ACC 497 Week 3 Analyzing a Case With Acceptable Alternatives Example

Two Acceptable Answers to One Acquisition: Comparing Full GAAP With the Private Company Alternatives for Goodwill and Intangibles When a Composite Sign Maker Buys a Competitor

[Student Name]

University of Phoenix

ACC/497: Advanced Topics in Accounting Research

Week 3 Assignment

[Instructor Name]

[Date]

The sign maker, the acquired competitor and all figures are composites written for a model paper; standards and research findings come from the sources listed.

A composite company designs, fabricates and installs illuminated signs for retailers, hospitals and office parks. It is owned by two families and financed by a regional bank. In June it bought a smaller competitor with a strong base of hospital customers for $9.0 million in cash. The acquired company's tangible assets and liabilities had a net fair value of $3.6 million. When GAAP offers two acceptable answers, the research question changes from what the rule requires to which rule best serves the people who read these statements. This paper compares the two treatments available to the sign maker.

Full GAAP

Under the business combinations guidance, the buyer recognizes identifiable intangible assets at fair value separately from goodwill. An appraiser identified customer relationships with hospital systems valued at $2.4 million, with an estimated life of eight years, a three-year noncompete agreement with the seller valued at $0.3 million and the competitor's trade name, valued at $0.5 million and expected to be used for ten years. Goodwill is the remaining $2.2 million. Full GAAP leaves goodwill unamortized and requires an impairment test every year.

Annual amortization would be $300,000 for customer relationships, $100,000 for the noncompete for three years and $50,000 for the trade name, a total of $450,000 in each of the first three years and $350,000 thereafter, plus the cost of an annual goodwill impairment test.

The Private Company Alternatives

The Private Company Council developed alternatives adopted by the FASB. One lets a private company write goodwill off evenly across a period no longer than a decade and look at impairment only when a triggering event occurs (Financial Accounting Standards Board, 2014a). A second allows it to stop recognizing separately customer-related intangibles that cannot be sold or licensed independently of the business and noncompetition agreements, subsuming them into goodwill (Financial Accounting Standards Board, 2014b). A company electing the second must also elect the first.

The hospital customer relationships cannot be sold apart from the business, and the noncompete is covered by the second alternative, so both would be subsumed. The trade name could be sold or licensed, so it is still recognized. Goodwill becomes $9.0 million less $3.6 million less $0.5 million, or $4.9 million. Amortized over ten years, it produces $490,000 a year, plus $50,000 for the trade name, $540,000 in total, level for ten years.

Comparing the Effects

Annual amortization is $90,000 higher under the alternatives for the first three years and $190,000 higher in years four through eight. In years nine and ten, full GAAP expense falls to $50,000 while the alternatives continue at $540,000. Over ten years, total amortization is $5.4 million under the alternatives, compared with $3.2 million under full GAAP for the recognized intangibles, with $2.2 million of unamortized goodwill still on the balance sheet under full GAAP unless impaired. Under full GAAP, income is higher but carries the risk of a large impairment loss in a bad year; under the alternatives, expense is predictable, and goodwill steadily declines.

Presentation and Disclosure

Under either approach, the acquisition is described in a note with the purchase price, the assets acquired and liabilities assumed and the reasons for the acquisition. Under the alternatives, the note also states the elections, the amortization period for goodwill and the policy for evaluating triggering events. The balance sheet shows goodwill net of accumulated amortization. Because the elections apply to all future acquisitions as well, the note tells readers how later deals will be treated, which improves consistency from year to year.

Cost and Complexity

Full GAAP requires valuing each intangible separately at acquisition and testing goodwill every year, often with a valuation specialist. The alternatives reduce the valuation work at acquisition and replace annual testing with an assessment of triggering events. For a company of this size, the savings in fees and staff time are meaningful.

Users

The bank is the main outside user. The loan officer confirmed that the bank analyzes borrowers on cash flow and tangible net worth, excluding goodwill and intangibles, so the choice does not affect covenants. The owners prefer steady expense to an unpredictable impairment. Fields et al. (2001) reviewed research on accounting choice and noted that choices are often explained by contracting, asset pricing and information concerns; here, with no public investors and covenants unaffected, cost and predictability dominate.

Tax Is Unaffected

The choice does not change income taxes. For federal tax purposes, the purchase was structured as an asset acquisition, and the amount allocated to goodwill and other intangibles is amortized over fifteen years under the tax rules regardless of the book treatment. Either book method creates a temporary difference with tax amortization, and the deferred tax accounting follows whichever book method is chosen.

A Caution About the Future

The alternatives are available only while the company is not a public business entity. If the families later sold the company to a public buyer or took it public, the alternatives would have to be removed retrospectively, requiring the valuations that were skipped. The families have discussed a sale within ten years, most likely to a private equity firm, which would not by itself end eligibility.

Recommendation

The sign maker should elect both alternatives. The bank's analysis is unaffected, the owners value predictable expense and the company avoids recurring valuation costs. The policy note will describe the elections, and management will document the triggering-event assessment each year. Beatty and Weber (2006) found that managers' goodwill impairment decisions were influenced by debt contracts and compensation, and replacing annual testing with amortization reduces that room for discretion. If the owners decide to pursue a sale to a public company, the controller should revisit the choice before the next acquisition.

Conclusion

Both treatments are acceptable. Full GAAP reports $3.2 million of separate intangibles and $2.2 million of unamortized goodwill; the alternatives report a $0.5 million trade name and $4.9 million of goodwill amortized over ten years. For this private company, the alternatives better balance cost, predictability and users' needs.

References

Beatty, A., & Weber, J. (2006). Accounting discretion in fair value estimates: An examination of SFAS 142 goodwill impairments. Journal of Accounting Research, 44(2), 257-288. https://doi.org/10.1111/j.1475-679X.2006.00200.x

Fields, T. D., Lys, T. Z., & Vincent, L. (2001). Empirical research on accounting choice. Journal of Accounting and Economics, 31(1-3), 255-307. https://doi.org/10.1016/S0165-4101(01)00028-3

Financial Accounting Standards Board. (2014a). Intangibles, goodwill and other (Topic 350): Accounting for goodwill (a consensus of the Private Company Council) (Accounting Standards Update No. 2014-02).

Financial Accounting Standards Board. (2014b). Business combinations (Topic 805): Accounting for identifiable intangible assets in a business combination (a consensus of the Private Company Council) (Accounting Standards Update No. 2014-18).