What is Goodwill Impairment?
Goodwill Impairment it is a deduction from the earnings that companies record on their income statement after identifying that the acquired asset associated with the goodwill has not performed financially as expected at the time of its acquisition.
Goodwill Impairment Test is required by US GAAP wherein the balance sheet goodwill should be valued at-least-once annually to check if the balance sheet value is greater than the market value and if there is any resulting impairment, then it should be written off as impairment charges in the Income Statement.
The goodwill impairment made headlines in 2002 as companies disclosed massive goodwill write-offs by adopting new accounting rules (AOL reported $54 billion and McDonald’s reported $99 million) to sort the misallocation of assets made at the time of the dot com bubble between 1995 and 2000. Most recently (2019), Kraft recorded impairment charges of $15.4 billion to lower the carrying amount of Goodwill.
Goodwill Impairment Formula
Common Methods of Goodwill Impairment Test
Goodwill can be affected by events like the deterioration of the economic condition, change in government policies or regulatory norms, competition in the market, etc. These events have a direct impact on the business and hence can affect the goodwill. The need for goodwill impairment test when any such events have an impact on the goodwill.
The two common methods are as below:
- #1 – Income Approach – Estimated future cash flows are discounted to a single current value.
- #2 – Market Approach – Examining the assets and liabilities of companies who are a part of the same industry.
Steps for Goodwill Impairment Test
Goodwill impairment testing is a multi-step process; it requires assessment of the current situation, identification of the impairment and calculation of the impairment. This is further explained below:
1. Assessment of the Current Situation
The current condition of the acquired business needs to be assessed so as to understand whether impairment testing is actually needed. As mentioned above, events like a change in government policies, change in management or fall in the share price, possible bankruptcy would trigger deterioration of the financial condition. A company is required to assess the fair value of the company or the reporting unit in the first half of a fiscal year as to whether or not an adjustment for impairment needs to be recorded.
2. Identification of the Impairment
The current fair market value of the reporting unit should be compared to the carrying amount. The carrying amount of the reporting unit should include goodwill and any unrecognized intangible assets. There is no goodwill impairment if the current fair market value of the reporting unit is greater than the carrying amount and there is no need to conduct the next step. If the carrying value is greater than the current fair market value of the reporting unit, then the impairment needs to be calculated.
3. Calculation of the Impairment
By comparing the current fair market value of the reporting unit to the carrying amount if the carrying amount is greater, this would be the impairment which needs to be calculated. The maximum impairment value will be the carrying amount as it cannot exceed this value.
Examples Of Goodwill Impairment Test
A simple example would be of you buying a vintage bike. You buy it reading all the reviews on the internet regarding the brand and the model and you are convinced in buying it at a rate which is higher than its actual value owing to its popularity among the masses. After a year or so, you realize the cost involved in maintaining the bike is far more than that what you spend on the fuel. That’s when you realize that the bike is not performing as per the expectation that was set at the time of purchase.
Similarly, companies are required to conduct an impairment test annually with respect to the goodwill of an acquired company.
XYZ Inc. acquires the assets of ABC Inc. for $15 million; its assets were valued at $10 million and goodwill of $5 million was recorded on its balance sheet. A year later, XYZ Inc. assesses and tests its assets for impairment and concludes that ABC Inc.’s revenue has been declining remarkably. Due to this, the current value of company ABC Inc.’s assets has gone down from $10 million to $7 million, thereby resulting in an impairment to the assets of $3 million. Eventually, the value of the asset of goodwill drops down from $5 million to $2 million.
Let’s see how impairment impact is recorded on the income statement, balance sheet, and cash flow statement.
Goodwill reduces from $5 million to $2 million.
An impairment charge of $3 million is recorded, which reflect a reduction in the net earnings by $3 million.
Cash Flow Statement
Important Points to Note
- The assets should go undergo a thorough assessment to identify the fair market value before impairment testing.
- If the assessment identifies impairment, the impairment charge should be completely written off as a loss on the income statement.
- The difference between the recorded value (historical value) and the current fair market value must be recorded as a loss on the income statement. Impairment cannot be recorded as a negative value.
- The goodwill impairment test is an annual exercise that companies need to perform to eliminate worthless goodwill.
- It is trigger by both internal and external factors like change in management, the decrease in share price, regulatory change, etc.
This has been a guide to what is Goodwill Impairment and its definition. Here we discuss the steps to test goodwill for impairment along with its formula and practical examples. You can learn more about financing from the following articles –