:

Entities are not required to determine the fair value of reporting units that are not being tested for impairment or for which only a qualitative impairment test is performed. It may be costly for entities to perform fair value measurements for reporting units only because of the reconciliation to market capitalization. If an entity measures the fair value of most of its reporting units, especially its more significant ones, it may still be useful for the entity to compare the aggregate of those reporting units it measures at fair value with its market capitalization. Paragraphs 3.25 and 3.26 of the AICPA Accounting and Valuation Guide Testing Goodwill for Impairment address this topic:

As indicated in the above paragraphs, in “performing an overall comparison to market capitalization,” an entity could (1) “include the current year fair values for reporting units for which quantitative measurements . . . were performed” and (2) use a reasonable method to “estimate the fair value for the reporting units for which qualitative assessments were performed.” Similarly, an entity that has reporting units with no assigned goodwill would not be required to perform a goodwill impairment test for those reporting units; accordingly, the fair value of those reporting units may not be readily available. We believe that the fair value of those reporting units could also be estimated by using a reasonable method. While such an approach may not be as precise as a market capitalization reconciliation in which the current fair values for all reporting units are calculated as of the measurement date, it may provide information about the reasonableness of the control premium for the entity as a whole.

If, after performing the quantitative impairment test, an entity determines that the goodwill related to one or more of its reporting units is impaired, it may be prudent for the entity to complete a full market capitalization reconciliation to support its conclusions about fair value. Similarly, entities that experience a prolonged decrease in stock price may want to perform a market capitalization reconciliation to verify the reasonableness of their fair value measurements for each of their reporting units. Depending on the facts and circumstances, such a decrease could be identified as a significant driver of fair value that could lead the entity to conclude that a quantitative market capitalization reconciliation is necessary.

The FASB declined to create a different accounting model for reporting units with zero or negative carrying amounts. The Board instead opted to have entities disclose when they have one or more reporting units with a zero or negative carrying amount, the amount of goodwill allocated to each of those reporting units, and the reportable segment that includes the reporting unit (see Section 5.2.4). Paragraphs BC47 and BC48 of ASU 2017-04 explain the Board’s rationale for this decision:

The guidance in U.S. GAAP does not specify whether an entity should use an enterprise premise or an equity premise in assigning assets and liabilities to a reporting unit to determine its carrying amount. Under an enterprise premise, debt is excluded from the liabilities available for assignment to a reporting unit; under an equity premise, debt is included in those liabilities (see Section 2.4.4). A reporting unit that uses an equity premise sometimes may have a zero or negative carrying amount because debt is assigned to the reporting unit; such a situation may not have occurred if the entity had used an enterprise premise.

In paragraph BC51 of ASU 2017-04, the FASB cautioned that “the allocation of assets and liabilities to reporting units should not be viewed as an opportunity to avoid impairment charges and should only be changed if there is a change in facts and circumstances for a reporting unit.” Further, in paragraph BC52 of the ASU, the Board reiterated:

Therefore, when a reporting unit has a zero or negative carrying amount, the entity should consider whether using an enterprise premise to determine the carrying amount and fair value of the reporting unit would result in a more appropriate goodwill impairment assessment. In addition, we observe that a significant decline in the carrying amount of a reporting unit may suggest that the entity should test the reporting unit for impairment in the periods before its carrying amount becomes zero or negative.

The fair value of a reporting unit is determined on the basis of the reporting unit as a whole, not just the portion attributable to the parent (i.e., the controlling interest). That is, the entity calculates the full fair value of the reporting unit, including the portion attributable to the noncontrolling interest, when determining the fair value of a reporting unit. As a result, the entity compares the fair value of the reporting unit as a whole with its full carrying amount for the impairment test.

Under ASC 805, when an entity initially acquires a controlling, but less than 100 percent, interest in an acquiree, the acquirer recognizes the assets acquired, liabilities assumed, and any noncontrolling interests generally at their fair values and recognizes goodwill attributable to both the controlling and the noncontrolling interests. Before the adoption of FASB Statement 141(R) (codified in ASC 805), entities did not recognize the portion of goodwill attributable to the noncontrolling interest. Therefore, if an entity acquired a controlling, but less than 100 percent, interest before it adopted Statement 141(R), it would have only recognized the portion of goodwill attributable to the parent and therefore may have recorded less goodwill than it would have after adopting Statement 141(R) (ASC 805). As a result, additional “cushion” in the reporting unit could exist (i.e., the fair value of the reporting unit as a whole would have most likely exceeded the carrying amount if only a portion was “stepped up” in the acquisition). While the entity will still measure the fair value of the reporting unit on the basis of the reporting unit as a whole, if the entity calculates an impairment loss and the goodwill is only related to the parent (i.e., it was recorded before the adoption of Statement 141(R)), ASC 350-20-35-57A states that “the goodwill impairment loss would be attributed entirely to the parent.” If the goodwill is attributable to both the parent and the noncontrolling interest, “[a]ny impairment loss measured in the goodwill impairment test shall be attributed to the parent and the noncontrolling interest on a rational basis.” For more information about attributing goodwill impairment losses between the parent and the noncontrolling interest, see Section 6.2.2 of Deloitte’s Roadmap Noncontrolling Interests.