What Is a Goodwill Impairment?
Goodwill impairment occurs when a company decides to pay more than book value to acquire an asset – then the value of that asset declines. The difference between the amount that the company paid for the asset and the book value of the asset is known as goodwill. The company has to adjust the book value of that goodwill down if it becomes impaired.
Goodwill impairment is an accounting charge. Companies record it when the carrying value on financial statements exceeds goodwill’s fair value. In accounting, goodwill is recorded after a company acquires assets and liabilities. But, at a price in excess of their identifiable net value. When the fair value of goodwill drops below the previously recorded value from the time of the acquisition, and impairment is recorded.
Goodwill is an intangible asset. It accounts for the excess purchase price of another company. The excess can be based on proprietary or intellectual property, brand recognition, and patents. Intangibles that are not easily quantifiable. Impairment may occur if the assets acquired no longer generate the financial results that were previously expected of them at the time of purchase. A test for goodwill impairment per generally accepted accounting principles (GAAP) must be undertaken, at a minimum, on an annual basis.
Goodwill impairment arises when there is deterioration in the capabilities of acquired assets to generate cash flows, and the fair value of the goodwill dips below its book value. Perhaps the most famous goodwill impairment charge was the $54.2 billion reported in 2002 for the AOL Time Warner, Inc. merger. This was, at the time, the largest goodwill impairment loss ever reported by a company. (Source:investopedia)
How Goodwill Impairment Works
Goodwill is an intangible asset commonly associated with the purchase of one company by another. Specifically, goodwill is recorded when the purchase price is higher than the net of the fair value of all identifiable assets. This includes tangible and intangible assets and liabilities assumed in the process of an acquisition. Examples of goodwill are the value of a company’s brand name, solid customer base, good customer relations. Also, good employee relations, and any patents or proprietary technology represent some instances of goodwill.
Goodwill impairment is an earnings charge that companies record on their income statements. They do this after they identify that there is persuasive evidence to justify a writedown. When assets associated with the goodwill can no longer demonstrate financial results. At least, results that were expected at the time of its purchase. Many companies acquire other firms and pay a price that exceeds the fair value of assets and liabilities. The difference between the purchase price and the fair value of acquired assets is recorded as goodwill. However, unforeseen circumstances can arise that decrease expected cash flows from acquired assets. Then the goodwill recorded can have a current fair value that is lower than what was originally booked. As a result, the company must record a goodwill impairment.
Why Track and Adjust Goodwill for Impairment?
A large amount of goodwill impairment could indicate serious problems. It could mean that a company is not making sound investment decisions in physical assets. Or, that it could be paying more for an asset than it should. Goodwill can represent a large part of a company’s value or net worth. If a company doesn’t test for goodwill impairment, it could overstate its value or net worth. Goodwill is an intangible asset. So, treating it like a normal asset and amortizing it does not give a clear picture as to the value of the asset. It needs to be tested for impairment once a year.
U.S. generally accepted accounting principles (GAAP) require companies to review their goodwill for impairment at least annually at a reporting unit level. Events that may trigger goodwill impairment include a deterioration in economic conditions, increased competition, loss of key personnel, and regulatory action. The definition of a reporting unit plays a crucial role during the test; it is defined as the business unit that a company’s management reviews and evaluates as a separate segment. Reporting units typically represent distinct business lines, geographic units, or subsidiaries.
The basic procedure governing goodwill impairment tests as set out by the Financial Accounting Standards Board (FASB) in “Accounting Standards Update No. 2017-04, Intangibles—Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment.”
Goodwill Impairment Test
Companies need to perform impairment tests annually. Or, whenever a triggering event causes the fair market value of a goodwill asset to drop below the carrying value. Triggering events that may result in impairment are adverse changes in the general condition of the economy. Or, increased competitive environment, legal implications, changes in key personnel, or declining cash flows. In short, any situation where current assets show a pattern of declining market value. There are two methods commonly used to test for impairment to goodwill:
- Income approach – discounting estimated future cash flows to a single current value
- Market approach – examining the assets and liabilities of companies in the same industry
Example of a Goodwill Impairment Adjustment
A company accounts for its goodwill on its balance sheet as an asset. It does not, however, amortize or depreciate the goodwill as it would for a normal asset. Instead, a company needs to check its goodwill for impairment at least yearly. The asset becomes impaired by a decline in the value of the asset below the purchase price. As a result, the company would record a goodwill impairment. This is a signal that the value of the asset has fallen below the amount that the company originally paid for it.
Here is an example and its impact on the balance sheet, income statement, and cash flow statement. Company ABC acquires the assets of Company XYZ for $15M. ABC values its assets at $10M and recognizes goodwill of $5M on its balance sheet. After a year, company ABC tests its assets for impairment. It finds out that company XYZ’s revenue has been declining significantly. As a result, the current value of company XYZ’s assets has decreased from $10M to $7M. The result is an impairment of the assets of $3M. This makes the value of the asset of goodwill drop down from $5M to $2M.
- Balance Sheet – Goodwill reduces from $5M to $2M.
- Income Statement – An impairment charge of $3M is recorded, reducing net earnings by $3M.
- Cash Flow Statement – The impairment charge is a non-cash expense and added back into cash from operations. The only change to cash flow would be if there was a tax impact, but that would generally not be the case, as impairments are generally not tax-deductible.
Changes in Accounting Standards for Goodwill
Goodwill impairment became an issue during the accounting scandals of 2000–2001. Many firms artificially inflated their balance sheets by reporting excessive values of goodwill. This was allowed at that time to be amortized over its estimated useful life. Amortizing an intangible asset over its useful life decreases the amount of expense booked in any single year. Accounting scandals and subsequent changes in rules forced companies to report goodwill at realistic levels. Current accounting standards require public companies to perform annual tests on goodwill impairment. Also, goodwill is no longer amortized. In accordance with both GAAP in the United States and IFRS in the European Union and elsewhere, goodwill is not amortized.
Companies should assess whether or not an adjustment for impairment is needed within the first half of each fiscal year. This impairment test may have a substantial financial impact on the income statement. It will be charged directly as an expense or written off until the asset of goodwill is completely removed from the balance sheet. In order to accurately report their value from year to year, companies do the impairment test. Impairment losses are, functionally, like accumulated depreciation.
Up Next: What Is a Proforma Invoice?
A proforma invoice is a preliminary bill of sale. It is sent to buyers in advance of a shipment or delivery of goods. The invoice will typically describe the purchased items and other important information. This includes items like the shipping weight and transport charges. Proforma invoices often come into play with international transactions. They are often used for customs purposes on imports.
Proforma invoices are sent to buyers ahead of a shipment or delivery of goods or services. Most proforma invoices provide the buyer with a precise sale price. There are no guidelines dictating the exact presentation or format of a proforma invoice. A proforma invoice really only requires a limited amount of information. Enough to allow customs to determine the duties needed after a general examination of the included goods.