auditing fair value measurements and … fair value measurements and disclosures: allocations of the...

AUDITING FAIR VALUE MEASUREMENTS AND DISCLOSURES:

ALLOCATIONS OF THE PURCHASE PRICE UNDER FASB

STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 141, BUSINESS COMBINATIONS, AND TESTS OF IMPAIRMENT UNDER

FASB STATEMENTS NO. 142, GOODWILL AND OTHER INTANGIBLE ASSETS, AND NO. 144, ACCOUNTING FOR THE

IMPAIRMENT OR DISPOSAL OF LONG-LIVED ASSETS

A TOOLKIT FOR AUDITORS

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Excerpts from FASB Statements No. 141, Business Combinations, No. 142, Goodwill and Other Intangible Assets, No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, Concepts Statement No. 6, Elements of Financial Statements, and Emerging Issues Task Force Issue No. 95-3, “Recognition of Liabilities in Connection with a Purchase Business Combination," copyright by Financial Accounting Standards Board, 401 Merritt 7, Norwalk, CT 06857, are reproduced by permission. Complete copies of the documents can be obtained from the FASB (www.fasb.org).

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Notice to Readers

This publication, Auditing Fair Value Measurements and Disclosures: Allocations of the Purchase Price Under FASB Statement of Financial Accounting Standards No. 141, Business Combinations, and Tests of Impairment Under FASB Statements No. 142, Goodwill and Other Intangible Assets, and No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, presents recommendations on the application of generally accepted auditing standards to audits of financial statements that recognize fair value measurements under the referenced accounting standards. The guidance on auditing fair value measurements in those circumstances is illustrated in this publication principally through discussions of its application in a business combination, as many concepts and principles are revealed in this common business situation. In addition to illustrating the application of guidance on auditing fair value in a business combination, the concepts and procedures described herein may be useful when auditing goodwill and other intangible assets accounted for under Financial Accounting Standards Board (FASB) Statement No. 142 and when auditing impairment or disposal of assets accounted for under FASB Statement No. 144. Therefore, the illustrative audit program in Appendix III and illustrative disclosure checklist in Appendix IV cover FASB Statements No. 142 and No. 144 in addition to FASB Statement No. 141. Additionally, Appendix V and Appendix VI provide an overview of FASB Statements No. 141 and No. 144 and discuss certain auditing considerations. The auditing guidance in this publication is an Other Auditing Publication as such is defined in Statement on Auditing Standards (SAS) No. 95, Generally Accepted Auditing Standards (AICPA, Professional Standards, vol. 1, AU sec. 150). Other Auditing Publications have no authoritative status; however, they may help the auditor understand and apply SASs. If an auditor applies the auditing guidance included in an Other Auditing Publication, he or she should be satisfied that, in his or her judgment, it is both appropriate and relevant to the circumstances of his or her audit. The auditing guidance in this publication has been reviewed by the AICPA Audit and Attest Standards staff and is presumed to be appropriate. This publication has not been approved, disapproved, or otherwise acted upon by any senior technical committee of the AICPA or the FASB and, as previously indicated, has no authoritative status.

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FASB Statement No. 141 Auditing Guidance Task Force Lynford E. Graham, Chair James S. Rigby, Jr. Greg Bailes Francis E. Scheuerell, Jr.

AICPA Staff Gretchen Fischbach Charles E. Landes Technical Manager Director Audit and Attest Standards Audit and Attest Standards We wish to acknowledge that this publication draws from the following AICPA publications: • Professional Issues Task Force, Practice Alert No. 2002–02, Use of

Specialists • AICPA Practice Aid Assets Acquired in a Business Combination to Be Used

in Research and Development Activities: A Focus on Software, Electronic Devices, and Pharmaceutical Industries

The Task Force gratefully acknowledges the contributions of James S. Gerson and John P. Brolly. The Task Force also acknowledges the following individuals whose technical review and comments contributed to the development of this publication: Brad Mescher, Herb Schulken, R. Scott Blackley, Susan L. Menelaides, Carl L. Williams, III, Steven L. Schenbeck, William F. Messier, Jr., Marc Simon, Neil J. Beaton, James Feldman, David R. Noonan, and Fred Widmann.

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INTRODUCTION AND OVERVIEW....................................................................................................... 1

FAIR VALUE CONCEPT IN FASB STATEMENT NO. 141.................................................................. 2

RESPONSIBILITY FOR FAIR VALUE MEASUREMENTS AND DISCLOSURES.......................... 2 Management’s Responsibility for Making the Fair Value Measurements and Disclosures..................................................................................................................................................... 2 Auditor’s Responsibility for Evaluating Conformity of Fair Value Measurements and Disclosures With GAAP............................................................................................................ 3

AUDIT PLANNING CONSIDERATIONS................................................................................................ 3 Knowledge of the Business ..................................................................................................... 3 Risk Assessment....................................................................................................................... 5 Timing Considerations ............................................................................................................. 7 Auditor Experience Considerations........................................................................................ 8 Use of a Valuation Specialist ................................................................................................... 9

SUBSTANTIVE TESTING OF FAIR VALUE MEASUREMENTS AND DISCLOSURES.............. 14 General ..................................................................................................................................... 14 Testing Significant Assumptions, Valuation Model, and Underlying Data ....................... 15 Developing Independent Fair Value Estimates for Corroborative Purposes.................... 18 Reviewing Subsequent Events and Transactions ............................................................... 18 Consistency ............................................................................................................................. 19 Disclosures in the Financial Statements of the Combined Entity ..................................... 19 Evaluating Results of Procedures Performed...................................................................... 20

COMMUNICATIONS............................................................................................................................... 21 Management Representations ............................................................................................... 21 Communication With Audit Committees .............................................................................. 22

REPORTING CONSIDERATIONS......................................................................................................... 22 Reliance on the Work of the Specialist ................................................................................. 23 Scope Limitations ................................................................................................................... 23 GAAP Departures.................................................................................................................... 25

OTHER CONSIDERATIONS .................................................................................................................. 25 Auditor’s Responsibility for Information in Documents Containing Audited Financial Statements ............................................................................................................................... 25 Interim Period Reporting ........................................................................................................ 26

APPENDIX I: VALUATION APPROACHES TO ESTIMATING FAIR VALUE................................ 28

APPENDIX II: ILLUSTRATIVE CHECKLIST FOR BUSINESS COMBINATIONS ........................ 38

APPENDIX III: ILLUSTRATIVE AUDIT PROCEDURES FOR AUDITING UNDER FASB STATEMENT NO. 141, BUSINESS COMBINATIONS; FASB STATEMENT NO. 142, GOODWILL AND OTHER INTANGIBLE ASSETS; AND FASB STATEMENT NO. 144, ACCOUNTING FOR THE IMPAIRMENT OR DISPOSAL OF LONG-LIVED ASSETS................. 60

APPENDIX IV: DISCLOSURE CHECKLIST: FASB STATEMENT NO. 141, BUSINESS COMBINATIONS; FASB STATEMENT NO. 142, GOODWILL AND OTHER INTANGIBLE

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ASSETS; AND FASB STATEMENT NO. 144, ACCOUNTING FOR THE IMPAIRMENT OR DISPOSAL OF LONG-LIVED ASSETS ................................................................................................ 77

APPENDIX V: IMPAIRMENT OF LONG-LIVED ASSETS TO BE HELD AND USED .................. 93

APPENDIX VI: IMPAIRMENT OF GOODWILL.................................................................................... 99

APPENDIX VII: MANAGEMENT CONSIDERATIONS WHEN ENGAGING A VALUATION SPECIALIST ............................................................................................................................................ 103

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INTRODUCTION AND OVERVIEW 1. Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 141, Business Combinations, addresses financial accounting and reporting for business combinations. All business combinations within the scope of the Statement are accounted for using the purchase method. FASB Statement No. 141 requires the acquiring entity to, among other things, determine the cost of the acquired entity (that is, the purchase price) and to assign that cost to the assets acquired and liabilities assumed on the basis of their fair values.1 2. When financial statements under audit recognize the effects of a business combination, the auditor should obtain sufficient competent audit evidence to provide reasonable assurance that the fair value measurements relating to the assets acquired in the business combination and the related disclosures in the financial statements are in conformity with generally accepted accounting principles (GAAP). The AICPA’s Auditing Standards Board has approved for issuance Statement on Auditing Standards (SAS) No. 101, Auditing Fair Value Measurements and Disclosures.2 The guidance in the SAS is general in nature and not intended to address auditing considerations relating to specific types of assets, liabilities, components of equity, transactions, or industry-specific practices. This publication provides guidance on auditing fair value measurements and disclosures when the financial statements report the effects of a business combination accounted for as required by FASB Statement No. 141. That auditing guidance is based on SAS No. 101. 3. Given the complexity associated with estimating the fair values of the assets and liabilities of the acquired entity, the acquiring entity often engages or employs a valuation specialist. Among other things, the specialist should be an individual with skills and experience in developing fair value measurement estimates. This publication contains guidance to help auditors evaluate the qualifications of the valuation specialist who estimates the fair value of assets acquired and liabilities assumed in a business combination. The publication also will help auditors apply the auditing guidance in SAS No. 73, Using the Work of a Specialist (AICPA, Professional Standards, vol. 1, AU sec. 336).

1 It is not the intent of this publication to provide a comprehensive discussion of, or implementation guidance relating to, the accounting requirements in Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 141, Business Combinations. Readers should refer to FASB Statement No.141 for an understanding of all of the applicable requirements of that standard. 2 Statement on Auditing Standards (SAS) No. 101, Auditing Fair Value Measurements and Disclosures, is effective for audits of financial statements for periods beginning on or after June 15, 2003. Earlier application is permitted.

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FAIR VALUE CONCEPT IN FASB STATEMENT NO. 141 4. FASB Statement No. 141, defines the fair value of an asset (liability) as “the amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale.” Although GAAP may not prescribe the method for measuring the fair value of an item, it expresses a preference for the use of observable market prices to make that determination. In the absence of observable market prices, GAAP requires fair value to be based on the best information available in the circumstances. 5. The measurement of fair value may be relatively simple for certain assets or liabilities such as, for example, investments that are bought and sold in active markets that provide readily available and reliable information on the prices at which actual exchanges have occurred. However, the measurement of fair value for other assets or liabilities acquired may be more complex. For example, some intangible and other assets may not have an observable market price or may possess such characteristics that it becomes necessary for management to estimate its fair value based on the best information available in the circumstances. Those estimates of fair value are inherently imprecise. That is because, among other things, the estimates may be based on assumptions about future conditions, transactions, or events whose outcome is uncertain and will therefore be subject to change over time.

RESPONSIBILITY FOR FAIR VALUE MEASUREMENTS AND DISCLOSURES 6. Among other things, SAS No. 101 defines the responsibilities of management and the auditor with respect to fair value measurements and disclosures. Management’s Responsibility for Making the Fair Value Measurements and Disclosures 7. SAS No. 101 states that management is responsible for making the fair value measurements and disclosures included in the financial statements. In connection with that responsibility, management needs to establish an accounting and financial reporting process for determining the fair value measurements and disclosures, select appropriate valuation methods, identify and adequately support any significant assumptions used, prepare the valuation, and ensure that the presentation and disclosure of the fair value measurements are in accordance with GAAP. 8. Management may engage or employ a valuation specialist to determine the fair values of assets acquired in a business combination. In that situation,

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management is responsible for evaluating the specialist’s qualifications to determine that the specialist has the necessary skills or knowledge to perform the subject valuation. Auditor’s Responsibility for Evaluating Conformity of Fair Value Measurements and Disclosures With GAAP 9. The auditor should evaluate whether management’s fair value measurements and disclosures, and the allocation of the acquisition cost relating to the business combination are in conformity with FASB Statement No. 141 and any other applicable GAAP. The auditor makes that evaluation based on the: a. Understanding of the requirements of FASB Statement No. 141 and

any other applicable GAAP b. Knowledge of the business acquired and industry in which it operates c. Results of audit procedures performed to test the fair value

measurement of assets acquired or liabilities assumed d. Results of other audit procedures 10. An acquiring entity may engage or employ a valuation specialist to estimate the fair value of certain assets acquired and liabilities assumed. The auditor may choose to use that specialist’s work as audit evidence when performing substantive tests of management’s fair value estimates. Paragraphs 33, 34, and 46 through 49 of this publication discuss matters the auditor considers when evaluating the qualifications and objectivity of the specialist management engages or employs. Paragraphs 50 through 75 contain guidance on testing management’s fair value measurements, including those based on the work of the valuation specialist. 11. As part of the substantive testing, the auditor also may engage or employ a valuation specialist to evaluate the work of management’s valuation specialist. Paragraphs 35 through 37 of this publication discuss matters to consider when evaluating the qualifications and objectivity of the specialist the auditor engages or employs. SAS No. 73 provides general guidance to the auditor on using the findings of a specialist he or she engages or employs.

AUDIT PLANNING CONSIDERATIONS Knowledge of the Business 12. SAS No. 22, Planning and Supervision (AICPA, Professional Standards, vol. 1, AU 311.06), states:

The auditor should obtain a level of knowledge of the entity’s business that will enable him [or her] to plan and perform [the] audit in accordance with generally accepted auditing standards. That level of knowledge should enable [the auditor] to

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obtain an understanding of the events, transactions, and practices that, in [the auditor’s] judgment, may have a significant effect on the financial statements.

Knowledge of the Acquiring Entity’s Business 13. The auditor should obtain a knowledge of the acquiring entity’s business that includes, for example, the types of products and services sold by the business and its production, marketing, distribution, and compensation methods. Auditors also should consider matters and trends affecting the industry in which the acquiring entity operates, such as economic conditions, changes in technology, government regulations, and competitive conditions (including specific current and potential competitors), to the extent they may have an effect on the financial statements being audited. Knowledge of the Acquisition 14. If a business combination has occurred or is contemplated before period end, the auditor should obtain an understanding of the nature and business purpose of the acquisition. This knowledge should be sufficient to enable the auditor to evaluate whether the amounts and disclosures in the financial statements properly report the substance of the underlying business combination. For example, if the business purpose of the acquisition is primarily to obtain access to the acquired entity’s existing products and intellectual property, workforce, and customer lists, but still meets the definition of a business under Emerging Issues Task Force (EITF) Issue No. 98-3, “Determining Whether a Nonmonetary Transaction Involves Receipt of Productive Assets or of a Business,” the auditor would not expect that a significant portion of the purchase price would be allocated to acquired in-process research and development (IPR&D). Nevertheless, all assets acquired and liabilities assumed that have significant value would be considered in the allocation. The understanding also may help the auditor identify matters for which he or she may want to obtain specific audit evidence. 15. The auditor may obtain the understanding of the acquisition by: a. Making inquiries of the chief executive officer; the chief financial officer;

representatives of the acquiring entity’s marketing, business development, research and development or technology departments; and of other personnel familiar with the acquisition.

The auditor’s inquiries of the above parties should provide information about the following items: • Customer base • Markets served by the entity and those it would like to serve • Competitive conditions • Regulatory requirements • Sensitivity to economic conditions

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• Product or service line(s) • Historical and existing product lifecycles and changes in volumes and

average selling prices over those lifecycles • Manufacturing capabilities • Distribution capabilities • Management team • Base (or core) technology • Future products and dependency of future products on base (or core)

technology • Management’s technology development plans • Capabilities of personnel to conduct research and development

This listing is not meant to be all-inclusive. It is designed to illustrate the type of knowledge that will help the auditor design effective substantive audit procedures.

b. Reading and understanding the terms of acquisition agreements, due

diligence reports, acquired entity prospectuses or offering memoranda, analysts’ reports, appraisals, board minutes and other related board materials, and preacquisition disclosures made by the acquired entity.

Risk Assessment 16. SAS No. 47, Audit Risk and Materiality in Conducting an Audit (AICPA, Professional Standards, vol. 1, AU sec. 312.12), states that “the auditor should consider audit risk and materiality both in (a) planning the audit and designing audit procedures, and (b) evaluating whether the financial statements taken as a whole are presented fairly, in all material respects, in conformity with generally accepted accounting principles.” 17. The auditor assesses the risk of material misstatement (whether caused by error or fraud) during planning. The risk of material misstatement of fair value measurements of assets acquired or liabilities assumed in a business combination varies with, among other things, the reliability of management’s measurement process. The reliability of the measurement process in turn varies with the degree of uncertainty associated with the fair value estimate. Complex fair value measurements normally are characterized by greater uncertainty regarding the reliability of the measurement process. This greater uncertainty may be a result of:

• The length of the forecast period • The number of significant and complex assumptions associated with the

process • A higher degree of subjectivity associated with the assumptions and factors

used in the process • A higher degree of uncertainty associated with the future occurrence or

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outcome of events underlying the assumptions used • Lack of objective data when highly subjective factors are used 18. SAS No. 55, Consideration of Internal Control in a Financial Statement Audit (AICPA, Professional Standards, vol. 1, AU sec. 319), as amended, requires the auditor to obtain a sufficient understanding of internal control to plan the audit. In the context of fair value measurements and disclosures, the auditor obtains an understanding of the process relating to the determination of those measurements and disclosures. 19. When obtaining the understanding of the entity’s process for determining fair value measurements and disclosures relating to assets acquired and liabilities assumed in a business combination, the auditor considers, for example: • Controls over the process used to determine fair value measurements,

including, for example, controls over data and the segregation of duties between those committing the entity to the underlying transactions and those responsible for undertaking the valuations.

• The expertise and experience of those persons determining the fair value measurements.

• The role that information technology has in the process. • The types of accounts or transactions requiring fair value measurements or

disclosures (for example, whether the accounts arise from the recording of routine and recurring transactions or whether they arise from nonroutine or unusual transactions).

• The extent to which the entity’s process relies on a service organization to provide fair value measurements or the data that supports the measurement. When an entity uses a service organization, the auditor considers the requirements of SAS No. 70, Service Organizations (AICPA, Professional Standards, vol. 1, AU sec. 324).

• The extent to which the entity engages or employs specialists in determining fair value measurements and disclosures.

• The significant management assumptions used in determining fair value. • The documentation supporting management’s assumptions. • The process used to develop and apply management assumptions, including

whether management used available market information to develop the assumptions.

• The process used to monitor changes in management’s assumptions. • The integrity of change controls and security procedures for valuation models

and relevant information systems, including approval processes. • The controls over the consistency, timeliness, and reliability of the data used

in valuation models. 20. Based on the understanding of the entity’s process, the auditor assesses control risk. The control risk assessment is the process of evaluating

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the extent to which internal control may be relied upon in designing substantive tests. Based on the assessment of the risk of material misstatement and of control risk, the auditor determines the nature, timing, and extent of substantive audit procedures. 21. SAS No. 55 discusses the inherent limitations of internal control. Fair value estimates often involve subjective judgments by management. This may affect the nature of controls that are capable of being implemented and thus may increase the possibility of management override of controls (see SAS No. 99, Consideration of Fraud in a Financial Statement Audit [AICPA, Professional Standards, vol. 1, AU sec. 316]). For example, pressure to meet future earnings expectations of analysts or other external parties may provide incentives for management to intentionally misstate the fair value of assets acquired and liabilities assumed in a business combination. Therefore, the auditor also uses the understanding of the acquiring entity and its environment when assessing the risk of a material misstatement. 22. The auditor’s risk assessment is a continuous process. At any time during the audit (for example, while performing client acceptance or continuance procedures, or during engagement planning) the auditor may become aware of a business combination. That fact may alter the auditor’s judgment about the levels of inherent and control risks; his or her preliminary judgment about materiality; and consequently the nature, timing, and extent of audit procedures. In that situation, the auditor may wish to reevaluate the nature, timing, and extent of audit procedures that he or she plans to apply. Timing Considerations 23. If the auditor plans to use the work of management’s valuation specialist (either engaged or employed by management) as audit evidence in performing substantive tests, the auditor should consider performing procedures to identify any issues or concerns with the qualifications or objectivity of the valuation specialist or with the valuation methodology or assumptions. If the acquisition has not been consummated at the commencement of audit planning, the auditor can perform the following procedures before the valuation specialist completes the valuation: • Evaluate the professional qualifications of the valuation specialist (see

paragraphs 33 and 34). • Obtain an understanding of the nature of the work performed or to be

performed by the specialist (see paragraphs 38 through 42)

24. If the business combination was consummated before audit planning, the auditor also should plan to perform audit procedures relating to the fair value measurement of assets acquired and liabilities assumed in that business

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combination and allocation of the purchase price as early as possible during the audit (preferably during the process or soon after the business combination is consummated). This will enable timely resolution of any issues relating to that allocation, including the allocation of the purchase price to intangible assets and goodwill. In this regard, the auditor understands the requirements of paragraph 39 of FASB Statement No. 141. 25. An acquiring entity may effect a business combination at or near the end of a reporting period. Therefore, the valuation specialist may be unable to complete the valuation before the issuance of the financial statements. The specialist may, however, make a tentative allocation of the purchase price using the values that have been determined and preliminary estimates of the fair values that have not yet been finalized. In that case, the auditor should ascertain that a valuation specialist has been engaged and expects to complete the valuation study within a reasonable period of time subsequent to the acquisition. The auditor also should consider this matter during the risk assessment process, when evaluating the sufficiency of audit evidence, and when considering the reasonableness and appropriateness of the financial statement disclosures as well as the type of audit report to issue (see paragraph 74). If the purchase price allocation is not complete by the time the acquiring entity issues its financial statements, the auditor should determine that the notes to the financial statements disclose that fact as required by paragraph 51(h) of FASB Statement No. 141. Auditor Experience Considerations 26. Auditing complex fair value measurements relating to business combinations may require the assignment of more experienced auditors and more extensive supervision. Generally accepted auditing standards (GAAS) require that audit team members be assigned to tasks and supervised commensurate with their level of knowledge, skill, and ability so they can evaluate the audit evidence they are examining. When auditing financial statements reporting the effects of a business combination accounted for under FASB Statement No. 141, the auditor should possess a level of knowledge of the acquisition and the acquiring entity’s business and its operating characteristics sufficient to understand the events, transactions, and practices that may have a significant effect on the fair value measurements and disclosures, and the allocation of the acquisition costs. 27. Best practices suggest that senior engagement team personnel should design the substantive procedures relating to valuation method and the assumptions underlying the method. The extent of involvement by the audit partner and manager generally depends on:

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• The experience of the personnel who will be performing the substantive procedures.

• The complexity of the acquired and acquiring entities’ businesses. • The significance of the acquisition in relation to the financial statements taken

as a whole. • The auditor’s assessment of the risk of material misstatement due to error or

fraud (see paragraphs 16 through 22). 28. The auditor should consider whether expertise is available within his or her firm to evaluate the valuation methodology. If the expertise is not available within the firm, best practices suggest that the auditor should engage the services of a valuation specialist to assist in that evaluation process. Use of a Valuation Specialist 29. Specialists typically are engaged in the following ways: • Management engages or employs a valuation specialist and the auditor uses

that specialist’s work as audit evidence in performing substantive tests to evaluate the allocation of purchase price.

• The auditor engages a valuation specialist to assist the auditor in evaluating

the valuation performed by the acquiring entity ’s valuation specialist. 30. Given the complexity associated with estimating the fair value of the assets acquired and liabilities assumed of the acquired entity, the acquiring entity often engages an outside valuation specialist. In the atypical situation in which the acquiring entity (a) is experienced in accounting for acquisitions and (b) is competent in selecting and applying an appropriate approach and using valuation methods to estimate the fair value of assets acquired and liabilities assumed in a business combination, the acquiring entity may conclude that it can use an in-house valuation specialist rather than engage an outside specialist. In that situation, the auditor performs the same procedures that he or she would perform had the valuation been performed by an outside specialist (see paragraphs 33 and 34, and 38 through 42). 31. The auditor may have sufficient expertise to evaluate the findings of management’s valuation specialist. However, it is sometimes necessary for auditors to engage or employ a valuation specialist to perform that evaluation, especially when the acquisition has a material effect on the entity 's financial statements.

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32. Regardless of whether management or the auditor engages or employs a valuation specialist, the auditor should follow the guidance provided in SAS No. 73 (AU sec. 336.08–.11) to: • Evaluate the professional qualifications of the valuation specialist. • Obtain an understanding of the nature of the work performed or to be

performed by the valuation specialist. Evaluating the Professional Qualifications of the Valuation Specialist Engaged or Employed by Management 33. The auditor should evaluate the valuation specialist’s qualifications to determine that the specialist has or had the necessary skills or knowledge to estimate the fair value of tangible and intangible assets acquired and liabilities assumed in a business combination.3 In evaluating the qualifications of the valuation specialist engaged or employed by management to value such assets, the auditor considers the following: • The professional certification, license, or other recognition of the competence

of the specialist in his or her field. Specifically, whether the specialist possesses an accreditation in valuation issued by a recognized body, such as the AICPA, the American Society of Appraisers, the Institute of Business Appraisers, or the National Association of Certified Valuation Analysts.

• The reputation and standing of the specialist in the views of peers and others

familiar with the specialist’s capability or performance. • The specialist’s level of experience with fair value measurements of tangible

and intangible assets acquired and liabilities assumed in a business combination.4

• The specialist’s level of experience in the acquired entity’s industry or the

level of knowledge of that industry. 34. The auditor may be unable to determine whether management’s valuation specialist has or had the necessary skills or knowledge to perform the

3 The auditor evaluates the specialist’s qualifications for the purpose of deciding whether to use the specialist’s work as audit evidence in performing substantive tests designed to evaluate material financial statement assertions. 4 Valuations performed for purposes of determining the fair value of financial statement items in accordance with generally accepted accounting principles (GAAP) require skills not required when performing other types of valuations. Some valuation professionals consider valuations performed for such purposes to be a specialty within the valuation profession and refer to a valuation specialist who performs those valuations as a “fair value measurement specialist.”

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valuation. In that situation, the auditor should discuss with the appropriate acquiring entity management the possibility of engaging a different specialist. Evaluating the Professional Qualifications of the Valuation Specialist Engaged or Employed by the Auditor 35. The auditor also may use a valuation specialist to evaluate the findings of the acquiring entity’s valuation specialist. The valuation specialist the auditor uses may be an outside specialist or a specialist employed by the auditor’s firm. 36. When the auditor engages an outside specialist, the auditor evaluates the specialist’s qualifications as discussed in paragraphs 33 and 34. The auditor generally would be aware of the qualifications of a specialist employed by the audit firm. However, the auditor considers that an internal specialist is subject to the firm's requirements with respect to independence. Also, the auditor should consider which auditing standard applies to the use of the audit firm specialist (see paragraph 37). 37. If the specialist is effectively functioning as a member of the audit engagement team, SAS No. 73 does not apply. SAS No. 22 applies in that situation because the specialist requires the same supervision and review as other assistants. For example, if a specialist is used to perform procedures as part of the engagement team, such as performing computer-assisted audit techniques, then SAS No. 22 applies. However, if the client engages the audit firm's valuation department to fair value the assets acquired and liabilities assumed in a business combination, and the auditor subsequently utilized that work, the specialist is not a member of the engagement team and the auditor should follow the guidance in paragraphs 33 and 34.5 Understanding the Nature of the Work of Management’s Specialist 38. Once the auditor is satisfied with the qualifications of the specialist management engaged or employs, the auditor should obtain an understanding of the nature of the work performed or to be performed by that specialist. The auditor can obtain the understanding in many ways, including reading the specialist’s valuation report (draft, preliminary, or final) and professional literature dealing with the subject specialty, discussing the subject with other auditors who have performed similar engagements in the same field, discussing the subject

5 The Sarbanes-Oxley Act of 2002 prohibits an auditor of a public company from performing for an audit client certain nonaudit services, including valuation services. Additionally, auditors who are members of the AICPA and are not auditing public companies should be familiar with Interpretation 101-3, “Performance of Other Services,” of Rule 101, Independence, of the AICPA’s Code of Professional Conduct (AICPA, Professional Standards, vol. 2). Auditors are advised to stay abreast of changes to the AICPA’s Code of Conduct and in regulations or legislation that are applicable to them and that may prohibit certain nonaudit services, including valuation services.

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with the specialist or with other specialists, and attending relevant seminars on the subject. 39. Regardless of how the auditor obtains the understanding, the auditor should: • Understand the objective and scope of the specialist’s work.

• Evaluate the specialist’s understanding of the GAAP definition of fair value

relating to the specific item valuation. • Understand the methods or assumptions used or to be used as well as any

nonclient data that the specialist intends to use. • Identify the data to be supplied by the client to the specialist, so the auditor is

aware of what may need to be subjected to audit testing. • Compare the current methods and significant assumptions with the methods

and assumptions used in valuations of assets acquired in previous valuations (or business combinations).6

• Evaluate any restrictions on the specialist's access to necessary key entity

personnel, records, or files. • Evaluate the valuation specialist’s understanding that the valuation findings

will be used by the auditor to evaluate the related assertions in the financial statements.

• Consider the anticipated timing of the availability of the valuation conclusions

and written report. Identify in advance, if possible, timing issues that might affect timely reporting and auditing of the fair value estimates.

• Identify whether the written valuation report will include the specific items the

auditor will need to perform that evaluation and support the auditor’s procedures.

40. If the auditor concludes that he or she will use the findings of the specialist, it is recommended that the auditor consider the need to communicate with the specialist to confirm the terms of the engagement between the specialist and management7 and to cover such matters as:

6 When the purpose of the valuation is to assess impairment, such as under FASB Statement No. 142, the auditor may need to also consider whether the methods and assumptions are consistent with those used in the prior period. 7 See Appendix VII, “Management Considerations When Engaging a Valuation Specialist.”

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41. The auditor should consider obtaining a confirmation directly from the specialist regarding the nature and scope of his or her engagement.

42. The use of the findings of management’s specialist does not allow the auditor to shift his or her audit responsibilities to the valuation specialist. Therefore, the auditor performs substantive procedures to test the entity’s fair value estimates, including those determined by the valuation specialist (see paragraphs 50 through 67). Understanding the Nature of the Work of the Auditor’s Specialist 43. Generally, using a specialist within the audit firm reduces audit risk because the specialist should be familiar with the firm's professional policies. In addition, the other members of the audit team are generally familiar with the specialist's qualifications. Auditors employed by firms that make use of subsidiaries or affiliated organizations should take special care in assessing the internal specialist's familiarity with firm policies. Even though the specialist and the auditor may be part of the same "parent" firm, the specialist may not be familiar with the audit firm's policies.

44. If the auditor has engaged an outside specialist, the auditor may want to establish an understanding with the specialist regarding the service to be performed. That understanding helps reduce the risk that either the auditor or the valuation specialist may misinterpret the needs or expectations of the other party. The auditor may want to document the understanding in writing.

45. Additionally, the auditor should obtain an understanding of the nature of the work performed or to be performed by the specialist, whether an outside specialist or one employed by the auditor’s firm. The matters the understanding should cover are listed in paragraph 39. Relationship of the Specialist to the Acquiring Entity 46. In obtaining an understanding of the valuation work performed or to be performed, the auditor should evaluate the relationship of the valuation specialist to the acquiring and acquired entities. In performing that evaluation, the auditor pays particular attention to any situations in which the entities have the ability, through employment, ownership contractual rights, family relationships, or otherwise, to directly or indirectly control or significantly influence the valuation specialist’s work. 47. There is no single, uniform set of conflict-of-interest standards applicable to valuation specialists who perform fair value measurements,8 each credentialing body establishes the ethical standards applicable to its own 8 However, if the valuation specialist is a member of the AICPA, he or she must comply with Rule 102, Integrity and Objectivity, of the AICPA’s Code of Professional Conduct (AICPA, Professional Standards, vol. 2).

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members. For example, Uniform Standards of Professional Appraisal Practice (USPAP) requires that the valuation specialist disclose, in the valuation report, the existence of any circumstances that might be deemed to present a conflict of interest. Nondisclosure of any such matter is a breach of USPAP. If the auditor is uncertain about the possibility of a relationship between the engaging entity and the valuation specialist, the auditor should consider contacting the specialist and inquiring about any relationship between them. 48. If a relationship between the acquiring entity and the valuation specialist is disclosed or otherwise identified, the auditor obtains a full understanding of the nature of the relationship. This will allow the auditor to assess the risk that the specialist’s objectivity might be impaired. For example, the valuation specialist may disclose that the valuation firm receives a $5,000–per-month retainer from the acquiring entity to ensure the valuation firm’s availability to provide services on short notice. If the valuation firm is a large well-known firm, it is unlikely that such a retainer would unduly influence the work of the valuation firm. Such a retainer, if paid to a small or single-member valuation firm, could lead to the auditor’s further consideration of the relationship. 49. If the auditor is unable to conclude that the specialist’s relationship to the acquiring and acquired entities does not impair the specialist’s objectivity, the auditor should: • Perform the substantive procedures described in paragraphs 50 through 67

with a heightened degree of professional skepticism. • Pay special attention to those elements of the valuation that are highly

dependent on the valuation specialist’s judgment (for example, the assumptions). The evidence considered in support of the assumptions should be scrutinized for completeness and lack of bias.

Alternatively, the auditor may engage a valuation specialist to evaluate the valuation work performed by management’s specialist. SUBSTANTIVE TESTING OF FAIR VALUE MEASUREMENTS AND DISCLOSURES General 50. The auditor uses both the understanding of management’s process for determining fair value measurements and his or her assessment of the risk of material misstatement to determine the nature, timing, and extent of the audit procedures. Substantive tests of the fair value measurements may involve (a) testing management’s significant assumptions, the valuation model, and the underlying data (see paragraphs 51 through 62, and 66 and 67); (b) developing

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independent fair value estimates for corroborative purposes (see paragraph 63); or (c) reviewing subsequent events or transactions (see paragraphs 64 and 65). Testing Significant Assumptions, Valuation Model, and Underlying Data 51. When auditing fair value measurements and allocation of acquisition cost relating to a business combination accounted for under FASB Statement No. 141, the auditor designs and performs substantive audit procedures to evaluate whether all of the following are true: • All tangible and intangible assets acquired and all liabilities assumed have

been identified and allocated an appropriate portion of the purchase price.

• The valuation methods used to estimate fair value of the acquired assets is appropriate.

• The assumptions underlying the approach(es) used to develop the fair value estimates are reasonable in the circumstances and reflect, or are not inconsistent with, market information.

• The valuation method(s) is applied consistently and any significant

assumptions that reflect management’s intent and ability are consistent with management’s plans.

• Management used relevant information that was available at the time.

Identification of All Intangible Assets9 52. An appropriate valuation should identify all intangible assets acquired. The auditor considers, based on his or her knowledge of the acquiring entity, the industry, and the particular acquisition, whether other intangibles may exist that are not included in the valuation. Paragraph 39 of FASB Statement No. 141 provides describes the circumstances under which an acquiring company should recognize an intangible asset apart from goodwill. Paragraph A14 of FASB Statement No. 141 provides a detail listing of intangible assets that meet the requirements to be recognized apart from goodwill. Auditors should review the items in paragraph A14 of FASB Statement No. 141 with management of the acquiring entity and, if necessary, the valuation specialist to determine whether any of those intangible assets exist at the acquisition date. 53. Although the auditor may not have the skills to value the assets acquired, he or she can evaluate the completeness of the allocation based on his or her knowledge of the matters identified in paragraph 52. If this knowledge indicates that intangibles or other assets may exist for which no allocation of fair

9 The valuation specialist can provide insight into the process of identifying all intangible assets.

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value has been made, the auditor should ascertain that proper consideration of those other assets was made in the allocation of purchase price for the acquisition. The auditor does so by discussing his or her concern with appropriate acquiring entity personnel and, if necessary, management’s valuation specialist.

Significant Assumptions 54. Assumptions are integral components of many valuation methods, for example, valuation methods that employ a combination of estimates of expected future cash flows together with estimates of the values of assets or liabilities in the future, discounted to the present. Auditors test the significant assumptions underlying a valuation method in order to evaluate whether such assumptions are reasonable and reflect, or are not inconsistent with, market information.10 55. Specific assumptions will vary with the characteristics of the item being valued and the valuation approach used. Appendix 1 discusses the three valuation approaches and the significant assumptions underlying each approach. 56. Assumptions ordinarily are supported by differing types of evidence from internal and external sources that provide objective support for the assumptions used. The auditor evaluates the source and reliability of evidence supporting management’s assumptions, including consideration of the assumptions in light of historical and market information. 57. Management is responsible for identifying the significant assumptions underlying the fair value measurement. Generally, significant assumptions cover matters that materially affect the fair value measurement and may include those that are: a. Sensitive to variation or uncertainty in amount or nature. For example,

assumptions about short-term interest rates may be less susceptible to significant variation than assumptions about long-term interest rates.

b. Susceptible to misapplication or bias. 58. The auditor considers the sensitivity of the valuation to changes in significant assumptions, including market conditions that may affect the value. Where applicable, the auditor encourages management to use techniques such as sensitivity analysis to help identify particularly sensitive assumptions. If management has not identified particularly sensitive assumptions, the auditor 10 Audit procedures dealing with management’s assumptions are performed in the context of the audit of the entity’s financial statements. The objective of the audit procedures is therefore not intended to obtain sufficient competent audit evidence to provide an opinion on the assumptions themselves. Rather, the auditor performs procedures to evaluate whether the assumptions provide a reasonable basis for measuring fair values in the context of an audit of the financial statements taken as a whole.

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considers whether to employ techniques to identify those assumptions. 59. In evaluating the reasonableness of the significant assumptions, the auditor considers whether the assumptions, individually and taken as a whole, are realistic and consistent with all of the following: a. The general economic environment, the economic environment of the

specific industry, and the entity’s economic circumstances b. Existing market information c. The plans of the entity, including what management expects will be the

outcome of specific objectives and strategies d. Assumptions made in prior periods, if appropriate e. Past experience of, or previous conditions experienced by, the entity to the

extent currently applicable f. Other matters relating to the financial statements, for example,

assumptions used by management in accounting estimates for financial statement accounts other than those relating to fair value measurements and disclosures

g. The risk associated with cash flows, if applicable, including the potential variability in the amount and timing of the cash flows and the related effect on the discount rate

60. The auditor also should consider GAAP requirements that may influence the selection of assumptions (see FASB Statement of Financial Accounting Concepts No. 7, Using Cash Flow Information and Present Value in Accounting Measurements).

Appropriateness of Valuation Model 61. The auditor reviews the model to determine whether it is appropriate considering the entity’s circumstances. For example, it may be inappropriate to use discounted cash flows for valuing an equity investment in a start-up enterprise if there are no current revenues on which to base the forecast of future earnings or cash flows.

Underlying Data

62. The auditor evaluates whether the data on which the fair value measurements are based, including the data used by a specialist, is accurate, complete, and relevant; and whether fair value measurements have been properly determined using such data and management’s assumptions. The auditor’s tests may include, for example, procedures such as verifying the source of the data, mathematical recomputation of inputs, and reviewing of information for internal consistency, including whether such information is consistent with management’s intent and ability to carry out specific courses of action (see paragraph 67).

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Developing Independent Fair Value Estimates for Corroborative Purposes 63. The auditor will generally use the valuations prepared by the valuation specialist as evidence when performing substantive procedures. The auditor may, however, make an independent estimate of fair value (for example, by using an auditor-developed model [often referred to as “shadow valuations”]) to corroborate the entity’s fair value measurement.11 When developing an independent estimate using management’s assumptions, the auditor evaluates those assumptions as discussed in paragraphs 54 through 60, and 67. Instead of using management’s assumptions, the auditor may develop his or her own assumptions in developing an independent estimate. In that situation, the auditor nevertheless understands management’s assumptions. The auditor uses that understanding to ensure that his or her independent estimate takes into consideration all significant variables and to evaluate any significant difference from management’s estimate. The auditor also should test the data used to develop the fair value measurements and disclosures as discussed in paragraph 62. If the auditor’s independent estimate is significantly different from management’s estimate, the auditor investigates the reasons for the difference. If the difference cannot be resolved, the auditor considers the effect on the audit report (see paragraphs 80 through 89). Reviewing Subsequent Events and Transactions 64. Events and transactions that occur after the business combination is consummated but before completion of fieldwork may provide audit evidence regarding management’s fair value measurements as of the date of the business combination.12 In such circumstances, the audit procedures described in paragraphs 50 through 62 may be minimized or unnecessary because the subsequent event or transaction can be used to substantiate the fair value measurement. 65. Some subsequent events or transactions may reflect changes in circumstances occurring after the date of the business combination and thus do not constitute competent evidence of the fair value measurement at the date of the business combination (for example, the prices of actively traded marketable securities that change after the date of the combination). When using a subsequent event or transaction to substantiate a fair value measurement, the auditor considers only those events or transactions that reflect circumstances that existed at the date of the business combination. 11 See SAS No. 56, Analytical Procedures (AICPA, Professional Standards, vol. 1, AU sec. 329). 12 The auditor’s consideration of such subsequent event or transaction is a substantive test and thus differs from the review of subsequent events performed pursuant to SAS No. 1, Codification of Auditing Standards and Procedures (AICPA, Professional Standards, vol. 1, AU sec. 560, “Subsequent Events”).

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Consistency 66. The auditor should evaluate whether the entity’s method for determining fair value measurements is applied consistently13 and if so, whether the consistency is appropriate considering possible changes in the environment or circumstances affecting the entity, or changes in accounting principles. If management has changed the method for determining fair value, the auditor considers whether management can adequately demonstrate that the method to which it has changed provides a more appropriate basis of measurement or whether the change is supported by a change in the GAAP requirements or a change in circumstances.14 For example, the introduction of an active market for an equity security may indicate that the use of the discounted cash flows method to estimate the fair value of the security is no longer appropriate. 67. If an assumption is reflective of management’s intent and ability to carry out specific courses of action, the auditor considers whether the assumption is consistent with the entity’s plans and the entity’s past experience in accomplishing those plans. Disclosures in the Financial Statements of the Combined Entity 68. FASB Statement No. 141 requires disclosure of specific information in the period in which a material business combination is completed (see FASB Statement No. 141, paragraph 51). It also requires certain disclosures if the amounts assigned to goodwill or to other intangible assets acquired and liabilities assumed are significant in relation to the total cost of the acquired entity (see FASB Statement No. 141, paragraph 52). Other disclosures are specified for the following situations: a. A series of individually immaterial business combinations are completed

during the period and are material in the aggregate (see FASB Statement No. 141, paragraph 53).

b. The combined entity is a public business enterprise15 (see FASB

13 When the purpose of the valuation is to assess impairment, such as under FASB Statement No. 142, Goodwill and Other Intangible Assets, the auditor may need to also consider whether the methods and assumptions are consistent with those used in the prior period. 14 Paragraph 16 of Accounting Principles Board Opinion No. 20, Accounting Changes, states that the presumption that an entity should not change an accounting principle may be overcome only if the entity justifies the use of an alternative acceptable accounting principle on the basis that it is preferable. 15 Public business enterprise is defined in FASB Statement No. 141 as follows:

An enterprise that has issued debt or equity securities that are traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local or regional markets), that is required to file financial statements with the Securities and Exchange Commission, or that provides financial statements for the purpose of issuing any class of securities in a public market.

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Statement 141, paragraphs 54 and 55) c. The financial statements reflect an extraordinary gain related to a

business combination (see FASB Statement No. 141, paragraph 56). d. A material business combination is completed after the balance sheet

date but before the financial statements are issued (see FASB Statement No. 141, paragraph 57).

69. As part of the evaluation of whether the financial statements under audit are in conformity with GAAP, the auditor evaluates the adequacy of disclosure in such financial statements. The auditor does this by comparing the disclosures in the financial statements with those required by GAAP. In the specific context of business combinations accounted for under FASB Statement No. 141, the auditor evaluates whether the notes to the financial statements of the combined entity encompass all of the applicable disclosures required by FASB Statement No. 141 and any other applicable GAAP.16 Appendix IV of this publication contains a disclosure checklist designed to help auditors evaluate the conformity of disclosures with the disclosure requirements in FASB Statement No. 141. 70. In addition to evaluating conformity with the disclosure requirements of FASB Statement No. 141, if an item contains a high degree of measurement uncertainty, the auditor assesses whether the disclosures are sufficient to inform users of such uncertainty.17 71. When auditing the disclosures made in the notes to the financial statements of a combined entity, the auditor ordinarily performs essentially the same types of audit procedures as those employed in auditing the amounts recognized in the financial statements. Evaluating Results of Procedures Performed 72. The auditor evaluates the sufficiency and competence of the audit evidence obtained from auditing the measurements and disclosures relating to a material business combination reported in the financial statements of a combined entity. The auditor also evaluates the consistency of that evidence with other audit evidence obtained and evaluated during the audit. 73. The auditor’s evaluation as to whether, based on the audit evidence obtained and evaluated, the measurements and disclosures relating to a material business combination reported in the financial statements are in conformity with GAAP is performed in the context of the financial statements taken as a whole (see SAS No. 47, Audit Risk and Materiality in Conducting an Audit [AU sec.

16 See also SAS No. 32, Adequacy of Disclosure in Financial Statements (AICPA, Professional Standards, vol. 1, AU sec. 431). 17 See AICPA Statement of Position 94-6, Disclosure of Certain Significant Risks and Uncertainties.

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312.36–.41]). The auditor uses his or her understanding of the requirements of FASB Statement No. 141, other relevant GAAP, the knowledge of the acquiring entity’s business and industry and the acquisition, together with the results of other audit procedures, to evaluate the accounting for assets acquired or liabilities assumed in a business combination. 74. The fair values reported in the financial statement may be based on a tentative allocation of the purchase price of the assets acquired and liabilities assumed in a business combination (see paragraph 25). If the auditor is unable to satisfy himself or herself about the reasonableness of the recorded allocation of the purchase price, the auditor (and the auditor’s valuation specialist, if applicable) should meet with management and resolve the difference of opinion. It may be possible to accelerate the completion of the valuation study, delay the issuance of the financial statements, or both, until a better estimate can be developed. If the matter is not resolved to the satisfaction of the auditor, the guidance in paragraph 89 should be considered. 75. If, in evaluating the audit evidence supporting the allocation of the purchase price in a business combination, the auditor concludes that he or she has not obtained sufficient competent audit evidence, the auditor should apply additional appropriate audit procedures. The inability to obtain sufficient competent audit evidence as to an assertion of material significance in the financial statements constitutes a scope limitation, and the auditor should consider the guidance in paragraphs 85 through 88.

COMMUNICATIONS Management Representations 76. SAS No. 85, Management Representations (AICPA, Professional Standards, vol. 1, AU sec. 333), as amended, requires the auditor to obtain written representations from management during the audit. The SAS contains guidance regarding the matters to which management’s representations should relate. In the context of an audit of financial statements reporting the effects of a material business combination effected during the reporting period, the auditor should obtain representations from management regarding its responsibility for the fair presentation of assets acquired and liabilities assumed in the business combination. Additionally, SAS No. 101 requires the auditor to obtain written representations from management regarding the reasonableness of significant assumptions underlying fair value measurements, including whether the assumptions appropriately reflect management’s intent and ability to carry out specific courses of action on behalf of the entity where relevant to the use of fair value measurements or disclosures. Depending on the nature, materiality, and complexity of the fair value measurements that form the basis for the allocation of the purchase price of the acquired entity, management representations about fair

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value measurements and disclosures contained in the financial statements may include representations about: • The appropriateness of the measurement methods, including related

assumptions, used by management in determining fair value and the consistency in application of the methods.

• The completeness and adequacy of disclosures related to fair values. • Whether subsequent events require adjustment to the fair value

measurements and disclosures included in the financial statements. 77. Management’s representations will vary considerably depending on its use of a specialist and the methods and assumptions underlying those methods.

78. The auditor should consider whether other representations concerning the accounting for the acquisition should be obtained from management. However, these representations should not be used as a substitute for performing substantive audit procedures. Communication With Audit Committees 79. SAS No. 61, Communication With Audit Committees (AICPA, Professional Standards, vol. 1, AU sec. 380),18 requires auditors to determine that certain matters related to the conduct of an audit are communicated to those who have oversight of the financial reporting process. Certain accounting estimates, such as the fair value measurements of assets acquired in a business combination, are particularly sensitive because of their significance to the financial statements and because of the possibility that future events affecting them may differ markedly from management's current judgments. SAS No. 61 (AU sec. 380.08) requires the auditor to determine that the audit committee is informed about the process used by management in formulating particularly sensitive accounting estimates, including fair value estimates, and about the basis for the auditor's conclusions regarding the reasonableness of those estimates. In implementing the requirements of the SAS, the auditor considers communicating the nature of significant assumptions used in fair value measurements, the degree of subjectivity involved in the development of the assumptions, and the relative materiality of the items being measured at fair value to the financial statements as a whole. REPORTING CONSIDERATIONS 80. The purpose of paragraphs 81 through 89 is to identify best practices in addressing reporting matters that could arise when auditing the fair value

18 The communications required by SAS No. 61, Communication With Audit Committees (AICPA, Professional Standards, vol. 1, AU sec. 380) are applicable to (a) entities that either have an audit committee or have otherwise formally designated oversight of the financial reporting process to a group equivalent to an audit committee (such as a finance committee or budget committee) and (b) all Securities and Exchange Commission (SEC) engagement

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measurements and disclosures of assets acquired and liabilities assumed in a business combination. Issues could result from concerns over the auditor’s ability to rely on the work of the specialist or to obtain sufficient competent audit evidence regarding the fair presentation in conformity with GAAP of the fair value measurements of the acquired assets and liabilities assumed. Reliance on the Work of the Specialist 81. Generally, the auditor should not refer to the work or findings of the valuation specialist in the auditor’s report on the financial statements. Reference to the specialist might be misunderstood to be a qualification of the auditor’s opinion or a division of responsibility, neither of which is intended. 82. Circumstances may arise, as a result of the valuation report or the findings of the specialist, wherein the auditor decides to add explanatory language to the auditor’s standard report in the form of an emphasis paragraph, or when a departure from an unqualified opinion on the financial statements is required. Reference to and identification of the specialist may be made in the auditor’s report if in the auditor’s judgment the reference will facilitate an understanding of the reason for the explanatory paragraph or the departure from an unqualified opinion. 83. SAS No. 58, Reports on Audited Financial Statements (AICPA, Professional Standards, vol.1, AU sec. 508), as amended, provides guidance with respect to the addition of an explanatory paragraph in the auditor’s report to emphasize a matter regarding the financial statements. For example, an acquiring entity may incur a significant IPR&D charge that could affect the comparability of the current period results of operations with those of the preceding period. In that situation, the auditor may wish to direct attention to the disclosures of the business combination and the IPR&D charge by means of an emphasis paragraph in the auditor’s report. Emphasis paragraphs are not required; however, they may be added at the auditor’s discretion. 84. If, as a result of performing audit procedures on the fair value measurements and disclosures of assets acquired in a business combination, the auditor concludes that a departure from an unqualified opinion is required, the form of the auditor’s report will be governed by the nature of the circumstances giving rise to the need for the report modification. The requirements of the Securities and Exchange Commission (SEC) staff concerning qualified opinions on financial statements filed with the SEC are set forth in Staff Accounting Bulletin 13 (Topic 1E) and would be applicable to financial statements filed with the SEC. Scope Limitations

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85. SAS No. 58 (AU sec. 508.22–.32) provides guidance to the auditor with respect to scope limitations (as distinguished from uncertainties) and their effect on the auditor’s report. The auditor is able to express an unqualified opinion on the financial statements only if the audit has been performed in accordance with GAAS and if the auditor has been able to apply all of the audit procedures considered necessary in the circumstances. Restrictions on the scope of the audit, whether imposed by the acquiring entity or by circumstances, such as the timing of the audit work, the inability to obtain sufficient competent audit evidence, or an inadequacy of the accounting records, may require the auditor to modify the report on the financial statements. 86. The auditor’s decision to express a qualified opinion or to disclaim an opinion because of a scope limitation depends on the auditor’s assessment of the importance of the omitted audit procedures in relation to the auditor’s ability to form an opinion on the financial statements taken as a whole. That assessment will be affected by the nature and magnitude of the potential effect of a misstatement of the assets acquired and liabilities assumed in a business combination and the significance to the financial statements being audited. 87. When a limitation on the scope of the audit is imposed by circumstances beyond the control of the acquiring entity or the auditor (such as, for example, a lack of historical or other information to enable the auditor to evaluate the reasonableness of the significant assumptions used by the valuation specialist to estimate the fair value of the assets acquired), the auditor ordinarily will express a qualified opinion. In the situation in which a restriction that significantly limits the scope of the audit is imposed by the acquiring entity and not by circumstances beyond its control, the auditor ordinarily should disclaim an opinion on the financial statements. 88. Situations may arise where an acquiring entity that lacks the sophistication to perform its own valuation refuses to engage a valuation specialist and makes its own estimate of the fair value of the acquired assets and liabilities assumed. In those circumstances, the auditor should recommend that the acquiring entity engage a qualified independent valuation specialist.19 If, in the auditor’s judgment, the valuation is not properly prepared, it may not provide sufficient audit evidence in support of the amounts assigned to assets acquired and liabilities assumed. In that situation, the lack of such audit evidence may constitute a scope limitation.

19 SAS No. 73, Using the Work of a Specialist (AICPA, Professional Standards, vol. 1, AU sec. 336), does not require that a specialist be independent of the auditee; however, the Sarbanes-Oxley Act of 2002 prohibits an audit firm from performing certain non-audit services, including valuations, for their audit clients (also, see footnote 5 of this publication). A valuation by an independent valuation specialist may constitute more reliable audit evidence than a valuation prepared by a nonindependent specialist.

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GAAP Departures 89. After performing the audit procedures, including evaluating the findings of the valuation specialist, the auditor may conclude that management’s assertions in the financial statements about the identification of or estimate of the fair value of the acquired assets are not presented or measured in conformity with GAAP. This situation could arise from unresolved differences of opinion over whether all intangibles (for example, customer contracts and related customer relationships) have been properly identified and valued, the appropriateness of the valuation method, or the reasonableness of the significant valuation assumptions (for example, the probabilities used in the expected cash flow method of FASB Concepts Statement No. 7). When financial statements are materially affected by a departure from GAAP and the auditor has performed an audit in accordance with GAAS, the auditor should issue a qualified or adverse opinion on the financial statements. In deciding whether the effects of a GAAP departure are sufficiently material to require either a qualified or adverse opinion, the auditor should consider not only the dollar magnitude of the departure but should also consider the qualitative implications of the matter.20

OTHER CONSIDERATIONS Auditor’s Responsibility for Information in Documents Containing Audited Financial Statements 90. The auditor’s responsibility for information published in certain documents containing audited financial statements is described in SAS No. 8, Other Information in Documents Containing Audited Financial Statements (AICPA, Professional Standards, vol. 1, AU sec. 550.04), as amended, as follows:

Other information in a document may be relevant to an audit performed by an independent auditor or to the continuing propriety of [the auditor’s] report. The auditor's responsibility with respect to information in a document does not extend beyond the financial information identified in [the auditor’s] report, and the auditor has no obligation to perform any procedures to corroborate other information contained in a document. However, [the auditor] should read the other information and consider whether such information, or the manner of its presentation, is materially inconsistent with information, or the manner of its presentation, appearing in the financial statements. [Footnote omitted.]

91. Accordingly, the auditor should read the disclosures relating to the fair values of assets acquired and liabilities assumed in a business combination that the entity presents in the Management’s Discussion and Analysis section of the annual report to shareholders filed with the SEC and other documents to

20 SEC Staff Accounting Bulletin No. 99, Materiality, presents a discussion of materiality considerations that are applicable to the financial statements of SEC registrants.

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consider whether the disclosures are consistent with the auditor’s knowledge of the acquiring entity and the acquisition, and the audited financial statements. 92. Although the auditor does not have an obligation to corroborate the financial information presented outside the financial statements, if such information is materially inconsistent with the audited financial statements, the auditor should discuss these matters with appropriate acquiring entity personnel. If the inconsistencies are not corrected to the auditor’s satisfaction, the auditor should follow the guidance set forth in SAS No. 8 (AU sec. 550.05-.06). Interim Period Reporting21 93. An accountant22 may become aware of an acquisition while performing a review of interim period financial information in accordance with SAS No. 100, Interim Financial Information (AICPA, Professional Standards, vol. 1, AU sec. 722). That guidance notes that the objective of a review of interim financial information is to provide the accountant with a basis for communicating whether the accountant is aware of any material modifications that should be made to the interim financial information for it to conform with GAAP.23 Procedures applied in performing a review of interim financial information generally are limited to inquiries and analytical procedures, and other procedures concerning significant accounting and disclosure matters relating to the interim financial information. Those procedures do not contemplate (a) tests of accounting records through inspection, observation, or confirmation; (b) tests of controls to evaluate their effectiveness; (c) obtaining corroborating evidence in response to inquiries; or (d) performing certain other procedures ordinarily performed in an audit. 94. When a business combination has been reported in interim period financial information that is the subject of a SAS No. 100 review, the accountant ordinarily would make inquiries of management and perform analytical procedures designed to ascertain whether the business combination as a whole appears to have been accounted for in conformity with GAAP. When making those inquiries the accountant may find the questions in Appendix II, Illustrative Checklist for Business Combinations, useful in formulating appropriate inquiries of management.

21 Even though the following guidance is intended for an accountant performing a review in accordance with SAS No. 100, Interim Financial Information (AICPA, Professional Standards, vol. 1, AU sec. 725), an accountant performing a review or a compilation of a nonpublic company in accordance with Statements on Standards for Accounting and Review Services may find the guidance in this section useful. 22 Although the review engagement is performed by the entity’s auditor, the discussion in this section refers to accountant to more clearly distinguish between the different levels of assurance between an audit and an engagement to review interim financial information. 23 A review of interim financial information does not provide a basis for expressing an opinion about whether the financial statements are presented fairly, in all material respects, in conformity with GAAP.

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95. The accountant should consider obtaining, in the representation letter for the review engagement, a specific representation concerning the valuation of and accounting for the acquired assets and liabilities assumed in a business combination, tailored as appropriate to the specific circumstances of the engagement. 96. If, based on performing the procedures set forth above, the accountant has reason to believe the acquiring entity’s fair value measurements or disclosures relating to assets acquired in a business combination may not be in conformity with GAAP, the accountant should discuss those concerns with the acquiring entity’s senior management and perform any additional procedures considered necessary to determine whether a material misapplication of GAAP or appropriate valuation practices may have occurred. If the additional procedures confirm a material error in the determination or recording of the assets acquired and liabilities assumed in a business combination, and the interim period financial information has not been issued or filed with, for example, the SEC on Form 10-Q in the case of a public company, the interim period financial information should be corrected before issuance or filing of the financial information. If the Form 10-Q already has been filed, management should be advised to discuss the matter with its legal counsel. 97. If, in the accountant’s judgment, management does not respond appropriately to his or her concerns within a reasonable period of time, the accountant should inform the audit committee or others with equivalent authority and responsibility (hereinafter referred to as the audit committee) of the matter as soon as practicable. If, in the accountant’s judgment, the audit committee (or board of directors) does not respond appropriately to that communication, the accountant should evaluate whether (a) to resign from the engagement to review the interim financial information and as the entity’s auditor, (b) to resign or decline to stand for reelection as the acquiring entity’s auditors, and (c) the actions of the acquiring entity and its audit committee trigger the auditor’s reporting obligations (with respect to public companies) under Section 10A of the Securities Exchange Act of 1934. The auditor may wish to consult with his or her legal counsel when making these evaluations. 98. If a business combination is contemplated but has not been consummated as of the date of the review of the interim financial information, the accountant should obtain from the acquiring entity’s senior management an understanding of the nature and purpose of the transaction and review the acquiring entity’s plan for completing the acquisition. The accountant may wish to consider the matters discussed in paragraphs 12 through 49, including the need to engage the services of a qualified independent valuation specialist. The accountant also should consider discussing with management the extent of the disclosures that management should make concerning the acquisition, such as disclosure in MD&A by a entity subject to the reporting requirements of the SEC.

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APPENDIX I: VALUATION APPROACHES TO ESTIMATING FAIR VALUE1 The purpose of this appendix is to provide background information that will enable auditors to better understand the valuation methods that a valuation specialist may use when estimating fair values. Most of the discussion and examples in this appendix are general in nature and thus not limited to valuations undertaken for purposes of determining fair values under Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 141, Business Combinations; FASB Statement No. 142, Goodwill and Other Intangible Assets; and FASB Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. However, readers are advised that this appendix is not meant to be a comprehensive discussion of the valuation approaches and related assumptions or to provide valuation guidance. Those matters are not within the scope of this publication. The Three Valuation Approaches It’s important to note that while generally accepted accounting principles (GAAP) may not prescribe the method for measuring the fair value of an item, the FASB has expressed a clear preference for the use of observable market prices to make that determination. In the absence of observable market prices, GAAP requires fair value to be based on the best information available in the circumstances. When observable market prices are not available, an entity often engages a valuation specialist to assist in the determination of fair values. The valuation methods used by the specialist should incorporate assumptions that marketplace participants would use in their estimates of fair value whenever that information is available without undue cost and effort. If information about market assumptions is not available, an entity may use its own assumptions as long as there are no contrary data indicating that marketplace participants would use different assumptions. The three approaches to determining fair value of assets, liabilities, and enterprises are the cost, market, and income approaches. Although many valuation methods are used in practice, all such methods can be classified as variations of one of the three approaches. This appendix summarizes the three approaches and the significant assumptions underlying each approach. Valuation specialists generally consider more than one approach when determining and enterprise’s value. As the determination of fair value is not an exact science, it is common for the results of one method to be used to

1 This appendix is based on information being developed by the AICPA Accounting Standards Team’s Valuation of Privately Held Company Equity Securities Task Force.

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corroborate, or to otherwise be used in conjunction with, the results of one or more other methods in a determination of fair value. If a valuation specialist has considered and applied multiple methods (for example, a discounted cash flow and an observed transaction in the marketplace that is not fully comparable) and one result is significantly different from the other(s), the auditor evaluates how the entity has investigated the reasons for these differences in establishing its fair value measurements. Significant differences are an indication that the methods, assumptions underlying the methods, and calculations should be reviewed by the specialist or management. If a valuation specialist does not use one or more of the three valuation approaches discussed in this appendix, the auditor may want to inquire as to why the approach or approaches were not used.2 Cost Approach The general principle behind the cost approach is the valuation of an asset or enterprise by determining the replacement cost of the assets or net assets of the enterprise.3 Replacement cost of an asset is what it would cost today to acquire a substitute asset of comparable utility. There are various methods to determine the replacement cost of an asset. They are as follows: • Fair market value in continued use — This is the fair market value of an item,

including installation and the contribution of the item to the operating facility. It is used when the willing buyer-willing seller transaction is taking place at an enterprise level, and the asset is expected to continue to be used as it is currently by the hypothetical willing buyer. This method is used and preferred among the cost methods when there is a similar-use asset. The value presupposes the continued utilization of the asset in conjunction with all other installed assets.

• Replacement cost new — This is the current cost, as of the date of the

valuation, of a similar new property having the nearest equivalent utility as the property being valued. This method fails to recognize loss of value of the item being valued that results from deterioration (for example, age and wear and

2 Under Uniform Standards of Professional Appraisal Practice (USPAP), a valuation specialist is required to consider all three approaches (cost, market, income), and if one or more is not used, the valuation specialist must explain why an approach was not used. 3 A concept sometimes used in some types of valuations is reproduction cost new. This is the cost of producing, at current prices and as of the valuation date, a replica of an item using the same or closely similar materials. This method is commonly used to value rare items. Reproduction cost new is often not appropriate as an approximation for replacement cost. Reproduction cost new is often used in insurance valuations and does not consider advances in technology and other factors that would result in a better or more productive asset, even if such asset could be obtained for the same cost today.

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tear) and generally is not used for business valuations or fair value measurements made for purposes of FASB Statement No. 141, FASB Statement No. 142, or FASB Statement No. 144.

• Depreciated replacement cost new — The most common replacement cost

method, this method adjusts the replacement cost new for depreciation due to the following:

— Loss in value caused by certain physical conditions (physical

depreciation). Physical conditions that affect value include deterioration from age, wear and tear from use, fatigue and stress, exposure to the elements, and lack of maintenance.

— Loss in value caused by conditions within the property (functional obsolescence). Causes of functional obsolescence include lack of utility, excess capacity, changes in design or technology, and efficiency.

— Loss in value caused by conditions external to the property (economic obsolescence). Causes of economic obsolescence include government regulation, availability of raw materials, availability of labor supply, utilization or profitability of the asset, and reduced demand for the products produced by the asset.

Depreciation for purposes of valuation is calculated based on the above factors. GAAP depreciation, which represents an allocation of historical costs, and depreciation based on Internal Revenue Service (IRS) scheduled service lives may not be appropriate measures on which to base adjustments for valuation purposes.

In some cases, replacement cost can be determined by comparing historical cost to a relevant current index published by a trade association or other independent source. An example is the valuation of a building using a relevant construction cost index that takes into account the kind of building and its location. In the absence of having built substantial goodwill or intangible value, an enterprise’s value under the cost approach is based on its tangible assets. The reliability of the valuation under the cost approach tends to be greater for tangible assets recently purchased in arms’ length transactions. Significant Assumptions of the Cost Approach Particularly in comparison with the market and income approaches, the assumptions underlying the cost approach are fairly straightforward. Cost approach assumptions relate to the various costs capitalized as part of an asset or assets of the enterprise being valued. For valuing early-stage enterprises, the cost approach assumes that expenditures needed to prove the feasibility of a product or service concept become part of an asset’s value. The rationale for this assumption is that if an expenditure results in the creation of value, an enterprise acquiring the asset would not have to replicate those costs — that is, they are

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already incorporated in the asset. A significant issue is the determination of what portion of sunk costs should be included as value. For example, if a biotechnology enterprise has spent $15,000,000 proving a new protocol for the treatment of cancer, the question arises about how much of that should be considered part of cost for valuation purposes. In some cases, research may be necessary to advance knowledge or acquire assets (for example, locate oil), and in those cases the cost of the research phase may be considered an integral part of the cost of the enterprise’s development. However, sunk costs that are incurred as the result of enterprise inexperience typically would not be considered as part of value under the cost approach. The valuation specialist should be expected to disclose in the valuation report the assumptions regarding the valuation of research, if research is a significant component of the valuation. The state of obsolescence or impairment of the asset subsequent to its creation is another assumption used in methods under the cost approach. Often an asset may be operationally functional but has lost value due to new products or services that are more efficient or operationally superior. Thus, although the historical cost of the asset may be easily determinable, its replacement cost may be less than historical cost due to obsolescence or impairment. The software industry, for example, has many examples of product obsolescence and impairment. The treatment of overhead costs under the cost method can be critical to the valuation. Therefore, the auditor should consider whether the valuation report will disclose the treatment of such costs (for example, general and administrative costs). The cost approach also contains the implicit assumption that all costs are incurred as of the valuation date. Thus, neither the time value of money nor inflation considerations are relevant. With respect to the time value of money, the implication is that capitalized interest (of the sort required by FASB Statement No. 34, Capitalization of Interest Cost) would not be included in the value of an asset. Because expenditures are considered to have been made as of the valuation date, there is no need to explicitly adjust for the effect of inflation, which affects an asset only during the time it is held after its acquisition. Market Approach The market approach can be used, for example, to determine the fair value of equity securities through financial-statement and nonfinancial-statement metrics and direct comparisons to other enterprises, examination of third-party investments in comparable equity securities of the enterprise, or examination of transactions in equity securities of comparable enterprises. The market approach bases the fair value measurement on what other similar enterprises or comparable transactions indicate the value to be. There are numerous market comparables methods, such as the guideline public company method (the results

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of which would require adjustment for valuing, for example, a privately held entity in view of the public-company nature of the comparable). When comparable enterprises are available, valuation specialists may use financial-statement metrics such as: • Price to cash flow • Price to earnings • Price to assets or equity • Price to revenue • Market value of invested capital4 (MVIC) to earnings before interest and taxes

(EBIT) • MVIC to earnings before interest, taxes, depreciation, and amortization

(EBITDA) • MVIC to revenue Nonfinancial statement and other metrics, often used by industry and analysts, may also be used by valuation specialists and include, for example: • MVIC to next year’s estimated revenue • Price to number of employees • Price to PP&E (property, plant, and equipment) A nonfinancial metric is often industry-specific and in general should be used by a valuation specialist only if it is generally accepted in the industry. The use of nonfinancial metrics has broadened in recent years, in part because of the recommendations of the report of the AICPA Special Committee on Financial Reporting (the Jenkins Committee) and the FASB’s Business Reporting Research Project “Improving Business Reporting: Insights into Enhancing Voluntary Disclosures.” Moreover, with many valuations, such as those of early-stage enterprises, some traditional metrics cannot be used because the enterprises have not yet matured enough to generate profits or revenues, and therefore nonfinancial metrics may be used in conjunction with the limited number of usable financial metrics. A significant limitation of the market approach, particularly when applied to valuing smaller entities or start-up entities, is that “true” comparables are unlikely to exist. For example, if the enterprise being valued has no earnings or has immaterial revenue, forecasts of financial statement amounts may be highly speculative. A valuation specialist may also employ a transactions-based method to develop a fair value of an enterprise. The basis for application of this method is

4 This is the market value of all classes of outstanding common stock, and all of the interest-bearing debt (representing the entire capital structure of the entity). Some definitions may exclude short-term notes payable from the calculation.

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transactions between the enterprise being valued and independent third-party investors. If transactions are used as a basis for valuing an enterprise, certain characteristics of those transactions may require special consideration by the valuation specialist. For example, if a transaction is a trade involving a large block of shares, the valuation specialist considers the fact that the transaction might not be representative of the fair value of the enterprise. If the purchaser is seeking control or a large share of the enterprise, the purchaser may have to pay, and the referenced transaction value(s) may therefore reflect, a premium (often denoted control premium) to induce the required number of shares to the sell side of the market. For example, the valuation specialist factors such premiums out of any fair value determination in order to determine the fair value of a minority common stock interest. Prices observed in issuances of some securities may be inappropriate as market comparables without adjustment because those transactions may involve control premiums and synergies that are specific to a particular buyer-seller relationship. For example, venture capitalists may pay above fair value prices due to seeking high returns from a few of many purchased business interests. Prices paid by major suppliers or customers for privately issued securities may also be inappropriate as market comparables without adjustment because such transactions may involve the granting of stated or unstated rights or privileges to the supplier or customer. Significant Assumptions of the Market Approach The key assumption of the market approach is that the selected comparable enterprise or transaction is “truly” comparable. Although a market based valuation is preferred when available, there typically are few truly comparable enterprises. To achieve comparability, the valuation specialist may need to make adjustments to an initial valuation that is based on a comparison to an enterprise that in one significant respect or another is not comparable to the enterprise being valued. In performing valuations of enterprises under the market approach, it is assumed not only that the industry, size of enterprise, marketability of the products or services, and management teams are comparable, but also that the enterprise’s stage of development is comparable. This last assumption often renders the market approach impractical for early-stage enterprises because pricing data for such enterprises is difficult, if not impossible, to find. Furthermore, even if pricing data can be found, until product or service feasibility is achieved, comparability among early-stage enterprises is difficult to achieve. Income Approach The principal notion supporting the income approach is that it views value as emanating from expectations of future income(s) and cash flows. It stands in

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contrast to the cost approach, which focuses on replacement cost, and to the market approach, which looks to find comparable data in the present. The income approach is implemented using both the discounted cash flow (DCF) and capitalization-of-earnings methods, which are described and contrasted in the following paragraphs. The income approach is future oriented. It seeks to convert future economic benefits into a present value and has strong conceptual support from many sources. First, it is in accordance with the definition of assets in the FASB’s Conceptual Framework: “Assets are probable [footnote omitted] future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.”5 Second, it is in accordance with the literature of finance that attributes value to the rational expectation of future economic benefits. Third, it is on a conceptual par with the market approach to valuation when the market approach cannot be used. A market price is the consensus of a large number of unrelated buyers and sellers, whereas the income approach is the simulation of that market price when no active market exists for the asset being valued. In general, the income approach calls for the estimation of future economic benefits and applies to them a rate of discount to equate them to a single present value. With one exception, discussed later in this appendix, the future benefits to be discounted are a stream or multiple streams of periodic cash flows attributable to the asset being valued.6 The cash flows to be discounted are “discrete.” That is, they are limited in duration rather than perpetual. Discrete cash flows occur in a variety of patterns: • Equal in each period. An example is the cash paid in equal monthly payments

by a homeowner on a mortgage loan. • Equal in each period, with an additional final balloon payment or terminal

value (the latter term being more commonly used by valuation specialists). An example is a bond or other debt instrument that calls for periodic payments of interest followed by a final payment of principal.

• Growing each period by a specified amount or percentage. Such a stream of

cash flows may or may not be accompanied by a balloon payment. If there is a balloon payment, there may be a growth factor (terminal value growth rate) applied in determining its amount.

• Unequal and occurring at irregular intervals. This pattern is typical in the

valuation of privately issued securities. 5 Financial Accounting Standards Board Statement of Financial Accounting Concepts No. 6, Elements of Financial Statements, paragraph 25. 6 This could be a single asset, a collection of assets, or an entire enterprise.

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An exception is made to discounting of cash flows if the cash flow is expected to be equal in amount each period and perpetual. In that case, value is obtained by “capitalizing” the cash flows rather than discounting them. To illustrate a discounted cash flow calculation, consider the case of a perpetual bond with a face amount of $1,000 that pays an annual amount of $80. Assume the required rate of return is 10 percent. The value of the bond in perpetuity is obtained by ignoring the face amount (which would never be received) and discounting the stream of interest payments as follows: Present value = $80/(1.10) + $80/(1.10)2 + $80/(1.10)3 +.......+ $80/(1.10)n = $800 with n approaching infinity. The same answer is obtained by a capitalization calculation that divides the constant perpetual cash flow by the required rate of return: Present value = $80/.10 = $800. In employing a capitalization-of-earnings method in an enterprise valuation, the enterprise’s perpetual cash flows should be measured and valued net of the outlays necessary to replace the capacity consumed in operating activities. In other words, the perpetual cash flows take into account necessary capital expenditures net of depreciation and amortization. In the long run, capital expenditures and related depreciation should net to zero. Furthermore, capitalization computations take into account the calculated depreciation associated with replacement costs, not historical costs. There are a variety of conceptual and practical challenges associated with the income approach. The first is the issue of how risk is assessed and assigned. In the “traditional” approach to valuation, risk is assigned to, or incorporated into, the discount rate. It is common practice for a valuation specialist to obtain from management its single best estimate of the cash flows of an enterprise for each future period and then to discount those amounts to present value using a risk-adjusted rate of return. The larger the perceived risk attached to the future cash flows, the higher the discount rate applied to them, and the lower their present value. This is similar to how the market determines the value of a bond after it has been rated by a ratings agency. A more recent variation on the income approach, as discussed in FASB Concepts Statement No. 7, Using Cash Flow Information and Present Value in Accounting Measurements, is to assign risk to the cash flows themselves and to discount those flows at the risk-free interest rate. This method, known as the expected cash flow method, is one in which the cash flow consequences of possible future outcomes are estimated. The probability of each potential cash flow outcome is then estimated. Each outcome is then weighted by its probability, and the weighted amounts are summed to determine expected cash flow.

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A problem exists both in concept and practice in dealing with the final cash flow amount, or terminal value. Forecasting future cash flows involves uncertainty, and the further the forecast goes into the future, the greater the uncertainty of the forecasted amounts. Because discounting attributes less value to cash flows the farther in the future they occur, there still is a point in time beyond which forecasted cash flows are no longer meaningful. For example, for enterprises with little or no operating history (such as, for example, start-up enterprises), forecasts beyond a few years are likely to be highly speculative and unreliable. Some valuation specialists use methods that split an enterprise’s streams of economic benefits into two or more parts and discount each stream at a different rate of return. This technique may be appropriate, for example, in the case of a casualty insurance enterprise that engages in the two separate and distinct activities of (1) underwriting insurable risks of loss, and (2) investing premiums received in advance while awaiting the payment of claims. Typically, the econ-omic results of those two activities can be readily separated, and the riskiness of each separately assessed. The assessment following such separation is similar to the investment analysis performed by financial analysts using the disaggregat-ed segment data of diversified enterprises. Another form of economic benefit stream splitting is to divide future earnings between so-called “normal earnings” and excess earnings. Normal earnings are derived by first identifying the net assets, at replacement cost, used in an enterprise’s regular business activities. A risk-adjusted rate of return is applied to those assets to determine the earnings they are assumed to produce, termed normal earnings. To the extent that actual sustainable future earnings exceed normal earnings, the difference is termed excess earnings.7 Excess earnings are considered to be attributable to intangible factors (for example, labor force and customer lists) and typically are given less value than normal earnings because they generally are the first earnings to disappear in economic downturns. One method typically used to value excess earnings is to capitalize them or discount them at a higher rate of return than normal earnings. In recent years, “real options” theory has been applied by some in the valuation of enterprises. In essence, real options methods are analogous to and determine value in the same manner as methods used for valuing financial options, and are categorized as a subset of the income approach because the methods are forward looking. Real options is an analytical tool. However, not all valuation specialists are familiar with the complexities of real options or are experienced using it in practice. Significant Assumptions of the Income Approach

7 The term is similar to the term economic rents as used in economic theory.

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The income approach relies on a number of assumptions, some of which may have a substantial impact on the resulting valuation. Even the rationale underlying the selection of the method to use in applying this approach may incorporate a number of assumptions. In theory, the traditional and expected cash flow methods under FASB Concepts Statement No. 7 result in a similar value. However, as is typically the case with valuations, duplication of exact results among valuation methods is rarely achieved; hence, the importance of the specific assumptions associated with each method. For the expected cash flow method, key assumptions include the forecasted cash flows and their respective probabilities. For the traditional method, key assumptions include the amounts of the forecasted cash flows, the terminal value growth rate, and the discount rate or capitalization rate. Forecasting cash flows, including developing underlying assumptions, is management’s responsibility. A valuation specialist reviews management’s forecasts of cash flows and the underlying assumptions for reasonableness and make adjustments to the valuation as appropriate. This is especially important in light of what some perceive to be a bias on the part of management toward “optimism” in cash flow forecasts. The length of time over which the forecasts are made affects their reliability and should be taken into account by the valuation specialist. Forecasts are made frequently for five-year periods, but in view of the speed at which technology becomes obsolete or changes, five years may be considered a long time for reliable forecasting. Accordingly, other relevant financial and nonfinancial measures of reliability, such as management’s prior record of success or the track records of comparable enterprises, should be considered. Moreover, forecasts prepared for use in a valuation should be consistent with forecasts that management prepares for the same periods for other purposes—for example, forecasts that management prepares for bankers. Strategic Benefits in Excess of Those Expected to Be Realized by Market Participants Fair value, as defined in the accounting literature, does not include strategic or synergistic value resulting from expectations about future events that are specific to a particular buyer because the value associated with those expectations is unique to the buyer and seller and would not reflect market-based assumptions. Therefore, when applying a market approach, if a buyer of the securities would be expected to pay the seller any significant consideration for strategic or synergistic benefits in excess of those expected to be realized by market participants, the valuation specialist will identify those excess benefits and remove them from the valuation. Synergistic or strategic value (often referred to as “investment value”) does not conform to the concept of fair value as that term is defined in GAAP.

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APPENDIX II: ILLUSTRATIVE CHECKLIST FOR BUSINESS COMBINATIONS This appendix contains an illustrative checklist that auditors can use to evaluate management’s accounting for a material business combination consummated during the period under audit. Each set of questions in the checklist is preceded by a summary of applicable accounting guidance. Those summaries have not been approved, disapproved, or otherwise acted upon by any senior technical committee of the AICPA or the Financial Accounting Standards Board (FASB) and have no official or authoritative status. Auditors are advised to refer to the relevant literature for a complete understanding of the applicable requirements. Additionally, because of its illustrative nature, the checklist addresses many, but not necessarily, all business combination issues that may arise in different situations. Auditors should tailor the checklist to the specific circumstances surrounding the business combination reported in the financial statements under audit. Use of a checklist, such as the one illustrated in this appendix, is not a substitute for expert advice or careful consideration of the requirements of FASB Statement of Financial Accounting Standards No. 141, Business Combinations, and any other applicable accounting principles.

FASB Statement No. 141 Checklist

Prepared by: Date: Reviewed by: Date:

Purpose

This checklist is intended to: • Assist in reviewing business combinations and identifying complex issues associated

with the combination. • Provide information on applicable current accounting and Securities and Exchange

Commission (SEC) guidance for business combinations. • Identify appropriate audit procedures to perform in the period of combination If a question is answered with a “No,” the auditor should consult the referenced literature to properly evaluate the effect of that response. Basic Procedures • Obtain a schedule of the calculation of the purchase price, its allocation to the assets

acquired and liabilities assumed (including amounts assigned to goodwill and intangibles) and any supporting schedules. Test the mathematical accuracy of these schedules.

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• Examine the purchase agreement and determine whether the schedule accurately

reflects the substance of the transaction. Determine that the transaction has been authorized by appropriate individuals. The agreement should, among other things, identify the nature of the business combination, and the rights and obligations of the parties. Examine documentation on a test basis in support of the computed consideration, including the fair values of the liabilities assumed, and the fair values assigned to the acquired assets.

• Consider the need for a valuation specialist to assist in the review of the purchase price calculations, the methods and assumptions used to assign values to the assets and liabilities, particularly with such items as intangibles; complex financial instruments; inventories; executive compensation plans; and plant, property, and equipment. Assistance may also be needed when allocating assets, including goodwill, and liabilities to reporting units.

• Test completeness by considering your knowledge of the acquiring entity’s business

and the nature of the industry, analyzing relationships of account balances to other related accounts, and considering evidence from other tests.

Determining Whether a Business Has Been Acquired Background FASB Statement No. 141 does not define what constitutes a "business" for purposes of determining whether a transaction should be accounted for as a business combination. For purposes of determining whether a group of net assets or the operations of an entity constitute a business, FASB Statement No. 141 states that entities should refer to the guidance in Emerging Issues Task Force (EITF) Issue No. 98-3, “Determining Whether a Nonmonetary Transaction Involves Receipt of Productive Assets or of a Business.”

When a group of acquired net assets or an acquired entity does not constitute a business, the acquiring entity must account for the acquisition pursuant to FASB Statement No. 142, Goodwill and Other Intangible Assets. FASB Statement No. 142 addresses accounting and reporting at acquisition for intangible assets acquired individually or with a group of other assets (but not those acquired in a business combination). Authoritative Guidance FASB Statement No. 141, paragraphs 9 through 12

Emerging Issues Task Force (EITF) Issue No. 98-3, “Determining Whether a Nonmonetary Transaction Involves Receipt of a Productive Asset or a Business” Checklist Determining whether a business has been acquired Yes, No, N/A • Do the assets and activities received in the transaction meet the definition of a

business included in EITF Issue No. 98-3?

• If a business has been acquired, has the entity applied the purchase method of accounting?

• If the acquisition does not meet the criteria for recognition as a business combination under FASB Statement No. 141, has the entity accounted for the intangible assets acquired in the transaction in accordance with FASB Statement No. 142?

Determining the Acquiring Entity

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Background Under FASB Statement No. 141, all pertinent facts must be considered in determining the acquiring entity, including (1) relative voting rights (along with any unusual or special voting arrangements and options, warrants, or convertible securities); (2) the existence of a large minority voting interest when no other owner or organized group of owners has a significant voting interest; (3) the composition of the board of directors and senior management; and (4) if the securities exchanged are publicly traded, whether a premium is paid over the market value of one of the entities' equity securities. In addition, when a business combination involves more than two entities, consideration should also be given to which entity initiated the combination and whether the assets, revenues, and earnings of one of the combining entities significantly exceed those of the others. Authoritative Guidance FASB Statement No. 141, paragraphs 15 through 19 Checklist Determining the acquiring entity Yes, No, N/A • Has the identification of the acquiring entity been made pursuant to FASB

Statement No. 141?

• If the business combination involves more than two entities, has consideration been given to which combining entity initiated the transaction and whether the assets, revenues, and earnings of one of the combining entities significantly exceed those of the others?

Determining the Cost of an Acquired Entity

Background Many different forms of consideration are issued to acquire the assets or stock of an enterprise in a purchase business combination. Consideration can include cash, debt securities, common stock, preferred stock, and stock options or warrants. Generally, consideration issued is recorded at fair value.

FASB Statement No. 141, paragraph 23 states that:

If the quoted market price is not the fair value of the equity securities, either preferred or common, the consideration received shall be estimated even though measuring directly the fair values of net assets received is difficult. Both the net assets received, including goodwill, and the extent of the adjustment of the quoted market price of the shares issued shall be weighed to determine the amount to be recorded. All aspects of the acquisition, including the negotiations, shall be studied, and independent [valuation] appraisals may be used as an aid in determining the fair value of securities issued. Consideration other than equity securities distributed to effect an acquisition may provide evidence of the total fair value received.

Authoritative Guidance FASB Statement No. 141, paragraphs 20 through 23 FASB Technical Bulletin (FTB) No. 85-5, Issues Relating to Accounting Business Combinations, Including Costs of Closing Duplicate Facilities of an Acquirer FASB Interpretation (FIN) No. 44, Accounting for Certain Transactions Involving Stock Compensation, paragraphs 83 through 85 EITF Issue No. 85-45, “Business Combinations: Settlement of Stock Options and Awards” EITF Issue No. 97-8, “Accounting for Contingent Consideration Issued in a Purchase Business Combination” EITF Issue No. 99-12, “Determination of the Measurement Date for the Market Price of Acquirer Securities Issued in a Purchase Business Combination” EITF Issue 00-23, Topics 7, 13, and 14, “Issues Related to the Accounting for Stock Compensation under APB Opinion No. 25 and FASB Interpretation No. 44” EITF Abstracts, Topic D-87, “Determination of the Measurement Date for Consideration Given by the Acquirer in a Business Combination When That Consideration Is Securities Other Than Those Issued by the Acquirer” SAB Topic 2-A6, Debt Issue Costs

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Checklist Determining the cost of an acquired entity Yes, No, N/A Debt securities • For debt securities issued that bear an interest rate materially above or below

the effective rate or current yield for an otherwise comparable security, has a premium or discount been imputed in accordance with Accounting Principles Board (APB) Opinion No. 21, Interest on Receivables and Payables? (FASB Statement No. 141, par. 20)

• Did the entity consider whether the imputation of interest gives rise to a book basis different from the tax basis that requires a temporary difference to be accounted for in accordance with FASB Statement No. 109, Accounting for Income Taxes?

Preferred stock • For preferred stock containing complex conversion features that raise issues

regarding the value of the preferred stock, did the entity obtain an opinion of an independent* valuation specialist to determine the value of the preferred stock? (FASB Statement No. 141, par. 21)

* AICPA Statement on Auditing Standard No. 73, Using the Work of a Specialist (AICPA, Professional Standards, vol. 1, AU sec. 336), does not require the valuation specialist to be an independent of the auditee; however, a valuation by an independent valuation specialist may be more objective and reliable than a valuation prepared by a non-independent specialist.

• If embedded conversion features exist, did the entity consider the guidance of EITF Issue No. 97-8 for valuing these conversion features? (See the section of this checklist titled “Accounting for Contingent Consideration—Contingencies Based on Either Earnings or Security Prices That Are Embedded in a Security or Are in a Separate Financial Instrument.”) (EITF Issue No. 97-8)

• If the preferred stock contains mandatory redemption features, did the entity consider whether a classification as mezzanine financing was appropriate? (EITF Abstracts, Topic D-98)

Equity securities • Did the entity value the equity securities issued based on the market price of the

securities a few days before and after the two entities reached agreement on the purchase price and the proposed transaction was announced in accordance with EITF issue No. 99-12? (FASB Statement No. 141, par. 22, and EITF Issue No. 99-12)

• If the purchase price (the number of shares or other consideration) subsequently changed substantively, did the entity recognize that a new measurement date for valuing the equity securities is appropriate? (EITF Issue No. 99-12)

• If the equity securities are not being valued at quoted market price due to the lack of a market or other features, is there objective and verifiable evidence that supports the use of a fair value other than quoted market price? (FASB Statement No. 141, par. 23)

Note: The SEC Staff has indicated that in the absence of objective and verifiable evidence that supports a different fair value, quoted market price is still the best available evidence of fair value. Use of a contemporaneous valuation by an independent qualified valuation specialist may be helpful in this valuation process.

Securities other than those issued by the acquiring entity • If the acquiring entity paid consideration in the form of securities other than its

own securities (for example, Company A acquired Company B by paying

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Determining the cost of an acquired entity Yes, No, N/A Company B with publicly traded shares of Company C), did the entity value those securities based on their fair value on the consummation date? (EITF Abstracts, Topic D-87)

Stock options and awards • If the acquiring entity settles outstanding stock options or awards (vested or

unvested) of the acquired entity as part of the acquisition, was the fair value of the stock options or awards issued recorded as part of the purchase price?

• If the acquiring entity reimbursed the acquired entity for the acquiring entity’s settlement of the acquired entity's outstanding stock options or awards (vested or unvested), was the fair value of the consideration issued recorded as part of the purchase price?

• If the acquired entity settled stock options or awards (vested and unvested) voluntarily, at the direction of the acquiring entity or as part of the acquisition, was a compensation charge recorded in the acquired entity’s separate financial statements in accordance with EITF Issue No. 85-45 and FIN 44, Question 14? (EITF Issue No. 85-45, FIN 44)

• If the acquiring entity issued its vested stock options or awards in exchange for vested stock options and awards of the acquired entity, was the fair value of the replacement options and awards recorded as part of the purchase price? (FIN 44)

• Was the fair value of any replacement stock options and awards determined on the measurement date in accordance with FASB Statement No. 141, paragraph 22, and EITF Issue No. 99-12? ( EITF 00-23 Issue 13 , EITF Issue No. 99-12)

• If the acquiring entity issued its unvested stock options or awards in exchange for unvested stock options and awards of the acquired entity, was the fair value of the replacement options and awards recorded as part of the purchase price? Was the fair value of the replacement options and awards determined on the measurement date in accordance with FASB Statement No. 141, paragraph 22, and EITF Issue No. 99-12? Was a portion of the intrinsic value of the replacement options and awards at the consummation date allocated to unearned compensation based on the portion of the intrinsic value relating to the future vesting period in accordance with FIN 44, paragraph 85? (FIN 44, EITF 00-23 Issues 7 and 13, EITF Issue No. 99-12 )

• If the acquiring entity issued cash, stock options, or awards to settle stock options or awards of the acquired entity (vested and unvested) when the acquiring entity was purchasing the minority interest, was an amount expensed in the acquired entity’s financial statements equal to the fair value of stock options multiplied by the ownership percentage before the purchase? The fair value of the stock option multiplied by the percentage acquired should be recorded as the purchase price.

• If unvested stock options or awards of the acquiring entity are given to acquired entity’s shareholders who are also management employees, has the acquiring entity considered the provisions of EITF Issue No. 95-8, which provides guidance for determining when contingent payments should be considered compensation expense and not part of the purchase price? (FASB Statement No. 141, par. 34, and EITF Issue No. 95-8)

Other acquisition costs • If unregistered securities with registration rights were issued, has the acquiring

entity (1) recorded the securities at the fair value of its registered securities less an estimate of the related registration costs and (2) accrued a liability for the present value of the estimated registration costs?

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Determining the cost of an acquired entity Yes, No, N/A Note: Pursuant to FASB Statement No. 141, Appendix A, paragraph A9, “A liability [for the estimated registration costs] shall be recognized at the date of acquisition in the amount of the present value of the estimates costs of registration.” • Have all internal costs associated with the acquisition been expensed as

incurred? If a entity maintains an acquisitions department, are these costs expensed as incurred?

Note: The SEC staff has indicated that it interprets the phrase "all internal costs" literally and without exception, and accordingly believes that all internal acquisition costs (for example, salaries, commissions, bonuses, employee benefits, and travel costs) associated with the acquisition should be expensed as incurred, even if those costs are incremental, nonrecurring, and directly associated with the business combination.

• If the acquiring entity intends to close a duplicate facility that it owns, has this cost been excluded from determination of the purchase price and expensed as incurred? (FTB 85-5)

Accounting for Contingent Consideration Background FASB Statement No. 141, paragraphs 25 and 27, state as follows:

Paragraph 25: A business combination agreement may provide for the issuance of additional shares of a security or the transfer of cash or other consideration contingent on specified events or transactions in the future. Paragraph 27: The contingent consideration usually should be recorded when the contingency is resolved and the consideration is issued or becomes issuable. In general, the issuance of additional securities or distribution of other consideration at resolution of contingencies based on earnings shall result in an additional element of cost of an acquired entity [and recorded at that date]. In contrast, the issue of additional securities or distribution of other consideration at resolution of contingencies based on security prices shall not change the recorded cost of an acquired entity.

When a business combination results in an excess of acquired net assets over cost (hereinafter referred to as “negative goodwill”) and contingent consideration exists, that when resolved, might result in the recognition of an additional element of cost with respect to the acquired entity (that is, a contingency based on earnings), FASB Statement No. 141, paragraph 46 requires recognition of a deferred credit. This deferred credit should be recorded as the lesser of (1) the maximum amount of contingent consideration or (2) the initial amount of negative goodwill. Later, when the contingency is resolved and the consideration is issued or becomes issuable, any difference between the fair value of the contingent consideration issued or issuable and the deferred credit should be treated as follows: • An excess of the fair value of the contingent consideration issued or issuable over the amount of the

deferred credit should be recognized as additional cost of the acquired entity. • An excess of the deferred credit over the fair value of the contingent consideration issued or

issuable should first be recognized as a pro rata reduction of the amounts that were initially assigned to eligible acquired assets, after which any remaining difference would be recognized as an extraordinary gain.

Authoritative Guidance FASB Statement No. 141, paragraphs 25 through 34, and 44 through 46 EITF Issue No. 84-35, “Business Combinations: Sale of Duplicate Facilities and Accrual of Liabilities”

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EITF Issue No. 95-8, “Accounting for Contingent Consideration Paid to Shareholders of an Acquired Company in a Purchase Business Combination” EITF Issue No. 97-8, “Accounting for Contingent Consideration Issued in a Purchase Business Combination” EITF Issue No. 97-15, “Accounting for Contingency Arrangements Based on Security Prices in a Purchase Business Combination” Checklist Accounting for contingent consideration Yes, No, N/A Contingencies based on earnings • Has the acquiring entity considered EITF Issue No. 95-8, which provides

guidance for determining when contingent payments should be considered compensation expense and not part of the purchase price? (EITF Issue No. 95-8)

• If contingent consideration is based on earnings, has the acquiring entity recorded the contingent consideration on the date the contingency is resolved and the additional consideration is distributable? (FASB Statement No. 141, par. 28)

Contingencies based on security price • If the contingency is based on security price and represents a guarantee of the

minimum market value on a specified date or dates, have securities issued unconditionally at the date of combination been recorded at this value? (FASB Statement No. 141, par. 29 and 30).

• If the contingency is based on security price, has the entity considered if the contingent consideration represents a below-market guarantee that should be accounted for under EITF Issue No. 97-15?

• If the contingency is based on security price, has the entity considered if the contingent consideration represents a contingency on future security prices that is not a guarantee of minimum value and should be accounted for under example 2 of EITF Issue No. 97-15?

Contingencies based on either earnings or security prices that are embedded in a security or are in a separate financial instrument

• If the contingent consideration is in the form of a separate financial instrument or embedded in a security, has the acquiring entity considered the provision of EITF Issue No. 97-8 that may require recording the separate or embedded financial instrument on the date of consummation of the business combination? ( EITF Issue No. 97-8)

Interest or dividends during the contingency period • Have amounts paid to an escrow agent representing interest and dividends on

shares held in escrow pending resolution of the contingency been accounted for depending on whether the contingency is based on earnings or security price (that is, not as interest expense or dividend distributions)? (FASB Statement No. 141, par. 32)

Tax effect of a contingent purchase price • Has the entity considered the deferred tax effect of imputed interest related to a

contingent purchase price in recording the contingent consideration? (FASB Statement No. 141, par. 33, and FASB Statement No. 109, par. 262)

Negative goodwill and contingent consideration • If there is contingent consideration and negative goodwill, has the entity

recorded a deferred credit for the lesser of (1) the maximum amount of contingent consideration or (2) the initial amount of negative goodwill? (FASB Statement No. 141, par. 46)

• Did the acquiring entity adjust the value of the deferred credit or value assigned

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Accounting for contingent consideration Yes, No, N/A to acquired assets and, if necessary the extraordinary gain, for differences between the fair value of the contingent consideration issued and the deferred credit recorded? (FASB Statement No. 141, par. 46)

Recording Assets Acquired and Liabilities Assumed Background An acquiring entity allocates the cost of an acquired entity to the assets acquired and liabilities assumed based on their fair value at the date of acquisition. The assets acquired include intangible assets that meet the recognition criteria in FASB Statement No. 141, paragraph 39, regardless of whether they had been recognized in the financial statements of the acquired entity. Authoritative Guidance FASB Statement No. 141 paragraphs 35 through 41 and 50 FASB Statement No. 142, Goodwill and Other Intangible Assets, paragraphs 32 through 35 FASB Interpretation No. 4, Application of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method EITF Issue No. 86-14, “Purchased Research and Development Projects in a Business Combination” EITF Issue No. 95-3, “Recognition of Liabilities in Connection with a Purchase Business Combination” EITF Issue No. 95-14, “Recognition of Liabilities in Anticipation of a Business Combination” EITF Issue No. 96-5, “Recognition of Liabilities for Contractual Termination Benefits or Changing Benefit Plan Assumptions in Anticipation of a Business Combination” EITF Issue No. 98-1, “Valuation of Debt Assumed in a Purchase Business Combination” EITF Issue No. 01-03 “Accounting in a Purchase Business Combination for Deferred Revenue of an Acquiree” EITF D-54 “Accounting by the Purchaser for a Seller’s Guarantee of the Adequacy of Liabilities for Losses and Loss Adjustment Expenses of an Insurance Enterprise Acquired in a Purchase Business Combination” SAB Topic 2-A5, Adjustments to Allowances for Loan Losses in Connection with Business Combinations (SAB 61) SAB Topic 2-A9, Liabilities Assumed in a Purchase Business Combination (SAB 100) SAB Topic 5-P, Restructuring Charges (SAB 100) SAS No. 73, Using the Work of a Specialist Nonauthoritative Guidance AICPA Practice Aid: Assets Acquired in a Business Combination to Be Used in Research and Development Activities: A Focus on Software, Electronic Devices, and Pharmaceutical Industries

Checklist Recording assets acquired and liabilities assumed Yes, No, N/A Marketable securities • Are marketable securities recorded at their current fair values? (FASB

Statement No. 141, par. 37(a))

Accounts receivable • Are accounts receivable of the acquired entity recorded at the present value of

amounts to be received determined at appropriate current interest rates, less allowances for doubtful accounts and collection costs? (FASB Statement No. 141, par. 37(b))

• If there has been a significant change in the allowance for doubtful accounts, has the entity determined the events that gave rise to the change?

Note: The SEC has expressed the view that a business combination should not cause a significant change in the allowance for doubtful accounts and would expect changes in the allowance to be recorded in the acquired entity’s financial statements before the acquisition or

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Recording assets acquired and liabilities assumed Yes, No, N/A the combined entity’s financial statements on a go-forward basis and not as a purchase accounting adjustment. (SAB Topic 2-A5 and 2-A9) Inventories • Are finished goods recorded at their estimated selling prices less the sum of (1)

costs of disposal, and (2) a reasonable profit allowance for the selling effort of the acquiring entity? (FASB Statement No. 141, par. 37(c)(1))

• Is work in process recorded at estimated selling prices of finished goods less the sum of (1) costs to complete, (2) costs of disposal and (3) a reasonable profit allowance for the completing and selling effort of the acquiring entity based on profit for similar finished goods? (FASB Statement No. 141, par. 37(c)(2))

• Are raw materials recorded at current replacement costs? (FASB Statement 141, par. 37(c)(3))

• If there has there been a significant change in the allowance for obsolete inventory, has the entity determined the events that gave rise to the increase in the allowance?

Note: The SEC staff has expressed the view that a business combination does not cause an increase in the allowance for obsolete inventory (unless it is part of a plan to integrate product lines of the combined entity) and would expect an expense to be recorded in the acquired entity’s financial statements before the acquisition or in the combined entity’s financial statements on a go-forward basis and not as a purchase accounting adjustment. (SAB Topic 2-A5 and 2-A9)

Plant and equipment (Also see “Fair value measurements and use of a specialist” in the “Auditing Matters” section of this checklist.)

• Are plant and equipment designated to be used recorded at current replacement cost for similar capacity unless expected use of the asset indicates a lower value to the acquiring entity? (FASB Statement No. 141, par. 37 (d)(1))

• Are plant and equipment designated to be sold recorded at fair value less cost to sell? (FASB Statement No. 141, par. 37(d)(2))

Intangible assets1 (Also see “Fair value measurements and use of a specialist” in the “Auditing Matters” section of this checklist.)

• Are intangible assets separately recognized pursuant to paragraph 39 of FASB Statement No. 141 and recorded at estimated fair value? (Consider Appendix A14 of FASB Statement No. 141, regarding the nature of the business, for all intangible assets that might require recognition apart from goodwill.)

• Are the valuation methodology employed and estimated lives assigned to intangible assets, particularly those assigned an indefinite life, reasonable? (FASB Statement No. 142, par. 11–14)

• Does the amortization method for intangible assets subject to amortization reflect the pattern in which the economic benefits of the intangible asset are consumed or otherwise used up?

Note: if a pattern cannot be reliably determined, a straight-line amortization method may be used (FASB Statement No. 142, par. 12-14).

Purchased research and development costs FASB Statement No. 141 does not change the requirement in paragraph 5 of FASB Interpretation No. 4, Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method, that amounts assigned to tangible and

1 For questions relating to in-process research and development costs, see the “Purchased Research and Development Costs” section of this checklist.

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Recording assets acquired and liabilities assumed Yes, No, N/A intangible assets to be used in a particular research and development project that have no future alternative use shall be charged to expense at the acquisition date (FASB Statement 141, par. 42). In December 2001, the AICPA published a Practice Aid entitled Assets Acquired in a Business Combination to Be Used in Research and Development Activities: A Focus on Software, Electronic Devices, and Pharmaceutical Industries. • If purchased research and development costs have been identified as intangible

assets, have we reviewed the independent valuation of the purchased research and development?

• Has the work been completed under the guidance outlined in the AICPA practice aid for IPR&D?

• If our procedures regarding the valuation specialist were satisfactorily completed (see “Use of a Specialist” in the “Auditing Matters” section of this checklist), has the purchased research and development been expensed? (FASB Statement No. 2 and FIN 4)

Other assets (Also see “Fair value measurements and use of a specialist” in the “Auditing Matters” section of this checklist.)

• Are other assets, including land, natural resources and non-marketable securities recorded at their appraised values? (FASB Statement No. 141, par 37f)

Accounts payable and long-term debt • Are accounts and notes payable, long-term debt, and other claims payable

recorded at present value of amounts to be paid determined at appropriate current interest rates? ( FASB Statement No.141, par. 37(g))

• If the debt contains a prepayment clause, have the provisions of EITF Issue No. 98-1 been considered in determining the appropriateness of the fair value of the debt?

Note: EITF Issue No. 98-1 recognizes that some present value calculations do not recognize the fair value of the prepayment clause. The EITF concludes that recognition of the fair value of the prepayment clause is appropriate for the debt to be recorded at fair value. (EITF Issue No. 98-1)

• If present value techniques are used to value the debt, has an appropriate discount rate applicable to the credit standing of the combined entities’ current interest rate been used?

Note: In the case of debt that remains solely an obligation of the acquired entity (that is, not guaranteed or collateralized by the acquirer), the current interest rate applicable to the credit standing of the acquired entity alone should be used. (EITF Issue No. 98-1)

Liabilities and accruals

• Are warranties, vacation pay, deferred compensation, other contingent liabilities and loss accruals recorded at the present value of amounts to be paid based on current interest rates? (FASB Statement No. 141, par. 37(j))

• If there has been a significant change in the acquired entity’s liabilities and accruals, has the entity acquiring entity determined the events that gave rise to the change?

Note: The SEC staff has expressed the view that a business combination should not cause a significant change in the liabilities and accruals, except for the effects of discounting and changes in interest rates, and would expect these changes to be recorded in the acquired entity’s financial statements before the acquisition or prospectively in the combined entity’s financial statements and not as a purchase accounting adjustment. (SAB Topic 2-A5 and 2-A9)

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Recording assets acquired and liabilities assumed Yes, No, N/A

• Are other liabilities and commitments (for example, deferred revenue) assumed in a purchase business combination recorded at the present values of the amounts to be paid to settle the obligations using appropriate current interest rates?

Note: An acquired entity’s deferred revenue balance at the date of acquisition recorded in its financial statements is generally not the amount that would be required to settle the underlying contractual performance obligation at the date of acquisition.

• Did the acquiring entity recognize a liability related to deferred revenue of an acquired entity only if that deferred revenue represented a legal obligation assumed by the acquiring entity (that is, a legal performance obligation, which could arise from contractual provisions or from consumer rights in the relevant jurisdictions.) (EITF Issue 01-03)

Note 1: The SEC staff believes that the acquirer should record a liability for the fair value of the contractual performance obligation at the date of acquisition based upon the nature of the activities to be performed, and the related costs to be incurred, after consummation. The fair value should consider the current market rates for performing the remaining services or providing the remaining products, if any, and also any proceeds yet to be received under the arrangement. The objective is for the acquiring entity to record a current market profit margin on the assumed obligation to perform services or provide products after the consummation of the business combination. Note 2: The acquired entity’s deferred revenue balance at the date of acquisition is generally not its fair value. This topic has received considerable attention by the SEC staff. The staff has stated that it will challenge a registrant when there are unexpected material differences between the amount of the purchase price that the acquiring entity allocates to the assumed liabilities and the amount in the historical financial statements of the acquired entity.

Pension obligations (Also see “Fair value measurements and use of a specialist” in the “Auditing Matters” section of this checklist.)

• Has the pension obligation been recorded as the difference between the projected pension obligation and the fair value of the plan assets, thereby eliminating any previously unrecognized net gain or loss, unrecognized prior service cost, or unrecognized net transition obligation? (FASB Statement No. 141, par. 37(h); FASB Statement No. 87, par. 74)

• If the acquiring entity intends to include employees of the acquired entity in the acquiring entity’s plan and grant credit for prior service and the acquisition agreement requires this action, has the acquiring entity recorded a liability in allocation of the purchase price? (Question 15 of the FASB Staff Implementation Guide on FASB Statement No. 87)

• If the acquiring entity intends to include employees of the acquired entity in the acquiring entity’s plan and grant credit for prior service and the acquisition agreement does not requires this action, has the acquiring entity accounted for this action as a plan modification? (Question 15 of the FASB Staff Implementation Guide on FASB Statement No. 87)

• If the acquired entity agrees to reimburse the acquiring entity for payments made under the acquired entity’s plan to retired participants of the plan at the date of the sale and transfer of the business, have those payments been actuarially determined and recorded as a receivable in the purchase allocation, leaving the obligation presented on a gross basis? (EITF Topic D-54)

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Recording assets acquired and liabilities assumed Yes, No, N/A Postretirement benefits other than pensions (Also see “Fair value measurements and use of a specialist” in the “Auditing Matters” section of this checklist.)

• Has an obligation been recorded for postretirement benefits other than pensions as the difference between the accumulated postretirement benefit obligation and the fair value of the plan assets adjusted for (1) any changes in assumptions based on the purchaser’s assessment of relevant future events and (2) changes to the terms of the substantive plan due to the purchase business combination? (FASB Statement No. 141, par 37(i); FASB Statement No. 106, par. 86)

• If the acquiring entity intends to increase postretirement benefits other than pensions for employees of the acquired entity and grant credit for prior service and the acquisition agreement requires this action, has the entity recorded a liability in allocation of the purchase price? (FASB Statement No. 106, par. 87)

• If the acquiring entity intends to increase postretirement benefits other than pensions for employees of the acquired entity and grant credit for prior service and the acquisition agreement does not require this action, has the acquiring entity accounted for this action as a plan modification? (FASB Statement No. 106, par. 87 )

Other liabilities and commitments • Are other liabilities and commitments, including unfavorable leases and

contracts, assumed in the acquisition recorded at the present value of amounts to be paid determined at appropriate current interest rates? (FASB Statement No. 141, par. 37(k))

Goodwill of the acquired entity • Was goodwill, if any, which was previously recognized by the acquired entity,

excluded from the allocation of the purchase price and appropriately not recognized by the acquiring entity? (FASB Statement No. 141, par. 38)

Accounting for goodwill Yes, No, N/A • Has the excess of the cost of an acquired entity over the amounts assigned to

assets acquired and liabilities assumed been recognized as goodwill? (FASB Statement No. 141, par. 43)

• Has the entity reviewed its purchase price allocation to ensure all intangible assets that can be separately recognized pursuant to par. 39 of FASB Statement No. 141, have been recorded apart from goodwill?

Review Appendix A, paragraph A14 of FASB Statement No. 141, for examples of intangible assets that meet the criteria for recognition apart from goodwill.)

• Does the entity have a documented policy for its review of goodwill for impairment in accordance with FASB Statement No. 142?

• Did the entity allocate goodwill to a reporting unit(s) as of the date of the acquisition? (FASB Statements No. 141, par. 50, and No. 142, par. 34)

• Is the methodology used to assign goodwill to the entity’s reporting unit(s) reasonable, supportable, and applied in a consistent manner and documented at the acquisition date? (FASB Statements No. 141, par. 50, and No. 142, par. 34.)

• Did the acquiring entity document the factors that contributed to a purchase price that resulted in recognition of goodwill? (FASB Statement No. 141, par. 50 and 51(b))

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Accounting for preacquisition contingencies Yes, No, N/A • If the fair value of a preacquisition contingency is determinable during the

allocation period, has the fair value of the contingency been included in the allocation of the purchase price? (FASB Statement No. 141, par. 40(a))

• If the fair value of a preacquisition contingency is not determinable, does it meet the criteria for inclusion in the purchase price? (FASB Statement No. 141, par. 40(b))

Note: A preacquisition contingency should only be included in the purchase price if both of the following criteria are met: (1) Information available before the end of the allocation period indicates that it is probable that an asset existed, a liability has been incurred, or an asset had been impaired at the consummation of the business combination. It is implicit in this condition that it must be probable that one or more future specific events will occur confirming the existence, (2) the amount of the asset or liability can be reasonably estimated.

• Are adjustments after the end of the allocation period that result from a preacquisition contingency other than a loss carry-forward included in the determination of net income in the period in which the adjustment is determined? (FASB Statement No. 141, par. 41)

Negative goodwill (For issues relating to contingent consideration and negative goodwill see the “Contingent Consideration” section of this checklist.)

Yes, No, N/A

• If there is negative goodwill, has management reassessed that all acquired assets and liabilities assumed have been identified and recognized, and performed “remeasurements” to verify that the consideration paid, assets acquired, and liabilities assumed have been properly valued? (FASB Statement No. 141, footnote 19)

• If negative goodwill remains, has management reduced all acquired assets on a pro rata basis, except for (1) financial assets other than investments accounted for by the equity method, (2) assets to be disposed of by sale, (3) deferred tax assets, (4) prepaid assets relating to pension and other postretirement benefit plans, and (5) any other current assets? If all eligible assets are reduced to zero and an amount of negative goodwill still remains, has the remaining unallocated negative goodwill been recognized immediately as an extraordinary gain? (FASB Statement No. 141, par. 44 and 45).

• If there are assets held for sale, have they been excluded from the pro rata allocation of negative goodwill?

Deferred income taxes—acquired entity (The involvement of appropriate level

tax professionals with domestic and international experience may be necessary.)

Yes, No, N/A

• Were deferred income taxes, if any, which were previously recognized by the acquired entity appropriately not recognized by the acquiring entity? (FASB Statement No. 141, par. 38)

Deferred income taxes—acquiring entity (The involvement of appropriate level tax professionals with domestic and international experience may be appropriate.)

• Did the acquiring entity recognize a deferred tax liability or asset for the differences between the assigned value and the tax bases of the recognized assets acquired and liabilities assumed in accordance with paragraph 30 of FASB Statement No. 109, Accounting for Income Taxes? (FASB Statement 141, par. 38)

• For nondeductible goodwill; unallocated negative, excess tax deductible goodwill; and acquired APB Opinion 23, Accounting for Income Taxes - Special Areas, differences that meet the indefinite reversal criteria, have no deferred

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Deferred income taxes—acquired entity (The involvement of appropriate level tax professionals with domestic and international experience may be necessary.)

Yes, No, N/A

taxes been provided? (FASB Statement No. 109, par. 30-34) • Have changes in the valuation allowance as a result of the business combination

been reflected in the purchase price allocation? (FASB Statement No. 109, par. 30)

• If, in the future, the combined entity will file a consolidated tax return, have the deferred tax accounts reflected this fact? (FASB Statement No. 109, par. 266)

• If an acquired tax benefit is not recognized (that is, a valuation allowance is established) at the acquisition date and the acquired tax benefit is subsequently recognized, has the recognition of the tax benefit been applied to reduce goodwill and then to reduce noncurrent intangible assets, before being recognized as a reduction of income tax expense? (FASB Statement No. 109, par. 30)

Allocation of assets acquired and liabilities assumed to acquiring entity’s reporting units

• Is the methodology used to assign the assets acquired and liabilities assumed to the entity’s reporting unit(s) reasonable, supportable, and applied in a consistent manner and documented at the acquisition date? (FASB Statements No. 141, par. 50 and 142, par. 33)

• Did the documentation for making the assignment to the entities reporting unit(s) include the basis for and method of determining the purchase price of the acquired entity and other related factors (such as the underlying reasons for the acquisition and management’s expectations related to dilution, synergies, and other financial measurements) at the acquisition date? (FASB Statement No. 141, par. 50)

The Acquisition Date

Background SFAS No. 141, paragraph 48 states as follows:

The date of acquisition…ordinarily is the date assets are received and other assets are given, liabilities are assumed or incurred, or equity interests are issued. However, the parties may, for convenience, designate as the effective date the end of an accounting period between the dates a business combination is initiated and consummated. The designated date should ordinarily be the acquisition date for accounting purposes if a written agreement provides that effective control of the acquired entity is transferred to the acquiring entity on that date, without restrictions except those required to protect the shareholders or other owners of the acquired entity, such as restrictions or significant changes in the operations, permission to pay dividends equal to those regularly paid before the effective date, and the like.

Authoritative Guidance FASB Statement No. 141, paragraphs 48 through 49

Checklist The acquisition date Yes, No, N/A • If the transaction has been recorded on a date other than that date on which

assets are received and other assets are given or securities issued, has a written agreement transferred effective control of the acquiring entity on the earlier date? (FASB Statement No. 141, par. 48 – 49)

Other Business Combination Issues

Checklist Other business combination issues Yes, No, N/A

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Other business combination issues Yes, No, N/A Conforming accounting policies • Absent justification for different accounting policies, have the acquired entity’s

accounting policies been conformed to those of the acquiring entity (for example, depreciation methods and lives)?

Push-down accounting • If the acquiring entity has purchased substantially all of the common stock of the

acquired entity, has the acquiring entity considered whether SAB Topic 5-J requires push-down accounting in the separate, post-acquisition financial statements of the acquired entity?

• If the acquiring entity uses borrowed funds to finance the purchase of a subsidiary or to finance a subsidiary’s operations, has the acquiring entity considered whether SAB Topic 5-J requires push-down of the parent entity debt to the subsidiary?

• Has management considered EITF Abstract, Topic D-97, “Push-Down Accounting,” and the use of push-down accounting for “substantially wholly owned” subsidiaries?

Note: The SEC staff believes that it is appropriate to aggregate the holdings of those investors who both "mutually promote" the acquisition and "collaborate" on the subsequent control of the investee entity (the collaborative group). The SEC staff believes that push-down accounting is required if a entity becomes substantially wholly owned by a group of investors who act together as effectively one investor and are able to control the investee.

Recognition of Liabilities For Exiting Certain Activities And For Terminating or Relocating Certain Employees of the Acquired Entity (EITF Issue No. 95-3)

Background EITF Issue No. 95-3 establishes the criteria that must be met to recognize liabilities for exiting certain activities and for terminating or relocating certain employees of the acquired entity in a purchase business combination. The costs of a plan to (1) exit an activity of an acquired entity, (2) involuntarily terminate employees of an acquired entity, or (3) relocate employees of an acquired entity should be recognized as liabilities assumed in a business combination and included in the allocation of the acquisition cost in accordance with FASB Statement No. 141 if certain conditions are met.

Checklist

Costs to exit certain activities or to involuntarily terminate or relocate certain employees of the acquired entity

Yes, No, N/A

Costs to exit certain activities: Intent: • Yes, management has the intent as of the consummation date to exit certain

activities of an acquired entity. Complete the remainder of this section. • No, management does not have the intent as of the consummation date to exit

certain activities of an acquired entity. All subsequent decisions to exit certain activities will be expensed as incurred or under the provisions of EITF 94-3; SAB 100, Restructurings; FASB Statement No. 144; or FASB Statement No. 146,* Accounting for Costs Associated with Exit or Disposal Activities. Do not complete the remainder of this section. Proceed instead to section of this checklist titled “Involuntary Employee Termination Benefits and Relocation Costs.”

* FASB Statement No. 146 is effective for exit or disposal activities that do not involve an entity newly acquired in a business combination and that was initiated after December 31, 2002.

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Yes, No, N/A

EITF Issue No. 94-3 applies to exit activities initiated under an exit plan that met the criteria of 94-3 before FASB Statement No. 146’s initial application.

Note: If the entity intends to recognize a liability for costs to exit an activity within the scope of EITF Issue No. 95-3, determine whether the criteria in the following bullets have been met by the entity. If, and ONLY if, these criteria are met (for example, answers are Yes to the next 4 bullets and Yes to either of the alternatives in the 5th bullet), a cost resulting from a plan to exit an activity of an acquired entity should be recognized as a liability assumed as of the consummation date of the acquisition.

• As of the consummation date of the acquisition, management having the appropriate level of authority begins to assess and formulate a plan to exit an activity of the acquired entity .

• As soon as possible after the consummation date, management having the appropriate level of authority completes the assessment of which activities of the acquired entity to exit and approves and commits the combined entity to the plan. Although the time required will vary with the circumstances, the finalization of the plan cannot occur beyond one year from the consummation date of the acquisition.

Note that when the entity’s policy requires, or if management elects to seek, approval from the board of directors (BOD) for an exit plan, a commitment date cannot be established until BOD approval has been obtained. (SAB Topic 5-P, Question 1)

• The plan specifically identifies all significant actions to be taken to complete the plan, activities of the acquired entity that will not be continued, including the method of disposition and location of those activities, and the plan’s expected date of completion.

The following have been considered in determining whether the plan is sufficiently detailed and whether the entity is able to reliably estimate the nature, timing and amount of exit costs (SAB Topic 5-P, Questions 2 & 3):

1. The plan is comparable in terms of level of detail and precision of estimation

to other operating and capital budgets the entity prepares. 2. Controls and procedures are in place to detect, explain and, if necessary,

correct variances or adjust accounting accruals. 3. Estimates reflect the most likely expected outcome given all the information

currently available to management. 4. All significant actions expected to be taken have been identified and are

documented in the plan in sufficient detail, including (but not limited to) details such as geographic locations, estimated costs, and expected cash flows.

5. The plan is the one that will be used to evaluate the performance of the individuals who will be responsible for executing the plan and for making periodic comparisons of planned versus actual results and variances.

6. The components used in making the detailed calculation in the plan and arriving at the estimated liability (for example, per person costs, and number of people) have a reasonably supportable basis.

7. The key assumptions used in developing the plan have a reasonably

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Yes, No, N/A

supportable basis. 8. If the plan affects multiple locations, costs have been identified by specific

property location. No higher level of aggregation is appropriate. • Actions required by the plan will begin as soon as possible after the plan is

finalized, and the period of time to complete the plan indicates that significant changes to the plan are not likely. The following factors may indicate that the plan might not begin or be executed within a period of time that is short enough to allow the entity to appropriately conclude that significant changes in the plan are unlikely (SAB Topic 5-P, Questions 5 & 6). Indicate whether these factors have been considered and whether it has been determined that these factors do not exist:

1. All significant actions to be undertaken have not been identified with sufficient

specificity or are not reasonably estimatable. 2. It is likely that execution of the plan will be delayed due to events or

circumstances that are reasonably likely to occur. 3. The entity lacks the internal controls or information to monitor effectively the

activities being performed, compare the costs incurred to plan, and make adjustments to the plan on a timely basis.

4. The plan will not be completed and the costs will not be incurred within one year of the commitment date. However, a plan might not be completed within one year of the commitment date due to factors outside the entity's control (that is, legal or contractual restrictions). In such cases, management must have appropriate evidence and support for concluding that the execution of the plan will not be materially affected by intervening developments.

• The cost is neither associated with nor incurred to generate revenues of the combined entity after the consummation date and meets either of the following criteria:

1. The cost has no future economic benefit to the combined entity, is

incremental to other costs incurred by either the acquired entity or the acquiring entity in the conduct of activities before the consummation date, and will be incurred as a direct result of the plan to exit an activity of the acquired entity. The notion of incremental does not contemplate a diminished future economic benefit to be derived from the cost but, rather, the absence of the cost in either entity's activities immediately before the consummation date;

-or- 2. The cost represents an amount to be incurred by the combined entity under a

contractual obligation of the acquired entity that existed before the consummation date and will either continue after the plan is completed with no economic benefit to the combined entity or be a penalty incurred by the entity to cancel that contractual obligation.

Involuntary employee termination benefits and relocation costs Intent: • Yes, management has the intent as of the consummation date to involuntarily

terminate (relocate) employees of the acquired entity. Complete the remainder of this section.

• No, management does not have the intent as of the consummation date to

involuntarily terminate (relocate) employees of the acquired entity. Do not complete the remainder of this section. Proceed instead to the next section of this checklist.

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Yes, No, N/A

Note: If the entity intends to recognize a liability for involuntary employee termination benefits and relocation costs within the scope of EITF Issue No. 95-3, determine whether certain criteria have been met. If, and ONLY if, these criteria are met (for example, answers are Yes to the next 4 bullets), a cost resulting from a plan to involuntarily terminate or relocate employees of an acquired entity should be recognized as a liability assumed as of the consummation date of the acquisition and included in the allocation of the acquisition cost. Costs related to activities or employees of the acquired entity that do not meet the conditions described below and initial and/or revised plan actions that result from events occurring after the consummation date do not result in an element of cost of the acquired entity. These costs should be either expensed or capitalized when incurred based on the nature of the expenditure and the capitalization policy of the combined entity.

• As of the consummation date of the acquisition, management having the appropriate level of authority begins to assess and formulate a plan to involuntarily terminate (relocate) employees of the acquired entity.

• As soon as possible after the consummation date, management having the appropriate level of authority completes the assessment of which employees of the acquired entity will be involuntarily terminated (relocated), approves and commits the combined entity to the plan of termination (relocation), and communicates the termination (relocation) arrangement to the employees of the acquired entity. The communication of the termination (relocation) arrangement should include sufficient detail to enable employees of the acquired entity to determine the type and amount of benefits they will receive if they are terminated (relocated).

Note 1: Although the time required will vary with the circumstances, the finalization of the plan of termination (relocation) and the communication of the termination (relocation) arrangement cannot occur beyond one year from the consummation date of the acquisition. Note 2: When the entity’s policy requires, or if management elects to seek, approval from the board of directors (BOD) for a termination or relocation plan, a commitment date cannot be established until BOD approval has been obtained. (SAB Topic 5-P, Question 1)

• The plan of termination (relocation) specifically identifies the number of employees of the acquired entity to be terminated (relocated), their job classifications or functions, and their locations.

• The following have been considered in determining whether the plan is sufficiently

detailed and whether entity is able to reliably estimate the nature, timing and amount of termination and relocation costs (SAB Topic 5-P, Questions 2 & 3):

1. The plan is comparable in terms of level of detail and precision of estimation to other operating and capital budgets the entity prepares.

2. Controls and procedures are in place to detect, explain and, if necessary, correct variances or adjust accounting accruals.

3. Estimates reflect the most likely expected outcome given all the information currently available to management.

4. All significant actions expected to be taken have been identified and are documented in the plan in sufficient detail, including (but not limited to) details such as geographic locations, estimated costs, and expected cash flows.

5. The plan is the one that will be used to evaluate the performance of the individuals who will be responsible for executing the plan and for making periodic comparisons of planned versus actual results and variances.

6. The components used in making the detailed calculation in the plan and arriving at the estimated liability (for example, per person costs and number of people) have a reasonably supportable basis.

7. The key assumptions used in developing the plan have a reasonably supportable basis.

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Yes, No, N/A

8. If the plan affects multiple entity locations, costs have been identified by specific property location. No higher level of aggregation is appropriate.

• Actions required by the plan of termination (relocation) will begin as soon as

possible after the plan is finalized, and the period of time to complete the plan indicates that significant changes to the plan are not likely. The following factors may indicate that the plan might not begin or be executed within a period of time that is short enough to allow the entity to appropriately conclude that significant changes in the plan are unlikely. (SAB Topic 5-P, Questions 5 & 6) Indicate whether these factors have been considered and whether it has been determined that these factors do not exist:

1. All significant actions to be undertaken have not been identified with sufficient specificity or are not reasonably estimatable.

2. It is likely that execution of the plan will be delayed due to events or circumstances that are reasonably likely to occur.

3. The entity lacks the internal controls or information to monitor effectively the activities being performed, compare the costs incurred to plan, and make adjustments to the plan on a timely basis.

4. The plan will not be completed and the costs will not be incurred within one year of the commitment date. However, a plan might not be completed within one year of the commitment date due to factors outside the entity's control (that is, legal or contractual restrictions). In such cases, management must have appropriate evidence and support for concluding that the execution of the plan will not be materially affected by intervening developments.

Testing compliance with EITF Issue No. 95-3 Obtain the formal plan of employee termination, relocation, or other exit activities from management and: • Read the plan. • Obtain a detailed understanding of the plan. • Review evidence that the plan has been approved (either in the board minutes or

another document) by the appropriate level of management or board. The level of approval should be consistent with our understanding of the approval process of the entity.

• Test completeness by considering knowledge of the entity’s business and prior years' audit results, analyzing relationships of account balances to other related accounts, and considering evidence from other tests.

• Using the documentation received supporting the analysis of exit costs and employee relocation and termination benefits, perform the following:

1. Test mathematical accuracy. 2. Obtain detailed liabilities listing and perform the following:

a. Trace totals from the detailed liabilities listing to the supporting documentation.

b. Select reconciling items, to an extent based on materiality and inherent risk, to achieve the audit objective of accuracy. Trace the selected reconciling items to supporting documentation.

c. Test the mathematical accuracy of the detailed liabilities listing. d. Where there are significant reconciling items, determine whether the

results of the investigations have been reviewed and approved by a responsible official.

3. Trace account balances to the general ledger. 4. Review the information for any possible omissions.

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Yes, No, N/A

Subsequent changes in the liability recorded • Assess subsequent changes in the liability recorded pursuant to EITF Issue No.

95-3 and document which of the following applies:

1. The ultimate amount of a cost expended is less than the amount recorded as a liability assumed in a purchase business combination as a result of applying EITF Issue No. 95-3 and the excess reduces the cost of the acquired entity.

2. The ultimate amount of a cost expended exceeds the amount recorded as a

liability assumed in a purchase business combination and is recorded as an additional element of cost of the acquired entity if an adjustment to an original estimate is determined within one year of the acquisition date. Any amounts incurred, thereafter, should be included in the determination of net income in the period in which the adjustment is determined.

Based on the determination above, determine whether the difference has been appropriately accounted for.

Allocation of Purchase Price to Assets to Be Sold (FASB Statement No. 144)

Appropriate accounting — assets Yes, No, N/A • For a newly acquired long-lived asset (disposal group) that will be sold, rather

than held and used, to be classified as held for sale it must meet the following characteristics: (1) sale must complete within the one year maximum holding period (or fall into one of the exceptions outlined in par. 31), and (2) the other criteria in FASB Statement No. 144, par. 30 are met (or are probable of being met within a short period following the acquisition, typically with three months).

• Has management recorded the long-lived assets (disposal group) classified as held for sale at the lower of its carrying amount or fair value less costs to sell (FASB Statement No. 144, par. 34-37)?

• Have the results of operations of these assets (disposal group) classified as held for sale been recognized in the period in which those operations occur, whether reported in continuing operations or discontinued operations (if the criteria in FASB Statement No. 144, paragraph 42, are met)?

• Any long-lived asset (disposal group) classified as held for sale is not being depreciated.

• If the acquirer has decided not to sell the long-lived assets (disposal group), the asset or assets comprising the disposal group should be measured individually at the lower of: 1. Carrying amount before the asset (disposal group) was classified as held for

sale, adjusted for any depreciation (amortization) expense that would have been recognized had the asset (disposal group) been continuously classified as held and used.

2. Fair value at the date of the subsequent decision not to sell.

• Any adjustments to the carrying value of the long-lived assets that are reclassified as held and used, resulting from the decision not to sell, are to be included in income from continuing operations in the period of the subsequent decision not to sell.

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Appropriate accounting — liabilities Yes, No, N/A • If the acquirer intends to record a charge on its books for the costs of an exit plan

or for the costs of involuntary termination benefits (both related to the acquirer’s business), has the entity considered the provision of EITF Issue No. 95-14, "Recognition of Liabilities in Anticipation of a Business Combination," which would not allow recognition of a liability under EITF Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)," until consummation of the purchase business combination?

• If the acquirer intends to terminate certain of its employees after consummation of a purchase business combination for which it has a contractual obligation to pay certain termination benefits, has the entity considered the provision of EITF Issue No. 96-5, "Recognition of Liabilities for Contractual Termination Benefits or Changing Benefit Plan Assumptions in Anticipation of a Business Combination," which would not allow recognition of a liability for these contractual termination benefits until consummation of the purchase business combination?

Auditing Matters Authoritative Guidance SAS No. 73, Using the Work of a Specialist (AICPA, Professional Standards, vol. 1, AU sec. 336) SAS No. 99, Consideration of Fraud in a Financial Statement Audit (AICPA, Professional Standards,

vol. 1, AU sec. 316) SAS No. 101, Auditing Fair Value Measurements and Disclosures2 Nonauthoritative Guidance AICPA publication: Auditing Fair Value Measurements and Disclosures, and Allocation of Cost Under Statement of Financial Accounting Standards No. 141, Business Combinations

Checklist Auditing Matters Yes, No, N/A Risk of fraud • For identified fraud risk factors and other conditions possibly impacting the

assessment of the risk of material misstatement due to fraud, specific risk factors have been identified and procedures in response to these factors designed and performed. (SAS No. 99)

Gathering disclosure information • Consider disclosure requirements carefully, and identify in advance the amounts

or information required for the disclosures. Gather such information contemporaneously and identify the source that will provide the other information when required for the disclosures.

Note: See Appendix IV.

Fair value measurements and use of a specialist For matters relating to auditing fair value measurements and using the work of a specialist, see Appendix III, the section entitled, Auditing Fair Value Measurements.

2 Statement on Auditing Standards (SAS) No. 101, Auditing Fair Value Measurements and Disclosures, is effective for audits of financial statements for periods beginning on or after June 15, 2003. Earlier application is permitted.

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APPENDIX III: ILLUSTRATIVE AUDIT PROCEDURES FOR AUDITING UNDER FASB STATEMENT NO. 141, BUSINESS COMBINATIONS; FASB STATEMENT NO. 142, GOODWILL AND OTHER INTANGIBLE ASSETS; AND FASB STATEMENT NO. 144, ACCOUNTING FOR THE IMPAIRMENT OR DISPOSAL OF LONG-LIVED ASSETS The following is an illustrative audit program that contains audit procedures that the auditor can apply when auditing fixed and intangible assets. The audit procedures are based on the requirements of Financial Accounting Standards Board (FASB) Statements No.141, Business Combinations; No. 142, Goodwill and Other Intangible Assets; and No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Because of the risk-based nature of audits and the particular facts and circumstances of each entity, this illustrative audit program cannot contain all of the possible audit objectives or procedures that might be necessary during an audit. Likewise, it is not the intent of this audit program to prescribe a series of minimum audit procedures to be performed in every engagement. Thus, the auditor should apply professional judgment in determining the nature, timing, and extent of audit procedures required during an audit and tailor this illustrative audit program to the requirements of the particular audit.

Done By

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LONG-LIVED ASSETS

Long-lived fixed assets are often associated and grouped with long-term intangible assets subject to amortization for purposes of testing impairment. When long-lived fixed assets have been grouped with long-term intangible assets subject to amortization, the impairment steps below should be completed for both long-lived fixed assets and long-term intangible assets subject to amortization included in the group. (See FASB Statement No. 144.) When intangible assets are not subject to amortization, entities should assess impairment in conjunction with goodwill and indefinite-lived intangible assets using the guidance in FASB Statement No.142. (For the applicable audit procedures, see section of this audit program entitled “Goodwill and Indefinite-Lived Intangible Assets Not Subject to Amortization.)”

OBJECTIVE: Evaluate for write-offs or impairments of fixed assets that are to be held and used (FASB Statement No. 144)

Discuss with the entity its policies and procedures to identify asset impairments. Assess these responses in light of known business and environmental conditions.

Identify interviewees.

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Identify independently whether events or changes in circumstances have occurred within the entity, its industry, or the economy in general indicating the carrying value of the long-lived fixed asset (asset group) may not be recoverable (for example, declining prices, diminished use, physical changes, or regulatory or legal issues). If there are no impairment factors present, document that.

If the entity is planning to dispose of an asset by abandonment, review the plan and determine whether management has classified the item as held and used pending actual disposition.

For long-lived fixed assets (asset group) that may be impaired: • Verify that management has grouped its assets appropriately

(for example, at the lowest level for which there are identifiable cash flows) to be able to perform an impairment assessment (note that appropriate asset groupings are critical to the impairment assessment). (FASB Statement No. 144, par. 10 through 14)

• Determine whether the carrying values of these assets are

recoverable. If the sum of the expected future cash flows (undiscounted and without interest charges) expected to result from the use and eventual disposition of the asset (asset group) is less than the carrying amount of the asset (asset group), the carrying value of the asset (asset group) is not recoverable and the entity has an impairment loss. (FASB Statement No. 144, par. 17)

• Consider physically inspecting the assets. For long-lived fixed assets (asset group) that are not recoverable, verify that an impairment loss recorded in the income statement was recorded to the extent that the carrying amount of the long-lived fixed assets (asset group) exceeds their fair value. Note: See the section of this illustrative audit program entitled “Auditing Fair Value Measurements.”

For allocated impairment losses, verify that the loss is allocated to the long-lived fixed assets of the group on a pro rata basis using the relative carrying amounts of those assets (except that the loss allocated to an individual long-lived asset of the group should not reduce the carrying amount of that asset below its fair value whenever that fair value is determinable without undue cost and effort) .

For assets written off or impaired: • Test amounts charged against income statement accounts. • Test the mathematical accuracy of the calculation. • Test amounts charged to the long-lived fixed assets (property,

plant, & equipment (PP&E)) accounts.

• Ensure that individual long-lived fixed assets are not written down below zero.

Review useful lives of the long-lived fixed assets to determine their

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reasonableness in the current operating environment Ensure the write-offs or impairments have been authorized and approved. Examine documentation (for example, minutes of meetings of board of directors and related committees, agreements, correspondence) that supports the accounting action.

Ensure that appropriate information for the required disclosure has been obtained or identified. Note: See the illustrative disclosure checklist in Appendix IV of this publication.

OBJECTIVE: Evaluate fixed assets (disposal groups) that are to be disposed of by sale or otherwise for write-offs or impairments. (FASB Statement No. 144)

In addition to the procedures illustrated here, other procedures may be relevant to address the FASB Statement No. 144 requirements that apply in the following situations: • When newly acquired long-lived fixed assets are to be sold • When management commits to a plan to sell long-lived fixed

assets after the balance-sheet date but before the issuance of the financial statements

• When goodwill is associated with the long-lived assets to be sold • When reviewing the costs that management included in "costs to

sell" • When management allocates an impairment loss to individual

long-lived fixed assets of a group • When there are changes to management’s plan of sale • When management removed an individual asset or liability from

a disposal group previously classified as held for sale. Note: For audit procedures applicable to long-lived assets that are to be abandoned or exchanged for similar productive assets, see the preceding objective.

Verify that long-lived fixed assets (disposal group) classified as to be disposed of by sale, meet the criteria for such classification that is in paragraph 30 of FASB Statement No. 144.

Ensure that held-for-sale assets are measured at the lower of their carrying amount or fair value less cost to sell. Note: See the section of this illustrative audit program entitled “Auditing Fair Value Measurements.”

Verify that an impairment loss recorded in the income statement was recorded to the extent that the carrying amount of the long-lived fixed assets exceeds their fair value less costs to sell. Note: Subsequent revisions (both upward and downward) should be reported as adjustments to the carrying amount of a long-lived asset to be disposed of. However, in no circumstances should the increase in fair value result in the long-lived asset being recorded at an amount in excess of its carrying amount immediately before the being classified as held for sale.

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For those long-lived fixed assets grouped with other assets or liabilities not covered by FASB Statement No. 144, ensure that a recognized impairment loss only reduces the carrying amounts of the long-lived assets in the group.

Verify that management has ceased recording depreciation/amortization as of the date the assets are reclassified to held for sale Note: Interest and other expenses attributed to the liabilities of a disposal group classified as held for sale should continue to be accrued.

Ensure that the carrying amounts of any assets not covered by FASB Statement No. 144, including goodwill, that are included in a disposal group classified as held for sale are adjusted in accordance with other applicable generally accepted accounting principles (GAAP) before measuring the fair value less cost to sell of the disposal group.

For assets written off or impaired: • Test amounts charged against income statement accounts. • Test the mathematical accuracy of the calculation. • Test amounts charged to the long-lived assets (PP&E) accounts. • Ensure that individual long-lived assets are not written down

below zero.

Ensure the write-off or impairments have been authorized and approved. Examine documentation (for example, minutes of meetings of board of directors and related committees, agreements, correspondence) that supports the accounting action.

Ensure that appropriate information for the required disclosure has been obtained or identified. Note: See the illustrative disclosure checklist in Appendix IV of this publication.

If a previously intended sale will not occur, determine the new value for the asset group. Assets and liabilities should be recorded at the lower of their carrying value (adjusted for depreciation that would have been recognized had the asset [disposal group] been continuously classified as held and used), or fair value less cost to sell at the date the disposal plans were changed.

If management has determined that an impairment analysis is not warranted, document management's basis for such a conclusion and consider obtaining a specific representation in the management representation letter.

DISCONTINUED OPERATIONS

For purposes of reporting discontinued operations, a component of an entity comprises operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity. (See FASB Statement No. 144.)

Before completing the audit procedures in this area, the procedures in the preceding section of this illustrative audit program should be

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completed. OBJECTIVE: Calculate and test income or loss reported in discontinued operations. (FASB Statement No. 144)

Test the mathematical accuracy of the calculation. Verify that the amount is accurately recorded net of taxes and that the appropriate tax rate was used in the calculation.

Examine documentation (for example, minutes of meetings of board of directors and related committees agreements, correspondence) that supports the discontinuance of the operations of the component.

Verify that the discontinued operation(s) was authorized and approved.

From knowledge of the business and its transactions gained during the course of the audit, consider whether there are other transactions that should be classified as discontinued operations, or that should be treated as prior year adjustments.

OBJECTIVE: Test the classification of discontinued operations. By examining related documentation and through discussions with management, verify that a component of an entity that either has been disposed of or is classified as held for sale is reported in discontinued operations when both of the following conditions are met:

• The operations and cash flows of the component have been (or

will be) eliminated from the ongoing operations of the entity as a result of the disposal transaction.

• The entity will not have any significant continuing involvement in

the operations of the component after the disposal transaction. Ensure that appropriate information for the required disclosure has been obtained or identified. Note: See the illustrative disclosure checklist in Appendix IV of this publication.

INTANGIBLE ASSETS SUBJECT TO AMORTIZATION

Note: Intangible assets are often grouped with fixed assets for purposes of testing impairment. When intangible assets have been grouped with long-lived fixed assets, the impairment steps for PP&E for both long-lived fixed assets and long-lived intangible assets subject to amortization should be performed.

OBJECTIVE: Evaluate the accounting policies for intangible assets subject to amortization. (FASB Statement No. 144)

Update the understanding of the entity’s accounting policies for intangible assets subject to amortization, including initial method of recognition and measurement, amortizable lives, method of

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amortization, and method of evaluating recoverability of intangible assets. Evaluate whether the policies for intangible assets subject to amortization are reasonable considering the industry, history of intangible asset additions, etc. Watch for significant changes in the asset’s use, adverse legal or regulatory environment, changing market values, and other factors.

Verify that the policy is in compliance with GAAP. Throughout performance of audit work for this area, ensure the entity is in compliance with its stated accounting policies.

OBJECTIVE: Analyze intangible assets subject to amortization account balances.

Obtain an analysis of the account balances of intangible assets subject to amortization. The analysis should include balances at the beginning of the period, additions, write-offs, amortization, and balances at the end of the period.

• Trace totals from the analysis of intangible assets subject to

amortization to the detailed records.

• If reconciling items were identified by management, select

reconciling items and trace the selected items to supporting documentation. Determine whether the results of the client's investigations have been reviewed and approved by a responsible official.

• Test the mathematical accuracy of the detailed listing.

• Scan the detailed listing of intangible assets subject to amortization to identify, and then investigate, significant or unusual items (for example, items that may be maintenance expense, asset no longer in use).

• If appropriate, examine support for any significant adjustments

made throughout the year in reconciling the detailed intangible assets subject to amortization records with the account(s) in the general ledger.

Consider performing substantive analytical procedures to identify situations requiring further attention:

• Consider the client's business and circumstances, including its information systems and control procedures, and compare recorded information to expectations.

• Assess reliability of the data, considering the extent of controls

reliance.

• Determine the variation amount or percentage to be used in the

investigation of differences from expectations.

• Investigate variations from expectations by seeking relevant

explanations from management and appropriate corroborating evidence (for example, reviewing ledgers, examining supporting

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documentation). OBJECTIVE: Examine documentation supporting significant additions.

Examine documentation (for example, invoices, agreements, and closing statements or other supporting records and documentation) supporting significant additions to intangible assets subject to amortization.

If not done in connection with the initial acquisition, verify that the client has ownership rights to intangible assets subject to amortization additions by examining supporting documentation and performing, as applicable, confirmation procedures with the appropriate agency (that is patent office, licensing bureau.

Perform the following procedures to ensure the addition was recorded at the appropriate amount:

• Verify that capitalized costs are in compliance with GAAP requirements (for example technological feasibility met, product design has been completed).

• Examine documentation (for example invoices, agreements, closing statements or other supporting records and documentation) that supports significant capitalized amounts.

• Evaluate the reasonableness of the amount. Note: See the section of this illustrative audit program entitled “Auditing Fair Value Measurements.”

Evaluate whether the amortization period is reasonable. OBJECTIVE: Recompute amortization expense. Recompute amortization expense either on a major asset classification by making approximations on an overall basis or by testing amortization recorded for individuals assets.

Review results and investigating significant differences. OBJECTIVE: Evaluate write-offs or impairments of long-lived intangible assets subject to amortization that are to be held and used.

Note: The procedures for evaluating long-lived intangible assets subject to amortization that are to be held and used for write-offs or impairments are the same as those listed under the first objective in this illustrative audit program. That objective is to “Evaluate for write-offs or impairments of fixed assets that are to be held and used (FASB Statement No. 144).”

OBJECTIVE: Evaluate long-lived intangible assets subject to amortization that are to be disposed of by sale or otherwise for write-offs or impairments.

The procedures for evaluating long-lived intangible assets subject to amortization that are to disposed of by sale or otherwise for write-offs

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or impairments are the same as those listed under the second objective in this illustrative audit program. That objective is to “Evaluate fixed assets (disposal groups.) that are to be disposed of by sale or otherwise for write-offs or impairments (FASB Statement No. 144)” OBJECTIVE: Review valuations performed for assets. Review valuations performed for assets. For third party, independent, valuations by a qualified valuation specialist, obtain an understanding of the method used and document this information, or for internally developed valuations, obtain an understanding of the method used, document this information, and assess reasonableness.

Ensure asset recording is appropriate, including amortization and any valuation reserve.

OBJECTIVE: Evaluate whether fully amortized assets are utilized.

Identify fully amortized assets in the asset register and obtain assurance that such assets, acquisitions, and other items are still utilized or held by the entity.

Determine whether amortization rates for similar assets are appropriate.

Ensure that appropriate information has been obtained for the required financial statement disclosure. Note: See the illustrative disclosure checklist in Appendix IV of this publication.

GOODWILL AND INDEFINITE-LIVED INTANGIBLE ASSETS NOT

SUBJECT TO AMORTIZATION: Part I

The audit procedures in this section assume the auditor has identified and tested the source of goodwill and indefinite-lived intangible assets in connection with the original business combination or other transaction. When this has not been performed, also complete the audit procedures in the section entitled “Goodwill and Indefinite-Lived Intangible Assets not Subject to Amortization: Part II.”

OBJECTIVE: Evaluate the accounting policies for goodwill and indefinite-lived intangible assets. (FASB Statement No. 142)

Update your understanding of the entity's accounting policies for goodwill and indefinite-lived intangible assets.

Assess management's or third party's capabilities to perform appropriate valuations and the process and assumptions used by management to develop the fair values to complete the second step of the goodwill impairment test and to determine the fair value of any indefinite-life intangible asset. It should be noted that an entity must determine the fair value of an indefinite-lived intangible asset even if the entity is not required to complete the second step of the goodwill impairment test. Also determine whether the audit team has sufficient knowledge and experience to review the valuations, including the underlying methods and assumptions.

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Consider the need to use a valuation specialist to assist in evaluating the client's or third party's valuation methodology and assumptions used in the calculations. Note: The Sarbanes-Oxley Act of 2002 prohibits an audit firm from providing valuation services to their public clients.

Evaluate whether the policies for goodwill and indefinite-lived intangible assets are reasonable considering the industry, history of goodwill and indefinite-lived intangible asset additions, and other items.

Verify that the policy is in compliance with GAAP. Throughout the performance of audit work for this area, ensure the entity is in compliance with its accounting policies.

OBJECTIVE: Test indefinite-lived intangible assets for impairment.

Test the analysis prepared by management for each indefinite-lived intangible asset by comparing its fair value against its carrying value. (See the separate section of this illustrative audit program entitled “Auditing Fair Value Measurements.”)

If the fair value is less than the carrying amount, determine if an impairment loss has been recognized and appropriately recorded in the income statement in an amount equal to that excess.

After the impairment loss is recognized, verify that management appropriately adjusted the carrying amount of the intangible asset so the adjusted carrying amount becomes its new accounting basis (a subsequent reversal of an impairment is prohibited).

OBJECTIVE: Test goodwill for impairment. Note: Under FASB Statement No. 142, paragraph 27, management may carry forward the prior year’s detailed determination of fair value of a reporting unit provided that all of the following criteria have been met: • The assets and liabilities that make up the reporting unit have

not changed significantly since the most recent fair value determination.

• The most recent fair value determination resulted in an amount that exceeded the carrying value of the reporting unit by a substantial margin.

• Based on an analysis of events that have occurred and circumstances that have changed since the most recent fair value determination, the likelihood that a current fair value determination would be less than the carrying amount of the reporting unit is remote.

Determine whether the identification of the reporting unit(s) are appropriate.

Determine that the allocation of the asset and liabilities to the reporting unit(s) is appropriate.

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Determine that the allocation of the goodwill to the reporting unit(s) is appropriate.

Recompute the net carrying amount of the reporting unit(s). Test the analysis prepared by management by comparing the fair value of the reporting unit against the carrying value of the reporting unit, including goodwill. (See the separate section of this illustrative audit program entitled “Auditing Fair Value Measurements.”)

If the carrying amount of a reporting unit exceeds its fair value as determined above, verify the second step of the goodwill impairment test has been appropriately completed by performing the following:

• Verify that management used the guidance in FASB Statement 142, paragraph 21, in determining the implied fair value and then compared the implied fair value of reporting unit goodwill with the carrying amount of that goodwill.

• If the carrying amount of reporting unit goodwill exceeds the implied fair value of that goodwill, verify that management recognized an impairment loss in an amount equal to that excess (the loss recognized cannot exceed the carrying amount of goodwill) .

• After the impairment loss is recognized, verify that management appropriately adjusted the carrying amount of the goodwill so that the adjusted carrying amount becomes its new accounting basis.

OBJECTIVE: Evaluate whether events or circumstances have occurred that would require an interim impairment test of goodwill and indefinite-lived intangible assets. Note: The following procedures are appropriate when the annual test occurs before the occurrence of these items.

Test goodwill and indefinite-lived assets for impairment if an event occurs or circumstances change that indicate the assets’ carrying amount may not be recoverable (interim triggering events) or should be written down. Example events or circumstances relating to goodwill include: • A significant adverse change in legal factors or in the business

climate • An adverse action or assessment by a regulator • Unanticipated competition • A loss of key personnel • A more-likely-than-not expectation that a reporting unit or a

significant portion of a reporting unit will be sold or otherwise disposed of.

• A significant asset group within the reporting unit is tested for recoverability under FASB Statement No.144.

• A goodwill impairment loss is recognized in the separate financial statements of a subsidiary that is a component of the reporting unit.

(See FASB Statement No. 142, paragraph 28 (a) through (g))

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If management has determined that an impairment analysis is not warranted, document management's basis for such a conclusion and consider obtaining a specific representation in the management representation letter.

GOODWILL AND INDEFINITE-LIVED INTANGIBLE ASSETS NOT

SUBJECT TO AMORTIZATION: Part II

Following are audit procedures to consider when the source of goodwill and indefinite-lived intangible assets has not been otherwise identified and tested in connection with the original business combination or other transaction.

OBJECTIVE: Agree detailed goodwill and indefinite-lived intangible asset listing to the analysis of goodwill and indefinite-lived intangible assets.

Trace totals to the analysis of goodwill and indefinite-lived intangible assets.

Select reconciling items and trace the selected reconciling items to supporting documentation. Determine whether the results of the client's investigations have been reviewed and approved by a responsible official.

Test the mathematical accuracy of the detailed listing. Scan the detailed listing of goodwill and indefinite-lived intangible assets to identify, and then investigate, significant or unusual items (for example, items that may be maintenance expense, asset no longer in use).

If appropriate, examine support for any significant adjustments made throughout the year in reconciling the detailed goodwill and indefinite-lived intangible asset records with the account(s) in the general ledger.

OBJECTIVE: Consider performing substantive analytical procedures.

Consider the client's business and circumstances, including its information systems and control procedures, and compare recorded information to expectations based on appropriate data.

Assess reliability of the data, considering the extent of controls reliance.

Determine the variation amount or percentage to be used in the investigation of differences from expectations.

Investigate variations from expectations by seeking relevant explanations from management and appropriate corroborating evidence (for example, reviewing ledgers, examining supporting documentation).

OBJECTIVE: Examine documentation supporting significant additions.

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Examine documentation (for example, invoices, agreements, closing statements, or other supporting records and documentation) that supports significant goodwill and indefinite-lived intangible asset additions.

Verify that the client has ownership rights to such goodwill and indefinite-lived intangible asset additions by examining supporting documentation and performing, as applicable, confirmation procedures with the appropriate agency (for example, patent office, licensing bureau).

Test to ensure the addition was recorded at the appropriate amount. Ensure the additions have been authorized and approved. OBJECTIVE: Update roll-forward information for goodwill and indefinite-lived intangible assets.

Update roll-forward information for all current agreements, including modifications and interpretations thereof.

OBJECTIVE: Verify that indefinite-life classifications are valid. Verify that management evaluates indefinite life classifications each reporting period to determine whether events and circumstances continue to support an indefinite useful life.

Examine evaluation results and ensure that for previously classified indefinite-lived intangible assets whose useful lives have subsequently been determined to be no longer indefinite are subjected to appropriate amortization prospectively over its estimated useful life and accounted for in the same manner as other intangible assets that are subject to amortization. Note: The intangible asset must be tested for impairment before amortizing.

BUSINESS COMBINATIONS

Auditors should be actively involved in concurrently (that is, as it progresses) reviewing a business combination that is within the scope of FASB Statement No. 141. As a result, year-end audit program procedures often focus on proper disclosure and the testing of asset impairment. Auditors often use some form of practice aid or checklist to ensure the key accounting matters are addressed at the time of the business combination. Appendix II of this publication contains an illustrative checklist for business combinations that may be used for such purpose.

Done

By Date Ref./

Comments AUDITING FAIR VALUE MEASUREMENTS

OBJECTIVE: Obtain sufficient competent audit evidence to provide reasonable assurance that fair value measurements and disclosures are in conformity with GAAP. Note: The procedures in this section reflect the additional guidance in SAS No. 101, Auditing Fair Values, as well as recommendations of

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the FASB Statement No. 141 Auditing Guidance Task Force. Required professional standards applicable as of December 31, 2002, include SAS No. 57, Auditing Accounting Estimates (AICPA, Professional Standards, vol.1, AU sec. 342), and SAS No. 73, Using the Work of a Specialist (AICPA, Professional Standards, vol. 1, AU sec. 336). Obtain an understanding of the entity’s transactions and environment relating to fair value measurements and disclosures.

• Identify the types of accounts or transactions requiring fair value measurements or disclosures (for example, whether the accounts arise from the recording of routine and recurring transactions or whether they arise from nonroutine or unusual transactions). Identify any special risks associated with these accounts or transactions.

Some fair value measurements normally are characterized by greater uncertainty regarding the reliability of the measurement process. This greater uncertainty may be a result of: 1. The length of the forecast period 2. The number of significant and complex assumptions associated

with the process 3. A higher degree of subjectivity associated with the assumptions

and factors used in the process 4. A higher degree of uncertainty associated with the future

occurrence or outcome of events underlying the assumptions used

5. Lack of objective data when highly subjective factors are used

• When an entity uses a service organization, the auditor considers the requirements of SAS No. 70, Service Organizations (AICPA, Professional Standards, vol. 1, AU sec. 324).

Obtain an understanding of the relevant controls over the entity’s fair value measurements and disclosures.

• Identify and evaluate controls over the process used to determine fair value measurements, including, for example, controls over data and the segregation of duties between those committing the entity to the underlying transactions and those responsible for undertaking the valuations.

• Identify and evaluate controls over the consistency, timeliness, and reliability of the data used in valuation models.

• Identify and consider the role that information technology has in the process.

• Identify and evaluate the integrity of change controls and security procedures for relevant information systems, including approval processes.

• Identify and evaluate any methods or procedures used to monitor changes in the business environment that would affect management’s assumptions.

Based on the circumstances and available information, determine whether to test the fair value measurement by using one or more of the following approaches: 1. Test management’s significant assumptions, the valuation

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model, and the underlying data (see this toolkit, paragraphs 50 through 62).

2. Develop independent fair value estimates for corroborative purposes (see this toolkit, paragraph 63).

3. Reviewing subsequent events or transactions (see this toolkit, paragraphs 64 and 65).

Use of a Valuation Specialist Internal or external, independent valuation specialists may be used to estimate fair values. When management is relying on the valuations of specialists for financial statement amounts: • Evaluate the expertise, objectivity and experience of those

persons determining the fair value measurements. (See paragraphs 33 and 34 of the AICPA toolkit; SAS No. 73 [AU sec. 336.08].)

• Consider the specialist’s relationship to the acquiring entity or the entity for which the valuation is performed. (See this toolkit, paragraphs 46 through 49.)

• Obtain an understanding of the nature of the work performed or to be performed by the specialist. (See paragraphs 38 through 42 and 46 through 49 of the AICPA toolkit). If the auditor concludes that he or she will use the findings of the specialist, it is recommended that the auditor consider the need to communicate with management and/or the specialist during the engagement process or soon thereafter to consider the terms of the engagement between the specialist and management.1 • Understand the objective and scope of the specialist’s

work.

• Evaluate the specialist’s understanding of the GAAP definition of fair value relating to the specific item valuation.

• Understand the methods or assumptions used or to be

used as well as any nonclient data that the specialist intends to use.

• Identify the data to be supplied by the client to the

specialist, so the auditor is aware of what may need to be subjected to audit testing.

• Compare the current methods and significant assumptions

with the methods and assumptions used in valuations of assets acquired in previous valuations (or business combinations).

• Evaluate any restrictions on the specialist's access to

necessary key entity personnel, records, or files. • Evaluate the valuation specialist’s understanding that the

valuation findings will be used by the auditor to evaluate the related assertions in the financial statements.

• Consider the anticipated timing of the availability of the

1 See Appendix V, “Management Considerations When Engaging a Specialist.”

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valuation conclusions and written report. Identify in advance if possible timing issues that might affect timely reporting and auditing of the fair value estimates.

• Identify whether the written valuation report will include the

specific items the auditor will need to perform that evaluation and support the auditor’s procedures.

Note: valuation standards do not require the preparation of a written report, but it is recommended that for fair value estimate auditing purposes a written report be obtained. The valuation method used to the estimate fair value of the acquired assets is appropriate.

• The method and assumptions used to develop the fair value is in accordance with appropriate and relevant GAAP requirements.

• If management may have identified that different valuation methods result in a range of significantly different fair value measurements, the auditor evaluates how management has considered the reasons for these differences in establishing its fair value measurements.

The assumptions underlying the approach used to develop the fair value estimates are reasonable in the circumstances and reflect, or are not inconsistent with, market information, as required by GAAP.

• Determine that management has identified significant assumptions underlying the valuations (that is, those that are sensitive to variation or bias). Identify and evaluate any specific risks identified.

• If management has not identified particularly sensitive assumptions, consider techniques to identify those assumptions.

• Ensure that there are no contrary data indicating that marketplace participants would use different assumptions (for example, discount rates that do not appear to reflect current market assumptions).

• Understand and consider the reasonableness of the significant assumptions.

To be reasonable, the assumptions on which the fair value measurements are based (for example, the discount rate used in calculating the present value of future cash flows),2 individually and taken as a whole, need to be realistic and consistent with: a. The general economic environment, the economic environment

of the specific industry, and the entity’s economic circumstances;

b. Existing market information; c. The plans of the entity, including what management expects will

be the outcome of specific objectives and strategies;

2 The auditor also should consider requirements of generally accepted accounting principles that may influence the selection of assumptions (see Financial Accounting Standards Board Statement of Financial Accounting Concepts No. 7, Using Cash Flow Information and Present Value in Accounting Measurements).

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d. Assumptions made in prior periods, if appropriate; e. Past experience of, or previous conditions experienced by, the

entity to the extent currently applicable; f. Other matters relating to the financial statements, for example,

assumptions used by management in accounting estimates for financial statement accounts other than those relating to fair value measurements and disclosures; and

g. The risk associated with cash flows, if applicable, including the potential variability in the amount and timing of the cash flows and the related effect on the discount rate.

• Identify any sources of documented support for management’s assumptions.

Test the data used to develop the fair value measurement.

• Consider procedures such as verifying the source of the data, and mathematical recomputation of selected inputs.

Determine the valuation method is applied consistently and any significant assumptions that reflect management’s intent and ability are consistent with management’s plans.

• Consider management’s past history of carrying out its stated intentions with respect to assets or liabilities.

• Review related written plans and other documentation, including, where applicable, budgets, minutes, and other such items.

• Consider management’s stated reasons for choosing a particular course of action.

• Consider management’s ability to carry out a particular course of action given the entity’s economic circumstances, including the implications of its contractual commitments

• Consider whether variances from the prior period fair value measurements result from changes in market or economic circumstances

Develop models to corroborate a fair value. An alternative method of auditing fair value is the use of an auditor’s model to corroborate management’s valuation. This is more likely to be considered when management or a valuation specialist has used a proprietary methodology or one not often used in developing a fair value estimate. • The auditor model should use assumptions consistent with those

used by management. • The management assumptions should be understood and

assessed as reasonable by the auditor. The auditor may need to supplement management assumptions with other assumptions when different estimation techniques are used.

• Significant differences between the auditor and management models should be reconciled, and /or may be the basis for additional procedures or a conclusion that the valuation cannot be supported.

Estimate subsequent event to estimate fair value. If the auditor is aware of an impending transaction to be realized at or near year end that may be the basis for a fair value estimate, the auditor may decide to look to this transaction as a basis for a fair value determination. Consider the following before relying on this anticipated event for the valuation:

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• Will the transaction meet the GAAP requirements for determining a fair value for the item or items in the transaction?

• Consider the likelihood that a change in management plans might result in a delay, modification, or cancellation of the transaction.

• Consider the availability of an alternative source for the fair value estimate in case the anticipated transaction is not completed.

• Consider whether any factors (for example, contractual contingencies, or the proximity of the transaction to the valuation date) might invalidate the use of the transaction as a fair value estimate at the date of the financial statements.

Other • If the fair value measurement was made at a date that does not

coincide with the date at which the entity is required to measure and report that information in its financial statements, obtain evidence that management has taken into account the effect of events, transactions, and changes in circumstances occurring between the date of the fair value measurement and the reporting date.

• If collateral is an important factor in measuring the fair value of the investment or evaluating its carrying amount, obtain audit evidence regarding the existence, value, rights, and access to or transferability of such collateral, including consideration of whether all appropriate liens have been filed, and consider whether appropriate disclosures about the collateral have been made.

• In some situations, additional procedures, such as the inspection of an asset by the auditor, may be necessary to obtain sufficient competent audit evidence about the appropriateness of a fair value measurement. For example, inspection of the asset may be necessary to obtain information about the current physical condition of the asset relevant to its fair value, or inspection of a security may reveal a restriction on its marketability that may affect its value.

• As a part of subsequent events procedures, consider whether transactions occurring subsequent to year end provide information that corroborates or questions the fair value estimates used for financial statement reporting purposes.

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APPENDIX IV: DISCLOSURE CHECKLIST: FASB STATEMENT NO. 141, BUSINESS COMBINATIONS; FASB STATEMENT NO. 142, GOODWILL AND OTHER INTANGIBLE ASSETS; AND FASB STATEMENT NO. 144, ACCOUNTING FOR THE IMPAIRMENT OR DISPOSAL OF LONG-LIVED ASSETS

This appendix contains a disclosure checklist designed to help auditors evaluate conformity of financial statement disclosures with the disclosures required by FASB Statements No. 141, Business Combinations; No. 142, Goodwill and Other Intangible Assets; and No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Even though care has been exercised in the preparation of this checklist, no representations are made regarding its completeness or accuracy as it relates to FASB Statements No. 141, No. 142, and No. 144. When evaluating the adequacy of disclosures pursuant to SAS No. 32, Adequacy of Disclosure in Financial Statements (AICPA, Professional Standards, vol. 1, AU sec. 431), the auditor considers whether a particular matter should be disclosed in light of the circumstances and facts of which he or she is aware. Because of its limited scope, this illustrative checklist cannot be used to evaluate the adequacy of other disclosures required by generally accepted accounting principles (GAAP) and that may be necessary for the financial statements under audit to be in conformity with GAAP.

FASB Statement No. 141, Business Combinations Yes No N/A

Financial Statement Disclosures Required for Business Combinations

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The financial statements should disclose the following for business combinations completed or initiated after July 1, 2001:

• Name and brief description of the acquired entity and percentage of voting equity interest acquired (F 141, par. 51(a))

• Primary reasons for the acquisition, including a description of the factors that contributed to a purchase price that results in recognition of goodwill (F 141, par. 51(b))

• Period for which the results of operations of the acquired entity are included in the income statement of the combined entity (F 141, par. 51(c))

• The cost of the acquired entity and, if applicable, the number of shares of equity interests (such as common shares, preferred shares, or partnership interests) issued or issuable, the value assigned to those interests, and the basis for determining that value (F 141, par. 51(d))

• A condensed balance sheet disclosing the amount assigned to each major asset and liability caption of the acquired entity at the acquisition date (F 141, par. 51(e))

• Contingent payments, options, or commitments specified in the acquisition agreement and the accounting treatment that will be followed should any such contingency occur (F 141, par. 51(f))

• Amount of purchased research and development assets acquired and written off in the period (see paragraph 42 of FASB Statement No. 141) and the line item in the income statement in which the amounts written off are aggregated (F 141, par. 51(g))

• Reason(s) for any purchase price allocation not yet finalized (F 141, par. 51(h))

• In periods subsequent to the period of the business combination, the nature and amount of any material adjustments made to the initial allocation of the purchase price (F 141, par. 51(h))

If the amounts assigned to goodwill or other intangible assets acquired are significant in relation to the total cost of the acquired entity, the following information should be disclosed in the financial statement of the combined entity in the period in which the entity completes a material business combination:

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For intangible assets subject to amortization:

• Total amount assigned and the amount assigned to any major intangible asset class (F 141, par. 52(a)(1))

• Amount of any significant residual value, in total and by major intangible asset class (F 141, par. 52(a)(2))

• Weighted-average amortization period, in total and by major intangible asset class (F 141, par. 52(a)(3))

For intangible assets not subject to amortization:

• The total amount assigned and the amount assigned to any major intangible asset class (F 141, par. 52(b))

For goodwill:

• Total amount of goodwill and amount that is expected to be deductible for tax purposes (F 141, par. 52(c)(1))

• Amount of goodwill by reportable segment, if the entity is required to disclose segment information in accordance with FASB Statement No. 131, Disclosures about Segments of an Enterprise and Related Information, unless not practicable (F 141, par. 52(c)(2))

Note: It would not be practicable for the entity to disclose this information if the assignment of goodwill to reporting units (as required by FASB Statement No. 142) has not been completed as of the date the financial statements are issued.

If a series of individually immaterial business combinations are completed during the year and they are material in the aggregate, management’s financial statements should disclose the following:

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• The number of entities acquired and a brief description of those entities (F 141, par. 53(a))

• Aggregate cost of the acquired entities, number of equity interests (such as common shares, preferred shares, or partnership interests) issued or issuable, and value assigned to those interests (F 141, par. 53(b))

• Aggregate amount of any contingent payments, options, or commitments and related accounting treatment that will be followed should any such contingency occur (if potentially significant in relation to the aggregate cost of the acquired entities) (F 141, par. 53(c))

• If the aggregate amount assigned to goodwill or other intangible assets acquired is significant in relation to total cost of the acquired entities, management should disclose in the financial statements the information required by paragraph 52 of FASB Statement No. 141. (See second bullet under “For Goodwill” section above.) (F 141, par. 53(d))

Direct, Integration, or Exit Costs

If the activities of the acquired entity that will not be continued are significant to the combined entity’s revenues or operating results or if the costs recognized under Emerging Issues Task Force (EITF) Issue No. 95–3, Recognition of Liabilities in Connection with a Purchase Business Combination, as of the consummation date are material to the combined entity, the following information should be disclosed in the financial statements of the combined entity in addition to the disclosures required by paragraph 51 of FASB Statement No. 141 (EITF Issue No. 95–3; Securities and Exchange Commission [SEC] Staff Accounting Bulleting [SAB] No. 100):

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For the period in which the business combination occurs

• A description of unresolved issues, types of additional liabilities that may result in an adjustment to the allocation of the acquisition cost and how any adjustment(s) will be reported if the acquiring entityhas not finalized a plan to exit an activity or involuntarily terminate (relocate) employees of the acquired entity as of the balance sheet date (EITF Issue No. 95-3, par. 1(a))

• A description of the type and amount of liabilities assumed and included in the acquisition cost allocation for costs to exit an activity of the acquired entity or to involuntarily terminate (relocate) employees of the acquired entity (EITF Issue No. 95-3, par. 1(b))

• A description of the major actions that comprise the plan to exit an activity or involuntarily terminate (relocate) employees of an acquired entity, activities of the acquired entity that will not be continued (including method of disposition), and the anticipated completion date and a description of employee group(s) to beterminated (relocated) (EITF Issue No. 95-3, par. 1(c))

Note: The SEC staff also indicates that public companies disclose when they began formulating the plan either in the notes to the audited financial statements or the Management’s Discussion and Analysis (MD&A) section of filings with the SEC. (SAB Topic 5-P, Question 16 — For MD&A disclosures when EITF Issue No. 95–3 applies, see the section of this checklist titled “Additional Disclosures Applicable Only to SEC Registrants and Other Public Companies”)

For the period subsequent to the acquisition date

• For all periods presented subsequent to the acquisition date the business combination occurred, through and including the period in which all actions under a plan to exit an activity or involuntarily terminate (relocate) employees of the acquired entity have been fully executed:

• A description of the type and amount of exit costs, involuntary employee termination costs, and relocation costs paid and charged against the liability (EITF Issue No. 95–3, par. 2(a))

• The amount of any adjustment(s) to the liability account and whether the corresponding entry was an adjustment of the cost of the acquired entity or included in net income for the period (EITF Issue No. 95–3 par. 2(b))

Financial Statement Disclosures Required for In-Process Research and Development (IPR&D) Acquired in a Business Combination

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Note: See SEC staff views, January 1999 letter to selected public company chief financial officers setting forth certain expectations for disclosures about IPR&D, among other things. Also, see the 2001 AICPA Practice Aid Assets Acquired in a Business Combination to Be Used in Research and Development Activities: A Focus on Software, Electronic Devices, and Pharmaceutical Industries.

• Nature and fair value of the projects acquired, and where multiple projects are involved, a summary of values assigned to IPR&D by project

• Appraisal method used to value projects and significant appraisal assumptions (periods of material cash flows, anticipated changes in pricing, margins or expenses, and the risk adjusted discount rate)

• Status of the development and the complexity or uniqueness of the work completed at the acquisition date

• Stage of completion at the acquisition date

• Nature and timing of remaining efforts for completion

• The anticipated completion date and when the entity expects IPR&D benefits to begin

• Projected costs to complete

• The material assumptions underlying the purchase price allocation

• Risks, uncertainties, and consequences associated with not completing development on schedule

In financial statements subsequent to the date of purchase of IPR&D:

• The status of efforts to complete the R&D projects and the impact from any delays

• Any material differences between projected results and actual results including a discussion of how failure to achieve projected results impacted (or will impact) expected return on investment, future results and financial condition

Extraordinary Gains

In the period in which an extraordinary gain is recognized related to a business combination (see paragraphs 45 and 46 of FASB Statement No. 141), the following main captions and disclosures should appear in an income statement and notes to the statements (F 141, par. 56; Accounting Principles Board No. 30, Reporting the Results of Operations — Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, par. 11):

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Main Captions • The caption “extraordinary items” should be used to identify

separately the effects of events and transactions, other than the disposal of a component of an entity, that meet the criteria for classification as extraordinary.

• Descriptive captions and the amounts for individual extraordinary events or transactions should be presented, preferably on the face of the income statement, if practicable. Otherwise, disclosure in related notes is acceptable.

Disclosure • The nature of an extraordinary event or transaction and the

principal items entering into the determination of an extraordinary gain or loss should be described.

• The income taxes applicable to extraordinary items should be disclosed on the face of the income statement. Alternatively, disclosure in the related notes is acceptable.

• In the period in which there is an extraordinary gain for unallocated negative goodwill, the financial statements should disclose the nature of the transaction, principal items entering into the determination of the gain, and the related tax effect.

Material Business Combination Completed After the Balance-Sheet Date

If practicable, if a material business combination is completed after the balance sheet date but before the financial statements are issued, the financial statements should disclose the information required by paragraphs 51 and 52 of FASB Statement No. 141 regarding the completed business combination and significant amounts that are assigned to goodwill or to other intangible assets. (F 141, par. 57)

Effect of Change in Accounting Principle

FASB Statement No. 141 requires that as of the earlier of the first day of the fiscal year beginning after December 15, 2001, or the date FASB Statement No. 142 is initially applied in its entirety, the amount of any unamortized deferred credit related to an excess over cost arising from (a) a business combination for which the acquisition date was before July 1, 2001, or (b) an investment accounted for by the equity method acquired before July 1, 2001, shall be written off and recognized as the effect of a change in accounting principle. With respect to this accounting change:

• Ensure that the effect of the accounting change and related income tax effects is presented in the income statement between the captions extraordinary items and net income. (F 141, par. 62)

• Ensure that the per-share information presented in the income statement includes the per-share effect of the accounting change. (F 141, par. 62)

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Additional Disclosures Applicable Only to SEC Registrants and Other Public Companies Yes No N/A

MD&A disclosures when EITF Issue No. 95–3 applies

If EITF Issue No. 95-3 applies, the following disclosures should appear in the MD&A section of filings with the SEC along with other business combination information:

• If not included in the footnote disclosures, when the registrant began formulating exit plans for which accrual may be necessary

• The likely effects of the plan on financial position, future operating results, and liquidity unless it is determined that a material effect is not reasonably likely to occur

• The periods in which material cash outlays are anticipated and the expected source of their funding

• Any material revisions to the plan or the timing of the plan's execution, including the nature and reasons for the revisions.

Supplemental Information on a Pro-Forma Basis

The financial statements should provide the following supplemental information on a pro-forma basis for the period in which a material business combination occurs (or for the period in which a series of individually immaterial business combinations occur that are material in the aggregate):

Note: In determining the pro-forma amounts, income taxes, interest expense, preferred share dividends, and depreciation and amortization of assets shall be adjusted by the entity to the accounting base recognized for each in recording the combination. (F 141 par. 55)

• The results of operations for the current period as though the acquisition(s) had been completed at the beginning of the period, unless the acquisition was at or near the beginning of the period. (F 141, par. 54(a))

• The results of operations for only the most recent comparable prior period presented as though the acquisition(s) was completed at the beginning of the period, if comparative financial statements are presented. (F 141, par. 54(b))

Note: Pro forma information related to results of operations of periods before the combination shall be limited to the results of operations for the immediately preceding period. (F 141, par. 55)

• Pro forma supplemental information must include (at a minimum): revenue, income before extraordinary items, and the cumulative effect of accounting changes, net income, and earnings per share. (F 141, par. 55)

• The nature and amount of any material, nonrecurring items included in the reported pro forma results of operations (F 141, par. 55 and 58(c))

Fees

The financial statements disclose separately the debt issue cost element of fees for services provided both in advising on the acquisition and to provide necessary financing. (SAB Topic 2A.6)

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Additional Disclosures Applicable Only to SEC Registrants and Other Public Companies Yes No N/A

Disclosures in Interim Financial Information

The summarized interim financial information of a public business entity shall disclose the following information if a material business combination is completed during the current year up to the date of the most recent interim statement of financial position presented:

• The information described in paragraph 51(a) through (d) of FASB Statement No. 141 (F 141, par. 58(a))

• Supplemental pro forma information that discloses the results of operations for the current interim period and the current year up to the date of the most recent interim statement of financial position presented (and for the corresponding periods in the preceding year) as though the business combination had been completed as of the beginning of the period being reported on. That pro forma information shall display (at a minimum) revenue, income before extraordinary items and the cumulative effect of accounting changes (including those on an interim basis), net income, and earnings per share. (F 141, par. 58(b))

• The nature and amount of any material, nonrecurring items included in the reported pro forma results of operations (F 141, par. 58(c))

FASB Statement No. 142, Goodwill and Other Intangible Assets Yes No N/A

Presentation

Intangible Assets

• Intangible assets presented as a separate line item(s) in the statement of financial position. (F 142, par. 42)

• Amortization expense and impairment losses for intangible assets presented within continuing operations line items in the income statement (F 142, par. 42)

Goodwill

• The aggregate amount of goodwill presented as a separate line item in the statement of financial position. (F 142, par. 43)

• The aggregate amount of impairment losses presented as a separate line item in the income statement within income from continuing operations, unless a goodwill impairment loss is associated with a discontinued operation. (F 142, par. 43)

• A goodwill impairment loss associated with a discontinued operation should be included on a net-of-tax basis within the results of discontinued operations. (F 142, par. 43)

Disclosures in Financial Statements in the Period of Acquisition for Intangible Assets Acquired Either Individually or With a Group of Assets

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• The total amount assigned and the amount assigned to any major intangible asset class (F 142, par. 44(a)(1))

• The amount of any significant residual value, in total, and by major intangible asset class (F 142, par. 44 (a)(2))

• The weighted-average amortization period, in total, and by major intangible asset class (F 142, par. 44 (a)(3))

For intangible assets not subject to amortization:

• The total amount assigned and the amount assigned to any major intangible asset class (F 142, par. 44(b))

• The amount of research and development assets acquired and written off in the period and the line item in the income statement in which the amounts written off are aggregated (F 142, par. 44(c))

Disclosure in Financial Statements for Each Period Presented

The following information shall be disclosed in the financial statements or the notes to the financial statements for each period for which a statement of financial position is presented:


• The gross carrying amount and accumulated amortization, in total, and by major intangible asset class (F 142, par. 45 (a)(1)

• The aggregate amortization expense for the period (F 142, par. 45(a) (2))

• The estimated aggregate amortization expense for each of the five succeeding fiscal years (F 142, par. 45 (a)(3))

For intangible assets NOT subject to amortization:

• The total carrying amount and the carrying amount for each major intangible asset class (F 142, par. 45(b))

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• The changes in the carrying amount of goodwill during the period, including

• The aggregate amount of goodwill acquired (F 142, par. 45(c)(1))

• The aggregate amount of impairment losses recognized (F 142, par. 45(c)(2))

• The amount of goodwill included in the gain or loss on disposal of all or a portion of a reporting unit. (F 142, par. 45(c)(3))

Note: Entities that report segment information in accordance with FASB Statement No. 131 shall provide the information above about goodwill in total and for each reportable segment and shall disclose any significant changes in the allocation of goodwill by reportable segment. If any portion of goodwill has not yet been allocated to a reporting unit at the date the financial statements are issued, that unallocated amount and the reasons for not allocating that amount shall be disclosed. (F 142, par. 45)

Impairment Losses

For each impairment loss recognized related to goodwill or to an intangible asset, the following information shall be disclosed in the notes to the financial statements that include the period in which the impairment loss is recognized:

For impairment loss related to an intangible asset:

• A description of the impaired asset and the facts and circumstances leading to the impairment (F 142, par. 46 (a))

• The amount of the impairment loss and the method for determining fair value (F 142, par. 46(b))

• The caption in the income statement or the statement of activities in which the impairment loss is aggregated (F 142, par. 46(c))

• If applicable, the segment in which the impaired intangible asset is reported under FASB Statement No. 131 (F142, par. 46(d))

For each impairment loss related to goodwill:

• A description of the facts and circumstances leading to the impairment (F 142, par. 47(a))

• The amount of the impairment loss and the method of determining the fair value of the associated reporting unit (whether based on quoted market prices, prices of comparable businesses, a present value or other valuation technique, or a combination thereof) (F 142, par. 47(b))

• If a recognized impairment loss is an estimate that has not yet been finalized (refer to F 142, par. 22), that fact and the reasons therefore and, in subsequent periods, the nature and amount of any significant adjustments made to the initial estimate of the impairment loss (F 142, par. 47(c))

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Transitional Disclosures

Upon completion of the first step of the transitional goodwill impairment test, the reportable segment or segments in which an impairment loss might have to be recognized and the period in which that potential loss will be measured should be disclosed in any interim financial information. (F 142, par. 60)

In the period of initial application and thereafter until goodwill and all other intangible assets have been accounted for in accordance with FASB Statement No. 142 in all periods presented, the following information should be displayed either on the face of the income statement or in the notes to the financial statements. (F 142, par. 61)

• Income before extraordinary items and net income for all periods presented adjusted to exclude amortization expense (including any related tax effects) are to be recognized in those periods related to goodwill.

o Intangible assets that are no longer being amortized

o Any deferred credit related to an excess over cost

o Equity method goodwill

• The adjusted income before extraordinary items and net income also shall reflect any adjustments for changes in amortization periods for intangible assets that will continue to be amortized as a result of initially applying FASB Statement No. 142 (including any related tax effects).

• The notes to the financial statements should disclose a reconciliation of reported net income to the adjusted net income.

• Adjusted earnings-per-share amounts for all period presented may be presented either on the face of the income statement or in the notes to the financial statements.

Previously Recognized Intangible Assets FASB Statement No. 141 requires that, for purposes of applying the Statement to intangible assets acquired in a transaction for which the acquisition date is on or before June 30, 2001, the useful lives of those previously recognized intangible assets shall be reassessed using the guidance in paragraph 11 of the Statement and the remaining amortization periods adjusted accordingly. That reassessment should be completed before the end of the first interim period of the fiscal year in which the Statement is initially applied. Previously recognized intangible assets deemed to have indefinite useful lives should be tested for impairment as of the beginning of the fiscal year in which the Statement is initially applied (in accordance with paragraph 17 of the Statement). That transitional intangible asset impairment test should be completed in the first interim period in which the Statement is initially applied, and any resulting impairment loss should be recognized as the effect of a change in accounting principle. With respect to this change in accounting principle:

• Ensure that the effect of the accounting change and related income tax effects is presented in the income statement between the captions extraordinary items and net income. (F 142, par. 53)

• Ensure that the per-share information presented in the income statement includes the per-share effect of the accounting change. (F 142, par. 53)

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Previously Recognized Goodwill FASB Statement No. 141 requires that an impairment loss recognized as a result of a transitional goodwill impairment test be recognized as the effect of a change in accounting principle. With respect to this change in accounting principle:

Presentation • Ensure that the effect of the accounting change and related income tax

effects is presented in the income statement between the captions extraordinary items and net income. (F142, par. 56)

• Ensure that the per-share information presented in the income statement

includes the per-share effect of the accounting change. (F 142, par. 56)

Interim Reporting, if applicable • Ensure that the impairment loss is recognized in the first interim period

irrespective of the period in which it is measured, consistent with paragraph 10 of FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements. (F 142, par. 56)

• Ensure that the financial information for the interim periods of the fiscal

year that precede the period in which the transitional goodwill impairment loss is measured is restated to reflect the accounting change in those periods. (F 142, par. 56)

• Ensure that the aggregate amount of the accounting change is included in

restated net income of the first interim period of the year of initial application (and in any year-to-date or last-12-months-to-date financial reports that include the first interim period). (F 142, par. 56)

Other Whenever financial information is presented that includes the periods that precede the period in which the transitional goodwill impairment loss is measured, the financial information should be presented on the restated basis. (F 142, par.56)

FASB Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets

Yes No N/A

Presentation of Impairment Loss Relating Long-Lived Asset (Asset Group) to Be Held and Used:

• Financial statements should include impairment loss as component of income from continuing operations before income taxes in the income statement of a business enterprise and income from continuing operations in the statement of activities of a not-for-profit organization. (F 144, par. 25)

• If a subtotal such as “income from operations” is used, the financial statements should include the impairment loss in that subtotal. (F 144, par. 25)

Financial Statement Disclosures for Impairment Losses Relating to Long-Lived Asset (Asset Group) to Be Held and Used

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Yes No N/A

For financial statements that include a period during which an entity recognizes an impairment loss, the notes should include the following:

• Description of impaired long-lived assets (asset group) and facts and circumstances leading to the impairment (F 144, par.26(a))

• If not separately presented or reported parenthetically on the face of the statements, the amount of impairment loss and the caption in the income statement or statement of activities where the impairment loss is aggregated (F 144, par.26(b))

• Method(s) used to determine the asset’s fair value (F 144, par.26(c))

• If applicable, the segment in which the impaired long-lived asset (asset group) is reported under FASB Statement No. 131. (F 144, par. 26(d)).

Presentation of Long-Lived Assets (Disposal Group) to Be Disposed of Other Than by Sale

• Long-lived assets to be disposed of other than by sale should be classified as held and used until disposal. (F 144, par. 27)

Presentation of Long-Lived Assets to Be Disposed of by Sale

The balance sheet should:

• Present the asset separately as held for sale. (F 144, par. 46)

• Present the assets and liabilities of a disposal group separately as held for sale. (Do not offset those assets and liabilities and present as a single amount.) (F144, par. 46)

• If the criteria to classify an asset as held for sale are met after the balance sheet date but before issuance of the financial statements, continue to classify the long-lived asset as held and used. (F 144, par. 33)

The income statement of a business enterprises or in continuing operations in the statement of activities of a not-for-profit organization should:

• If not a component of an entity, recognize the gain or loss in continuing operations before income taxes in the income statement of a business enterprise or in continuing operations in the statement of activities of a not-for-profit organization. (F 144, par. 45)

• If a subtotal such as “income from operations” is used, include gain or loss in that subtotal. (F 144, par. 45)

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Yes No N/A

Reporting Discontinued Operations

Note: Management cannot report the disposal of a component as a discontinued operation until financial statements for the period in which the component has been disposed of or is classified as held for sale have been "issued." For financial statement purposes, management should:

• If the disposal group is a component of an entity, in the period in which a component of an entity has been disposed of or is classified as held for sale, report the results of operations for the current and prior period, including any gain or loss, in discontinued operations. (F144, par. 42 and 43)

Note: The gains or losses include any gain recognized for any subsequent increase in fair value less cost to sell, but not in excess of the cumulative loss previously recognized for a write-down to fair value less cost to sell as well as any loss recognized for any initial or subsequent write-down to fair-value less cost to sell.

• Report the results of operations for the component of the entity in discontinued operations in the period(s) in which they occur. (F 144, par. 43)

• Report the results of discontinued operations, less applicable income taxes (benefit) as a separate component of income before extraordinary items and the cumulative effect of accounting changes, if applicable. (F 144, par. 43)

• Report the amount of gain or loss on the disposal reported on the face of the income statement or in the notes to the financial statements. (F 144,par. 43)

• Classify separately in the current period in discontinued operations adjustments to amounts previously reported in discontinued operations that are directly related to the disposal of a component of an entity in a prior period. (F 144, par. 43)

Financial Statement Disclosure Regarding Discontinued Operations

• A description of the nature and amount of adjustments to amounts previously reported in discontinued operations that are directly related to the disposal of a component of an entity in a prior period (F 144, par. 44)

Financial Statement Disclosures Relating to Long-Lived Asset (disposal group) that Either has Been Sold or is Classified as Held for Sale

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Yes No N/A

Financial statements that include the period in which a long-lived asset (disposal group) either has been sold or is classified as held for sale, should disclose all of the following in the notes. (F 144, par. 47)

• Description of facts and circumstances leading to the expected disposal and the expected manner and timing of that disposal (F144, par. 47(a))

• If not separately presented on the face of the statements, the carrying amount(s) of the major classes of assets and liabilities included as part of the disposal group (F144, par. 46 and par. 47(a))

• Loss from initial or subsequent write-down or gain from subsequent increase in fair value less cost to sell, but not in excess of the cumulative loss previously recognized (F 144, par. 37 and par. 47(b))

• If not separately presented in the income statement or statement of activities the caption that includes the above gain or loss (F144, par. 47(b))

• If applicable, amounts of revenue and pretax profit or loss reported in discontinued operations (F144, par. 47(c))

• If applicable, the segment in which the long-lived asset (disposal group) is reported under FASB Statement No. 131 (F144, par. 47(d))

• If a change to a plan of sale occurs, in the financial statements that include the period of that decision, a description of the facts and circumstances leading to the decision to change the plan to sell the long-lived asset (disposal group) and its effect on the results of operations for the period and any prior periods presented. (F144, par. 48)

Presentation of Long-lived Assets (Asset Group) Reclassified as Held and Used

(F 144 par. 38) (See above for disclosure requirements for assets held and used.)

• Classify any adjustment to the asset’s carrying amount that is not a component of entity in income from continuing operations in the same caption used to report the loss, if any recognized for a long-lived asset (disposal group) held for sale. (F 144, par. 39)

• If the original loss was previously reported in discontinued operations, reclassify that amount to income from continuing operations for all periods presented. (F 144, par. 39.)

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APPENDIX V: IMPAIRMENT OF LONG-LIVED ASSETS TO BE HELD AND USED1 Introduction FASB Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, discusses different accounting classifications of transactions for recording an impairment loss of long-lived assets, if an impairment exists. The classifications are: 1. Assets to be held and used2 2. Assets to be disposed of by sale. This appendix discusses auditing issues relating to fair value measurements in the context of long-lived assets classified as to be held and used pursuant to FASB Statement No. 144. Regardless of the transaction classification, the auditing issues relating to fair value measurements are the same. Summary of FASB Statement No. 144 Requirements for Long-Lived Assets to be Held and Used FASB Statement No. 144 requires that long-lived assets classified as to be held and used be assessed for impairment if events or changes in circumstances indicate that their carrying amount may not be fully recoverable.3 Paragraph 8 of FASB Statement No. 144 lists examples of events or changes in circumstances that may indicate that the carrying amount of long-lived assets (asset group) may not be recoverable. Those are: • A significant decrease in the market price of a long-lived asset (asset group). • A significant adverse change in the extent or manner in which a long-lived

asset (asset group) is being used or in its physical condition. • A significant adverse change in legal factors or in the business climate that

could affect the value of a long-lived asset (asset group), including an adverse action or assessment by a regulator.

• An accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of a long-lived asset (asset group).

1 This appendix is based in part on information that is being developed by the Auditing Standards Board’s Technical Audit Advisors Task Force for another AICPA publication. 2 This classification includes long-lived assets to be disposed of other than by sale until the assets are disposed of (see FASB Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, paragraph 27). 3 The carrying amount of a long-lived asset or asset group is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset or asset group.

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• A current-period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset (asset group).

• A current expectation that it is more likely than not (that is, the level of likelihood is greater than 50 percent) that a long-lived asset (asset group) will be sold or otherwise disposed of significantly before the end of its previously estimated useful life.

A search for asset impairment on a periodic basis is not required if there is no indication of potential impairment. Under FASB Statement No. 144 an entity uses the following approach for determining whether assets are impaired: • Consider whether indicators of impairment are present (see above). • If any of the impairment indicators are present, or if other circumstances

indicate that an impairment might exist, management must test recoverability to determine whether an impairment loss should be recognized.

FASB Statement No. 144 in effect establishes the following steps for determining whether an impairment loss should be recognized: • Group the long-lived assets with other assets and liabilities at the lowest level

for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities.

• Estimate the future net cash flows that are directly associated with and are expected to arise as a direct result of the use and eventual disposition of the asset (asset group) being considered for impairment. These future cash flows are undiscounted and without interest charges.

• Compare the estimated undiscounted net cash flows to the carrying amount of the assets (asset group) being considered for impairment. If less, recognize an impairment loss equal to any excess of the carrying amounts of the assets (asset group) in question over their fair values.

FASB Statement No. 144 permits an entity to use either a probability-weighted approach or a best-estimate approach in developing estimates of future cash flows. However, FASB Statement No. 144 clarifies that if (1) alternative courses of action to recover the carrying amount of a long-lived asset (asset group) are under consideration or (2) a range is estimated for the amount of possible future cash flows associated with the likely course of action, the likelihood of those possible outcomes should be considered; therefore, a probability-weighted approach may be useful (see paragraphs 39 through 54 and 75 through 88 of FASB Concepts Statement No. 7 for additional guidance). If the entity concludes that an impairment loss need not be recognized in accordance with FASB Statement No. 144, it should consider whether disclosure is required under SOP 94-6. For example, one or more impairment indicators may exist, but the undiscounted cash flows slightly exceed the carrying amount

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of the assets (asset group). Under SOP 94-6, Disclosure of Certain Significant Risks and Uncertainties, if indicators of impairment are present, but a loss is not required to be recognized, the estimate associated with the recoverability of the carrying amount of a long-lived asset (asset group) may be especially sensitive to change. Disclosure under SOP 94-6 would be required if (1) it is at least reasonably possible that management's estimate resulting in an impairment not being recorded will change in the near term and (2) the effects of the change would be material to the financial statements. There may be other situations where the disclosures required by SOP 94-6 may result in disclosures in the financial statements in advance of either the occurrence or existence of an impairment indicator or the recognition of an impairment loss. For assets to be held and used, if an impairment exists, the assets are written down to their fair value and continue to be amortized over their expected useful life. Subsequent increases in fair value of assets are not recognized in the financial statements. Paragraph 9 of FASB Statement No. 144 states that:

When a long-lived asset (asset group) is tested for recoverability, it also may be necessary to review depreciation estimates and methods as required by Accounting Principles Board Opinion No. 20, Accounting Changes, or the amortization period as required by FASB Statement No. 142 [Footnote omitted]. Any revision to the remaining useful life of a long-lived asset resulting from that review also shall be considered in developing estimates of future cash flows used to test the asset (asset group) for recoverability...,However, any change in the accounting method for the asset resulting from that review should be made only after applying FASB Statement No. 144.

Fair Value Concept in FASB Statement No. 144 Pursuant to FASB Statement No. 144, an impairment loss is the amount by which the carrying amount of a long-lived asset (asset group) exceeds its fair value. Under FASB Statement No. 144, the fair value of an asset is the amount at which an asset could be bought or sold in a current transaction between willing parties, that is, other than in a forced or liquidation sale. Quoted market prices in active markets are the best evidence of fair value and should be the basis of the measurement, if available. If quoted market prices are not available, management should make an estimate of fair value based on the best available evidence in the circumstances including prices of similar assets (asset group), discounted cash flows analysis, or other valuation technique. Financial Statement Presentation of Impairment Losses Related to Long-Lived Assets to be Held and Used The recognition of impairment on impaired assets to be held and used results in a permanent write-down of the cost basis of the affected assets. The assets should continue to be reported in the appropriate balance-sheet classification (for example, property and equipment or intangibles). Subsequently, the assets may

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not be written up, even though the fair value of those assets may increase at a later date. Impairment losses recognized for a long-lived asset (asset group) to be held and used should be reported as a component of income from continuing operations before income taxes. If an entity reports an operating measure such as "income from operations" or "operating income," the impairment loss must be included in that amount. FASB Statement No. 144 provides the following options for presenting impairment losses in the financial statements: • As a separate line item in the income statement • Aggregated in an appropriate line item in the income statement (for example,

as part of general and administrative expenses) with the amount of the loss noted parenthetically on the face of the income statement

• Aggregated in an appropriate line item in the income statement supplemented by disclosure in the notes to the financial statements of the amount of the impairment loss and the identification of the income statement caption that includes the loss.

For specific presentation and disclosure requirements, readers should refer to FASB Statement No. 144. Auditors may use the illustrative checklist in Appendix IV of this publication when evaluating the FASB Statement No. 144 disclosures in management’s financial statements. Auditing Considerations Overall Audit procedures will vary depending on the auditor’s risk assessment and the circumstances of the entity under audit. Appendix III of this publication contains an illustrative audit program that can be used to develop procedures for auditing the impairment of goodwill. When developing audit procedures, the auditor considers events or changes in circumstances that indicate that an impairment may exist (see FASB Statement No. 144, paragraph 8), the manner in which assets are used, and how assets generate cash flows. For example, economic conditions and industry downturns may result in cash flow erosion for many entities, and may indicate that there is an impairment of long-lived assets. In those situations, the auditor should be skeptical of any assertion by the entity that there is no need to test for impairment of long-lived assets because “nothing has happened.” Existing information and analyses developed for management review of the entity and its operations generally will be the principal evidence needed to determine when an impairment potentially exists. Management needs to maintain a system to capture information regarding the existence of potential impairment indicators, especially in a decentralized operating environment.

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Questions that might be asked of entity personnel to obtain an understanding of potential impairment of long-lived assets to which an entity may be exposed include the following: • Were there any changes in the operating conditions in the past year that may

have resulted in significant impairments of long-lived assets? • What controls are in place to identify conditions that may be indicators of

potential impairments of long-lived assets affecting the entity? • Have there been or are there any plans that result in significant changes to

capital deployed at the entity’s operating units? In addition to considering events or changes in circumstances, the auditor considers the effect on inherent risk of the existence of the different classifications of transactions for long-lived assets. The existence of different classifications of transactions may increase the inherent risk associated with management’s selection of the appropriate accounting treatment for the impairment of a particular asset or group of assets. That is because the different classifications may provide opportunities for management to engage in earnings management by misclassifying assets as, for example, to be held and used rather than to be disposed of. Undiscounted Cash Flow Projections and Assessment of Impairment The cash flow projection is critical in assessing the need to record an impairment loss. Chapter 3, “Financial Forecasts and Projections,” of Statement on Standards for Attestation Engagements No. 10, Attestation Standards: Revision and Recodification (AICPA, Professional Standards, vol. 1, AT sec. 301), may help the auditor understand the process that management uses when preparing its cash flow estimates. Management Representations The auditor should consider obtaining written representations from management about impairments of long-lived assets to be held and used affecting the financial statements, including specific representations as to the adequacy of related disclosures. If management has determined that an impairment analysis is not warranted, the auditor should consider requesting specific commentary in the management representation letter. Specific representations might include those that: • State that no events or changes in circumstances have occurred that indicate

the carrying amounts of long-lived assets to be held and used, including intangible assets that are subject to amortization, may not be recoverable.

• State that long-lived assets to be held and used, including intangible assets that are subject to amortization, have been reviewed for impairment whenever events or changes in circumstances have indicated that their carrying

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amounts may not be recoverable, and that, where appropriate under FASB Statement No. 144, such assets have been written down to fair value.

• State that the entity’s estimates of future cash flows are based on reasonable and supportable assumptions regarding the cash flows expected to result from the use of the assets and their eventual disposition.

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APPENDIX VI: IMPAIRMENT OF GOODWILL1 Introduction Financial Accounting Standards Board (FASB) Statement No. 142, Goodwill and Other Intangible Assets, addresses the post-acquisition financial accounting and reporting for goodwill and other intangible assets. This appendix summarizes some of the provisions of FASB Statement No. 142 relating to goodwill as well as some auditing considerations. Readers should refer to FASB Statement No. 142 and any related interpretations for an understanding of the full requirements of the Statement. Summary of FASB Statement No. 142 Requirements for Goodwill Under FASB Statement No. 142, goodwill will no longer be routinely amortized. Instead, it will be assigned to an entity's reporting units and tested for impairment at least annually. FASB Statement No. 142 defines a reporting unit as an operating segment (as that term is used in FASB Statement No. 131, Disclosures about Segments of an Enterprise and Related Information) or one level below an operating segment (referred to as a component). Those entities that are not required to report segment information in accordance with FASB Statement No. 131 are nonetheless required to determine their reporting units and test goodwill for impairment at the reporting unit level. Testing for impairment under FASB Statement No. 142 is, under certain circumstances, a two-step process. The first step (Step 1) is to determine the fair value of the reporting unit and compare that fair value to the carrying amount of the reporting unit. The process requires that all of the unit’s assets (other than goodwill) to be tested and adjusted for impairment under other accounting standards before testing goodwill for impairment. If the fair value of the reporting unit is less than its carrying amount (that is, its net assets), a second step (Step 2) is required. Step 2 is a process whereby it is assumed the reporting unit is being acquired as of the goodwill testing date in a business combination. This process assumes the reporting unit’s fair value is a surrogate for the reporting unit’s purchase price. The fair value of the reporting unit is allocated to all the assets and liabilities of the reporting unit using the purchase price allocation guidance in FASB Statement No. 141, Business Combinations. Goodwill, if any, that emerges from this process is called the “implied fair value of goodwill.” If the implied fair value of goodwill is less than the carrying value of the reporting unit’s goodwill, that difference is the amount of the impairment loss required to be recognized by a charge to operating income.

1 This appendix is based in part on information that is being developed by the Auditing Standards Board’s Technical Audit Advisors Task Force for another AICPA publication.

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Because of the significant effort that may be required to determine the implied fair value of a reporting unit's goodwill in Step 2 of the test, the FASB recognized that in some situations an entity might not be able to complete this process before issuing its financial statements. Paragraph 22 of FASB Statement No. 142 states that when such a situation occurs and a goodwill impairment loss is probable and can be reasonably estimated, the best estimate of the loss should be recognized in the financial statements. The fact that the amount of a goodwill impairment loss is an estimate must be disclosed, and any later adjustment that is made to the estimated loss upon finalizing Step 2 should be recognized in the subsequent reporting period. After a goodwill impairment loss is measured and recognized, the adjusted carrying amount of goodwill will become the new accounting basis for goodwill; subsequent reversal of previously recognized goodwill impairment losses is prohibited. The carrying amount of a reporting unit's goodwill should be tested for impairment at least annually and, in certain situations, on an interim basis. The annual goodwill impairment test of each reporting unit may be performed at any time during the year as long as the test is performed at the same time every year. Further, the goodwill of different reporting units may be tested for impairment at different times during the year. In addition to requiring annual testing of a reporting unit's goodwill for impairment, FASB Statement No. 142 requires an entity to also test goodwill for impairment between annual tests “if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount” (see FASB Statement No. 142, paragraph 28) Fair Value Concept in FASB Statement No. 142 FASB Statement No. 142, paragraph 23, states that “the fair value of an asset (or liability) is the amount at which that asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale. Thus, the fair value of a reporting unit refers to the amount at which the unit as a whole could be bought or sold in a current transaction between willing parties.” Paragraphs 23 and 24 of FASB Statement No. 142 outline a hierarchy of evidence to use as the basis for the fair value measurement. Pursuant to that guidance, quoted market prices in active markets are the best evidence of fair value, if available. The Statement further indicates that: However, the market price of an individual equity security (and thus the market

capitalization of a reporting unit with publicly traded equity securities) may not be representative of the fair value of the reporting unit as a whole…[due to the value that may be inherent in the ownership of a controlling interest in a reporting unit (that is, a control premium)].The quoted market price of an individual equity security, therefore, need not be the sole measurement basis of the fair value of a reporting unit.

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Paragraph 24 of the Statement further states that:

If quoted market prices are not available, the estimate of fair value shall be based on the best information available, including prices for similar assets and liabilities and the results of using other valuation techniques. A present value technique is often the best available technique with which to estimate the fair value of a group of net assets (such as a reporting unit). If a present value technique is used to measure fair value, estimates of future cash flows used in that technique shall be consistent with the objective of measuring fair value. Those cash flow estimates shall incorporate assumptions that marketplace participants would use in their estimates of fair value. If that information is not available without undue cost and effort, an entity may use its own assumptions. Those cash flow estimates shall be based on reasonable and supportable assumptions and shall consider all available evidence. The weight given to the evidence shall be commensurate with the extent to which the evidence can be verified objectively. If a range is estimated for the amounts or timing of possible cash flows, the likelihood of possible outcomes shall be considered.

Paragraph 25 of FASB Statement No. 142 allows an entity to estimate the fair value of a reporting unit by using a valuation technique based on multiples of earnings, revenues, or a similar performance measure (multiples) as long as that technique is consistent with the objective of measuring fair value. However, FASB Statement No. 142 states that the use of multiples would not be appropriate in situations in which the operations or activities of an entity for which the multiples are known are not of a comparable nature, scope, or size as the reporting unit for which fair value is being estimated. Financial Statement Presentation of Impairment of Goodwill Overall, FASB Statement No. 142 requires presentation and disclosures as follows (see paragraphs 44 through 47, 56, and 60 through 61 of FASB Statement No. 142 for the specific requirements; also see the illustrative disclosure checklist in Appendix IV of this publication): • Balance sheet — Separate line items must be presented for goodwill and

intangible assets. • Income statement — An entity must (1) present goodwill impairment losses

(other than transitional impairment losses) in a separate line item within income from continuing operations, unless an impairment loss is associated with a discontinued operation, and (2) present transitional impairment losses for goodwill and indefinite-lived intangible assets as the cumulative effect of a change in accounting principle.

• An entity must provide disclosures about goodwill impairments and the changes in the carrying amount of goodwill

Auditing Considerations Overall

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Audit procedures will vary depending on the auditor’s risk assessment and the circumstances of the entity under audit. Appendix III of this publication contains an illustrative audit program that can be used to develop procedures for auditing the impairment of goodwill. Management Representations The auditor should consider obtaining written representations from management about the impairment of goodwill affecting the financial statements, including specific representations about the adequacy of such disclosures. Specific representations might include those that: • State that the entity, using its best estimates based on reasonable and

supportable assumptions and projections, reviews for impairment of goodwill whenever events or changes in circumstances indicate that the carrying amount of goodwill might not be recoverable.

• Acknowledge that the entity has tested goodwill for impairment in accordance with the requirements of FASB Statement No. 142 and impairment losses have been recorded when required.

• In cases where Step 1 of the impairment test was failed, but no impairment loss was recorded, indicate that, although the carrying amount of a particular reporting unit (the representation should identify the reporting unit) exceeded its fair value, the entity has not recorded an impairment loss because the implied fair value of the reporting unit’s goodwill exceeded its carrying amount.

• State that the determination of fair value of reporting units and the implied fair value of goodwill was based on reasonable and supportable assumptions.

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APPENDIX VII: MANAGEMENT CONSIDERATIONS WHEN ENGAGING A VALUATION SPECIALIST Introduction Recent accounting standards have significantly increased the number of instances where management may need to engage the services of specialists in fair value measurement in conjunction with the preparation of information that is integral to the financial reporting process. Management is responsible for the content of the information included in the financial statements. In the context of fair value measurements, management is ultimately responsible for the assumptions underlying the valuation and for making the final determination on the amounts recognized in the financial statements. When engaging the specialist in business valuation, it is important and efficient to identify and resolve in advance as many potential issues as possible. Following recent pronouncements such as Financial Accounting Standards Board (FASB) Statement No. 141, Business Combinations, more entities and specialists than ever before will utilize engagement letters to ensure that the scope and quality of the specialist’s work will meet management’s needs, and as a means to formalize the understanding of the parties. The following are some of the practical issues that management should consider and possibly confirm in writing when making arrangements with the specialist at the outset of the engagement. Qualifications Management should be concerned with the qualifications and professional reputation of valuation specialists engaged to develop fair values. Inquiries should include: • Valuation experience and qualifications. When management retains valuation

specialists to perform valuations for financial reporting purposes, the valuation specialist should understand the definition and requirements in the accounting literature regarding the asset or liability being measured. Many valuation specialists develop expertise in particular valuation/measurement areas. Management should consider references and the expertise of the valuation specialist.

• Knowledge of the industry and industry information sources. When management retains valuation specialists to perform valuations for financial reporting purposes, the specialists should be recognized as possessing qualified industry-specific experience.

• Valuation standards. Adherence to recognized valuation industry standards such as Uniform Standards of Professional Appraisal Practice (USPAP) may be an indication of valuation quality.1

1 The AICPA’s Business Valuation Standards Task Force has issued an exposure draft entitled, Statement on Standards for Valuation Services No. 1. Once approved, the standard will provide

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Management should be aware that auditors will be interested in these same issues. Auditors will expect valuation specialists to meet the qualifications outlined in Statement on Auditing Standards (SAS) No. 73, Using the Work of a Specialist (AICPA, Professional Standards, vol. 1, AU sec. 336). Also, see paragraphs 33 and 34 of this publication. Definitions Governing Fair Value When working with fair value measurements related to recent accounting literature, it is important to recognize that measurement specialists perform a wide range of valuations for different purposes. One cannot be too specific in confirming that the appropriate accounting literature governing the fair value measurement is recognized and the definitions in the professional literature guide the performance of the engagement. Specialists should understand the FASB Statements of Financial Accounting Standards and other related accounting literature (such as technical interpretations of FASB Statements, AICPA Audit and Accounting Guides, and AICPA Practice Aids) that relate to the type of valuation required. For example, fair value has been defined in FASB Statement of Financial Accounting Standards No. 141, Business Combinations, as “The amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale.” This and other recent pronouncements stress the importance of using market transactions and market assumptions in determining fair value. Valuation specialists have no latitude in interpreting the requirements of these accounting requirements. The accounting standards must be followed, or the valuation may not be appropriate for financial reporting purposes. Engagement Considerations It may be helpful for management and the specialist to discuss and agree on the expected service to be provided. Illustrative points to discuss include: • The assets to be valued or measured should be agreed (for example, it is

recommended that each asset or asset group be specifically identified, not simple general asset categories). Assets not included as part of the engagement should be identified and the party responsible for providing any required fair value measurement should be identified. For example, in a purchase price allocation, the specialist providing the value of the individual intangible assets may not be the specialist providing the value of the individual tangible assets.

• The “as of” date of the fair value measurement.

guidance to valuation specialists in the performance of an engagement to develop and report on the valuation of a business, an interest in a business, or an intangible asset.

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• The date the specialist’s report will be provided (either a specific date or time required from receipt of required entity information).

• The accounting literature definition of fair value to be utilized.

• Professional valuation standards to be followed.

• Type, detail, and format of report to be provided. Auditors and regulators will expect that a written report be prepared and available as a basis for their review. Failure to produce a written report may interfere with an efficient and timely review of the valuation. USPAP guidance is available regarding report content.

• Expectations regarding specialists’ views and policies regarding updating the valuation.

Auditability Due to the importance of these fair value measurements to the financial reporting process, auditors will be obtaining an understanding of the assumptions and methods of fair value measurement, and assessing their reasonableness. They will also be testing data used in the analysis. The AICPA’s Auditing Standards Board has approved for issuance SAS No. 101, Auditing Fair Value Measurements and Disclosures. Assumptions and limiting conditions should be discussed early in the process. Management should inquire about and be alert to any restrictions (for example, information and access to key personnel) that might reasonably be expected to be encountered or might be imposed due to foreseeable circumstances. If such limitations are foreseen, their possible effect on the valuation procedures and conclusions should be discussed. Restrictions should be disclosed in the valuation report and their effects on the measurement process explained. The use of “proprietary” methods of valuation may inhibit or preclude the auditor’s review of the methods employed by the specialist, and may likely result in increases in audit time and costs, or a finding that the valuation is unacceptable for financial reporting purposes. Although the assumptions and methods of valuation are ultimately the responsibility of management, in cases in which the methodology proposed is unique or might be unfamiliar, an up-front discussion of auditability between the auditor, management, and the specialist is recommended. While the specialist may have experience in working with the entity’s independent auditors in past assignments, that may not provide assurance that new issues will not arise relating to the specific fair value engagement under discussion.

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Auditors do engage valuation specialists that may be part of or affiliated with the audit firm, or may engage independent specialists in helping them to assess the determination of fair values. Though not always necessary, auditors may sometimes find it helpful to have access to the underlying support for the fair value measurement report. It may be more effective and efficient to review the work the specialist performed than simply using external information in conjunction with the report in obtaining their required understanding of the fair value measurement report results. Access to the working papers or support information used by the specialist might be the subject of an up-front understanding between management and the valuation specialist. Other Issues A myriad of other issues might be relevant to specific valuation engagements. Advance thought and clear agreement on these issues can avoid future misunderstandings. For example, if challenged, is the specialist prepared to defend the measurement before regulatory authorities such as the Securities and Exchange Commission? What are the valuation specialist’s usual arrangements regarding such services? Will the specialist require a representation letter from management in connection with the engagement? What will be the content of that representation?