The private company alternative for goodwill

Private company goodwill vs public company goodwill

A private company acquires a business and recognizes goodwill of $1,000,000. Under the alternative, it amortizes $100,000 a year for 10 years. A public company recognizing the same goodwill amortizes nothing and tests the goodwill every year; its profit is $100,000 a year higher until an impairment, if any, arises.

A three-year example

A private company recognizes goodwill of $1,000,000 and elects the alternative. After two years of amortization, goodwill stands at $800,000. In year 3, the loss of a major customer is a triggering event. The company's fair value, tested at the entity level, is $200,000 below its carrying amount, so it recognizes a $200,000 impairment, leaving goodwill of $600,000, which it continues to amortize over the remaining 8 years at $75,000 a year.

How does the election affect financial ratios?

Amortization lowers net income and equity every year, but leaves EBITDA unchanged, since amortization is excluded from it. Lenders to private companies often measure covenants on EBITDA, so the election usually has little effect on covenant compliance, while avoiding the cost of annual valuations and the earnings shock of a sudden large impairment.

How is goodwill tested under the alternative?

Only when a triggering event occurs that indicates the fair value of the entity, or the reporting unit if that level is elected, may be below its carrying amount. Since a later update, private companies may also choose to assess triggering events only at the end of each reporting period rather than continuously during it. The test itself compares fair value with carrying amount, with an optional qualitative assessment first, and the loss is limited to the goodwill.

What related elections are available?

• Intangibles in a business combination: a private company may elect not to recognize separately customer-related intangible assets unless they can be sold or licensed independently, and noncompetition agreements, subsuming them into goodwill. Companies making this election must also amortize goodwill.
• Testing level: goodwill can be tested at the entity level rather than by reporting unit.

Who can use the private company alternative?

Entities that are not public business entities, including private companies and not-for-profit entities. A company that may go public, or be acquired by a public company, should consider that it would need to restate its financial statements without the alternative, which can be costly. The election is made as an accounting policy and applied to all existing and future goodwill. Moving back to the public company model later is a change in accounting principle that must be justified as preferable, so companies planning an IPO often avoid the election.

How is the amortization period chosen?

Ten years by default, which most electing companies use because it needs no further support, or a shorter period if the company can show another useful life is more appropriate, for example a business acquired for a technology with a short expected life. The period is chosen for each acquisition and can be revised downwards later, but the total cannot exceed 10 years.

How does IFRS compare?

Full IFRS never allows goodwill to be amortized. The IFRS for SMEs Accounting Standard, by contrast, amortizes goodwill over its useful life, using a period of no more than 10 years when the useful life cannot be estimated reliably. See ASC 350 explained and the goodwill impairment test.

This guide is general information. It is not tax or legal advice for your situation.