Goodwill and Intangible Assets Accounting Policy
Goodwill is not amortized; instead, it is reviewed for impairment annually (in the fourth quarter) or more frequently if indicators of impairment exist or if a decision is made to sell a business. A significant amount of judgment is involved in determining if an indicator of impairment has occurred. Such indicators may include deterioration in general economic conditions, negative developments in equity and credit markets, adverse changes in the markets in which an entity operates, increases in input costs that have a negative effect on earnings and cash flows, or a trend of negative or declining cash flows over multiple periods, among others. The fair value that could be realized in an actual transaction may differ from that used to evaluate the impairment of goodwill.
Goodwill is allocated among and evaluated for impairment at the reporting unit level, which is defined as an operating segment or one level below an operating segment. Alcoa has nine reporting units, of which five are included in the Engineered Products and Solutions segment. The remaining four reporting units are the Alumina segment, the Primary Metals segment, the Flat-Rolled Products segment, and the soft alloy extrusions business in Brazil, which is included in Corporate. Almost 90% of Alcoa's total goodwill is allocated to three reporting units as follows: Alcoa Fastening Systems (AFS) ($1,153) and Alcoa Power and Propulsion (APP) ($1,627) businesses, both of which are included in the Engineered Products and Solutions segment, and Primary Metals ($1,841). These amounts include an allocation of Corporate's goodwill.
In September 2011, the Financial Accounting Standards Board issued new accounting guidance for testing goodwill for impairment. The guidance provides an entity the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not (more than 50%) that the estimated fair value of a reporting unit is less than its carrying amount. If an entity elects to perform a qualitative assessment and determines that an impairment is more likely than not, the entity is then required to perform the existing two-step quantitative impairment test (described below), otherwise no further analysis is required. An entity also may elect not to perform the qualitative assessment and, instead, proceed directly to the two-step quantitative impairment test. The ultimate outcome of the goodwill impairment review for a reporting unit should be the same whether an entity chooses to perform the qualitative assessment or proceeds directly to the two-step quantitative impairment test.
In the 2011 fourth quarter, in conjunction with management's annual review of goodwill, Alcoa early adopted the new guidance. As a result, Alcoa instituted a policy for its annual review of goodwill to perform the qualitative assessment for all reporting units not subjected directly to the two-step quantitative impairment test. Management will proceed directly to the two-step quantitative impairment test for a minimum of three reporting units (based on facts and circumstances) during each annual review of goodwill. This policy will result in each of the nine reporting units being subjected to the two-step quantitative impairment test at least once during every three-year period.
Under the qualitative assessment, various events and circumstances (or factors) that would affect the estimated fair value of a reporting unit are identified (similar to impairment indicators above). These factors are then classified by the type of impact they would have on the estimated fair value using positive, neutral, and adverse categories based on current business conditions. Additionally, an assessment of the level of impact that a particular factor would have on the estimated fair value is determined using high, medium, and low weighting. Furthermore, management considers the results of the most recent two-step quantitative impairment test completed for a reporting unit (this would be 2010 in which the estimated fair values of all nine reporting units were substantially in excess of their carrying values) and compares the weighted average cost of capital (WACC) between the current and prior years for each reporting unit.
During the 2011 annual review of goodwill, management performed the qualitative assessment for six reporting units. Management concluded that it was not more likely than not that the estimated fair values of the six reporting units were less than their carrying values. As such, no further analysis was required.
Under the two-step quantitative impairment test, the evaluation of impairment involves comparing the current fair value of each reporting unit to its carrying value, including goodwill. Alcoa uses a DCF model to estimate the current fair value of its reporting units when testing for impairment, as management believes forecasted cash flows are the best indicator of such fair value. A number of significant assumptions and estimates are involved in the application of the DCF model to forecast operating cash flows, including markets and market share, sales volumes and prices, costs to produce, tax rates, capital spending, discount rate, and working capital changes. Most of these assumptions vary significantly among the reporting units. Cash flow forecasts are generally based on approved business unit operating plans for the early years and historical relationships in later years. The betas used in calculating the individual reporting units' WACC rate are estimated for each business with the assistance of valuation experts.
In the event the estimated fair value of a reporting unit per the DCF model is less than the carrying value, additional analysis would be required. The additional analysis would compare the carrying amount of the reporting unit's goodwill with the implied fair value of that goodwill, which may involve the use of valuation experts. The implied fair value of goodwill is the excess of the fair value of the reporting unit over the fair value amounts assigned to all of the assets and liabilities of that unit as if the reporting unit was acquired in a business combination and the fair value of the reporting unit represented the purchase price. If the carrying value of goodwill exceeds its implied fair value, an impairment loss equal to such excess would be recognized, which could significantly and adversely impact reported results of operations and shareholders' equity.
During the 2011 annual review of goodwill, management proceeded directly to the two-step quantitative impairment test for three reporting units as follows: the Primary Metals segment, building and construction systems, which is included in the Engineered Products and Solutions segment, and the soft alloy extrusions business in Brazil. The estimated fair values of these three reporting units were substantially in excess of their carrying values, resulting in no impairment.
As part of the 2011 annual review of goodwill, management considered the market capitalization of Alcoa's common stock in relation to Alcoa's total shareholders' equity. At December 31, 2011, the market capitalization of Alcoa's common stock was $9,207. While this amount is less than Alcoa's total shareholders' equity at December 31, 2011, the estimated aggregate fair value of Alcoa's reporting units was substantially in excess of the aforementioned market capitalization amount. In management's judgment, the main reasons for the difference between Alcoa's market capitalization and total shareholders' equity at December 31, 2011 are the overall decline in the capital markets and significantly lower commodity prices. As it relates to the capital markets, there was, and continues to be, significant uncertainty of the sovereign debt of many European countries. This uncertainty has affected the liquidity of many companies that either operate or are located in Europe, although, Alcoa has not been impacted significantly. The combination of this uncertainty and the continuing decline in commodity prices caused significant and volatile fluctuations in the price of Alcoa's common stock. At December 31, 2011 and 2010, the market price of Alcoa's common stock was $8.65 and $15.39, respectively, which equates to a decline of 44%. During 2011, the size and structure of Alcoa did not change and there were no specific events or transactions that would cause management to reasonably expect such a decline in the market price of Alcoa's common stock. As a result, management believes the quoted market price of Alcoa's common stock does not fully reflect the underlying value of the future aggregate cash flows of Alcoa's reporting units. Accordingly, management does not believe that the comparison of Alcoa's market capitalization and total shareholders' equity as of December 31, 2011 is an indication that goodwill is impaired.
Intangible assets with indefinite useful lives are not amortized while intangible assets with finite useful lives are amortized generally on a straight-line basis over the periods benefited. The following table details the weighted-average useful lives of software and other intangible assets by reporting segment (numbers in years):
| Segment | Software | Other intangible assets |
|---|---|---|
| Alumina | 10 | - |
| Primary Metals | 10 | 40 |
| Flat-Rolled Products | 9 | 10 |
| Engineered Products and Solutions | 9 | 17 |
Source: Alcoa Inc., Annual Report
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