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.
US GAAP requires a goodwill Impairment Test 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. 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-offsWrite-offsWrite off is the reduction in the value of the assets that were present in the books of accounts of the company on a particular period of time and are recorded as the accounting expense against the payment not received or the losses on the assets. 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 carrying amountCarrying AmountThe carrying amount or book value of asset is the cost of tangible, intangible assets or liability recorded in the financial statements, net of accumulated depreciation or any impairments or repayments. Accordingly, the carrying amount may differ from the market value of assets. 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 the goodwill impairment test is when any such events have an effect 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 an assessment of the current situation, identification of the impairment, and calculation of the impairment. It is further explained below:
1. Assessment of the Current Situation
The current condition of the acquired business needs to be assessed to understand whether impairment testing is 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 assetsIntangible AssetsIntangible Assets are the identifiable assets which do not have a physical existence, i.e., you can't touch them, like goodwill, patents, copyrights, & franchise etc. They are considered as long-term or long-living assets as the Company utilizes them for over a year. . 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 valueCarrying ValueCarrying value is the book value of assets in a company's balance sheet, computed as the original cost less accumulated depreciation/impairments. It is calculated for intangible assets as the actual cost less amortization expense/impairments. 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 that 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 that 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 reflects a reduction in the net earnings by $3 million.
Cash Flow Statement
In a cash flow statementCash Flow StatementStatement of Cash flow is a statement in financial accounting which reports the details about the cash generated and the cash outflow of the company during a particular accounting period under consideration from the different activities i.e., operating activities, investing activities and financing activities., expenses that reduce taxable income are included. An impairment charge is a non-cash expenseNon-cash ExpenseNon-cash expenses are those expenses recorded in the firm's income statement for the period under consideration; such costs are not paid or dealt with in cash by the firm. It involves expenses such as depreciation. that is non-tax deductible, and so they do not affect the 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 entirely 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 article 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 –