Internet Appendix: Industry Insights on Goodwill Accounting

Financial reporting changes and the internal information environment: evidence from SFAS 142 (Cheng, Cho, and Yang 2017)

Internet appendix: industry insights on goodwill accounting

This appendix provides a detailed summary of the insights obtained from a series of interviews we conducted with seven executives and four auditors. The executives, including two CFOs, are from two large banks and two large public companies located in Singapore, and all handle goodwill impairment tests for their respective corporations. The auditors, two of whom are partners, are from two Big Four accounting firms and have vast experience working with their clients on goodwill impairment tests. We first discuss, as described by the executives, how they approach goodwill impairment tests. We next summarize the interviewees’ perceived differences between the current and previous accounting treatment for goodwill. We then discuss the key challenges the practitioners face in approaching current goodwill accounting standards, before concluding with the auditors’ perspectives.

1.Overall, all the executives we interviewed agreed that their firms’ senior management is involved in the process, and some indicated that they use the same inputs for their internal budgeting and goodwill impairment testing.

One CFO describes the process as follows. “For our impairment tests, we use the discounted cash flow method. We try to be as specific as we can by using the growth rate of the specific model. … And then the discounted cash flow is [based on] the WACC of the business we have. We calculate the WACC on a regular basis so this data is there anyways, and we take the last quarter’s WACC as our discount factor.”
Another CFO says: “We go through quite a rigorous process to determine the terminal growth rate as well as our discount rate. We will do some research in terms of obtaining beta, the country-specific risk-free rate, etc. We collaborate with some external evidence and work with our advisers, be it the accounting firms or some of our bankers. When it comes to the terminal growth rate, we use the DCF model but the difficulty is the availability of data for a specific country or location. We need data for the next 20 or 30 years so we get various forms of data from World Bank, World ECD, etc.…The process is never a story of when we sit down and clear with the business unit and the CEO and after five minutes it is done. They will always try to challenge, push back, so on and so forth. Then subsequently, once we have the model run through various levels of challenges, we share it with our auditors. And the auditors will be another set of challenges.”

The interviewed executives comment that good governance is important for a rigorous goodwill impairment test.

One interviewed CFO comments: “We always emphasize the board of the company has approved this [valuation], and the independent board has approved this.”
When emphasizing the importance of governance, one of the interviewed audit partner says: “There are other people in the organization [with whom] you can share your views, have those conversations. There’s always the board; there’s always the audit committee.”

While firms are required to do the test at least once a year, typically in the fourth quarter, some firms do it quarterly. For example, two interviewed executives share the following.

“This is a fairly regular exercise that we do minimally once a year, but we try to do it quarterly because every quarter we announce results.”
“Every quarter we have to do the test already, but, at the end of the year, we do a more detailed reading.”

2.In terms of the perceived differences between the current and previous accounting regime, the interviewees generally agreed that the impairment test required under SFAS 142 is more rigorous and takes more time and effort. However, they view it as a good exercise that helps discipline the organization to provide more rigorous estimates, though it requires a lot of discretion and they do face more scrutiny from the auditors.

One CFO describes goodwill impairment test under the old regime: “When the standard didn’t require this [annual test], we still did DCF, but we were less concerned about the goodwill, because we always justified it. Because we always say the goodwill is there and in the short-term, because of this reason or that, the cash flows are not there, but it will come. And you know, we make excuses not to impair goodwill.”
He continues to describe goodwill impairment test under the new regime: “I think the impairment exercise is a very good discipline, it’s a necessary discipline. And it forces the companies to go through that exercise. You’re right that there’s a lot of judgment call, but at the end of the day, these are all subject to audit, so if the auditors don’t agree with the discount rates you use, they will come back and challenge you. And we have been challenged many times by the auditors.”
In terms of interactions with auditors, one executive says: “I think when people talk about how auditors might come in to look for this, we tend to take it quite seriously because auditors’ reports and whatever will flag out to the regulators and all. …Anything the auditors challenged or raised, we will have to make sure that we are comfortable with whatever we are doing. We have to address that point properly. So obviously if they raised certain concerns, then we will have to go back to the team who prepares it, and try to understand, fit in or provide the comment back, and see how we can actually make it better or more accurate.”

The executives view goodwill impairment test as a disciplinary tool that reminds companies to be more careful in M&A decisions.

One interviewed CFO considers the annual review of the fair value of goodwill as valuable. “I personally feel that it is valuable. The reason I say so is because it forces management to look again at whether the investment that has been made continues to be able to generate the value that was envisaged at the point of transaction.”
Another interviewed CFO comments: “Overall, I think you must have that discipline of impairment. It’s something that forces companies to know that, if I’m going to do this impairment exercise every quarter, I’d better make sure my acquisition is sound.”

3.However, managers also expressed their challenges in complying with the current goodwill accounting standards, indicating that significant judgment is required in coming up with the estimates and ensuring the assumptions are justifiable.

One interviewedbank executive discusses the difficult conversation at the management level when there’s an impairment required. “These numbers are large and the decisions are made at the senior management level, where they will have to make a call on balancing the accuracy of the numbers versus the knock on our capital. Obviously there’s a lot of judgment, and if you tweak your projections by a certain amount, then the number could change. They would need to decide within what range do they feel comfortable, and it’s not a precise number that you come down to. It’s like within the range that is acceptable and required by the accounting standards but yet does not significantly impact our Tier 1 or Tier 2 capital.”
One interviewed CFO provides an example of how, given the discretion in the standards, they chose to impair all of the goodwill for one of their units. “In my business, if I run my business well, I would add to the goodwill. For example, with my business in London, I paid 200 million of goodwill at that time. …I actually wrote it off one time because I could afford to. Having said that, I still think from an accounting point of view that was the wrong thing to do. If I sell my London business today, I could make at least 2 to 2.5 times of goodwill.”
Auditors recognize this issue. As one auditor partner comments, “Sometimes, it’s a timing issue where everyone is writing off. This is the time to do the kitchen sink, so you weight the cost and effort, and it’s clear in the market when I invested it was peak in the market, but now the cycle is here, there’s no way to justify, so why spend the effort? If I clean it off, then I don’t have this thing to worry about.”

4.Overall, auditors believe SFAS 142 has changed the nature of the discussion with clients and that there is variation in their clients’ ability in carrying out the impairment process, due to differences in client size, experience with goodwill, and management philosophy.

One audit partner describes the process as a journey. “In the old regime, even if there is an indicator of impairment, the magnitude of the impairment tends to be smaller, because you had the benefit of amortizing it for a couple years. … So does that conversation change because we changed the accounting standards? To me, definitely, because you don’t amortize, your risk of impairment is higher, or the charge is higher, and therefore the conversation with our clients will change.”
As another audit partner puts it: “The issue we face is that some preparers do not have the resources or the skillsets or the knowledge to actually provide a robust discounted cash flow. If you were to do it correctly, you would involve a very detailed discussion with the sales and business people, but typically this is done by the finance team who may not have all the information necessary to provide a rigorous support. ... We only look at how they come up with that. Is there any publication or empirical evidence to support that? If so, we are very happy you have evidence. If not, we can’t say the client is wrong. So it’s very challenging, and you are in a very hard space.”
The clients also find the information provided by the auditors useful. “The clients do look towards us for some industry insights. Which is why we are organized by sector, so we can give a value-add to our clients.”
Another auditor comments: “They will consider [our information], because it is one source of information that they will consider, and say whether that is something that would be reasonable to take on.”
Auditors note that not all preparers are equally capable of conducting a rigorous goodwill impairment test. As noted by one of the interviewed audit partners, “I could even say that, even though the standard has been around for quite some time, there’s still diversity in competency of people doing the test.”
Similarly, one audit partner notes that smaller or inexperienced businesses benefit the most from the process. “Small companies tend to struggle a little, and they do need help… So it’s an education process but we have to be very careful because we are auditors, and it’s against our own rules when the client says I put this impairment because the auditors tell us to.”