Goodwill Impairment: Causes And Consequences

Financial Modeling and Analysis

Goodwill impairment illustrates a decrease in the value of the goodwill in the balance sheet of a company. Goodwill is recorded during the M&A process of businesses when the purchase cost exceeds the fair market value of the company that has been acquired. The factors that lead to impairment are changes in market conditions, poor business financial performance, and other unexpected events. It is important to understand the causes, consequences, and best practices for the management of impairment. Delve deep into this article to get a finer knowledge of goodwill amortization and impairment in the business.

 

Goodwill Impairment

Source: Pinterest

 

Key Highlights

  • Goodwill impairment shows the dynamic character of the business operations and its related market conditions. The value of goodwill shows the extra business value that is incurred from its intangible set of assets like brand reputation, customer relations, and other non-physical assets. 
  • The value of goodwill will not depreciate or amortize like other physical assets. However, this value will be impaired by other factors like internal business changes, poor financial performance, regulatory changes, economic downturns, and changes in market conditions. If the goodwill value gets impaired by a decline in the value of the company’s intangible assets below the purchase price, it will be recorded as the impairment charge.
  • A recorded impairment charge signals about the potential issues in the business and its operations. This process ensures that the company’s financial statements are accurately represented by the economic realities. Managing the impairment of goodwill is essential for maintaining the confidence levels of investors, regulatory compliance, and strategic financial health of the company. 
  • The impairment expense is measured and recorded as the amount of difference between the current value of a company in the market and its purchase value of the intangible assets. The impairment will lead to a decrease in the value of the goodwill account on the balance sheet. 
  • In the income statement, this reduced impairment charge will in turn lead to the reduction of net earnings.  The impairment charge is considered a non-cash expense in the cash flow statement and is usually added back to the cash from the business operations. 
  • Goodwill impairment can be tested using different methods namely the income and market approaches. Companies are required to perform the impairment testing on a regular basis or as and when required by a triggering event in the market or company. These events might be an increased competitive environment, changes in the management team, a decline in cash flows, economic changes, and legal implications. 
  • Goodwill amortization is the process of regularly charging the cost of goodwill over a specific period. It is usually conducted on a 10-year basis as per the accounting standard requirements. Typically, it has been replaced by the impairment testing process. It basically involves the spreading of goodwill value over its useful life period. It simplifies the accounting process by decreasing the complexity and cost associated with annual impairment testing in the case of some small and private businesses. 
  • The goodwill amortization process involves initial recognition, amortization period, amortization expense, and impairment testing. Its advantage is providing a predictable spending pattern. It has several disadvantages like not accurately reflecting the true economic value of goodwill and it might lead to discrepancies between the book value and the market value of the goodwill. 

 

Goodwill Impairment Vs. Goodwill Amortization

There are several major differences between goodwill amortization and impairment. Some of them are briefed in the below area for your understanding.

  • The major difference is the context of recognition and timing. When the process of amortization involves regular and a systematic approach to expense recognition over a specific period, the process of impairment involves periodic assessment (mostly in a year gap or when an unexpected trigger event occurs) to determine whether a one-time reporting is essential or not.
  • The next point of difference is in the accounting approach. The goodwill amortization utilizes a predictable accounting approach that is spread over time, while the impairment reflects the current market conditions and the company performance that leads to potentially inappropriate reporting.
  • Another key difference is in the modern industry usage of both approaches. The goodwill amortization method is limited in usage among small businesses and some private companies under certain conditions. The impairment process is followed as a standard practice among public companies and many other private companies in the industry. This is due to the reason that the amortization method acts as a simple process in the accounting standards. 

Major Reasons For Goodwill Impairment

The impairment may occur due to a variety of reasons. These affecting factors can be either internal or external to the company and its operations. It is best to understand these causes for the timely identification and management of goodwill.  

  • One of the major reasons for the impairment is the economic downturns. Several broader economic factors like recessions or financial crises will reduce consumer spending, decrease the demand for services and products, and have a negative impact on the company’s profitability and cash flows.
  • Significant changes in the market conditions like technological advancements, increased competition, and shifts in the preferences of consumers will possibly affect the value of the goodwill. Also, the value of goodwill will be impaired if the company’s market position has been deteriorated.
  • The business’s operational challenges like management turnover, strategic issues, and operational inefficiencies will have an impact on the impairment. It will affect the expected benefits from acquisitions and lead to a reassessment of the value of goodwill. 
  • Another possible cause for the impairment of goodwill is the regulatory changes.  Certain new laws, regulations, or changes in the existing ones will have an impact on the company’s operations, compliance costs, and even the market opportunities of the business.  This can lead to a decrease in the projected revenue from the acquired company.
  • There can be certain performance issues and negative publicity that affect the value of goodwill. Consistent poor performance in finance like declining cash flows, revenues, margins, etc. indicates that the anticipated benefits from the bought company are not being realized. There are chances for certain events that might damage the company’s reputation like legal issues, ethical scandals, or product recalls. This will also reduce the value of goodwill.
  • The next reason for the impairment of goodwill is the strategic shifts and customer loss. Modifications in the company’s strategic direction like restructuring, divestitures, or changes in the business models will affect the goodwill value. Losing a significant number of customers or experiencing a substantial loss will impact the profitability and revenue of the company that was once used to support the initial valuation of the goodwill.
  • Technological aging is another possible reason for the impairment in this evolving and dynamic business environment. Rapid and dynamic technological changes will make the company’s services or products outdated. This will affect its competitive edge and reduce the goodwill value that is associated with the expanding technological ability of the company.
  • There are chances for industry-specific factors to occur like regulatory changes in the specific industry of the business, shifts in the industry trends, or commodity price fluctuations which will affect the value of goodwill.

 

You may also like to read about:

 

Consequences Of Goodwill Impairment

There are several significant consequences of the impairment of goodwill in a company. It will have impacts on the company’s financial statements, overall strategic outlook, and market perception. Some of the primary consequences of the impairment are listed below.

  • The major impact will be on the financial statements. The impairment will result in a non-cashable expense, which will in turn reduce the company’s net income for a specific period in which the impairment is recorded. The impairment charges will reduce the carrying amount of the goodwill value on the balance sheet of the company, which will directly decrease the equity of shareholders. When the net income of the company decreases, the lower earnings per share (EPS) will also reduce. EPS is a crucial measurement used for investors.
  • Another potential consequence of impairment is the market perception and investor confidence. The impairment charges will signal to financial analysts and potential investors that the past acquisitions of the target company have not performed as well as expected. It will potentially raise several concerns about the management’s decision-making and growth strategies of the company. A significant amount of impairment charges will lead to stock price volatility when the investors react to the sensed reduction in the company’s goodwill value. 
  • Debt contracts and credit ratings are other potential consequences of the impairment. Companies that have debt arrangements tied to their financial metrics like net income and equity may break up these contracts due to the impairment charges. It will lead to renegotiations with the lenders and other financial personnel. Several rating agencies might view significant impairment charges as a negative factor and this will affect the company’s credit rating systems and increase the borrowing costs.
  • Even though the goodwill impairment is not tax-deductible, the tax implications like differed tax assets and liabilities will affect the company’s overall tax position and future tax expenses.
  • Another significant impairment consequence is in the area of operational and strategic reassessment. Frequent impairments of goodwill values will make a company reassess its strategic implications like its approach towards mergers and acquisitions. The impairment charges will also lead the company management to focus on improving its core operations and less focus on the growth strategies by acquisitions.
  • There will be several impacts on the financial ratios of the company by impairments. The profitability ratios like ROA (return on assets) and ROE (return on equity) will decrease due to the reduction in the net equity and income of the company. Certain solvency ratios that are used for measuring the financial stability of the company like debt-to-equity ratio will decrease the equities.
  • There may be several effects on the internal and external reporting. The impairments will lead to an increase in the scrutiny from regulators, auditors, and analysts. They might require detailed justifications and explanations from the company management. Companies must provide a detailed disclosure statement about the impairment like the reasons for impairment, methods used to determine the fair value of goodwill, and the impacts on the financial statements.
  • The long-term business values like the company’s reputational damage and other operational adjustments are also affected by the impairment of goodwill. Several replicated or extensive impairment charges will harm the company’s reputation and make it hard for the company to lure investors and acquisition targets. 

 

Pinpointing And Estimating Goodwill Impairment

Identification and calculation of the impairment is an essential procedure in ensuring the company’s financial statements are accurate and reflect the current financial position of the company. The below section gives a brief overview of the steps involved in the process of identifying and measuring the impairment.

  • The first step is the identification of impairment through qualitative assessment. It includes an initial screening process and identification of indicators of impairment. The qualitative assessment will determine whether the company’s fair value of the reporting unit is less than its carrying amount. This assessment also considers other factors like industry and market trends, macroeconomic situations, cost factors, changes in the key personnel, significant adverse events, and overall financial performance. If the assessment indicated potential impairment, then quantitative testing must be conducted. Otherwise, no more testing is required.
  • The next step is the measurement of impairment through quantitative testing.  It provides the differentiating process between the fair value of the reporting unit of goodwill to its carrying charge. If the carrying costs exceed the fair value, a goodwill impairment is recorded. The fair value is determined through several approaches such as market approach, income approach, or discounted cash flow (DCF) analysis. 
  • Now the process is to measure the impairment loss. It is calculated as the difference between the carrying value of the reporting unit and its fair value. It is usually recorded as an expense in the income statement and it reduces the carrying cost of goodwill in the balance sheet of the company.

 

Goodwill Impairment Management

There are certain best practices to monitor and manage the impairment of goodwill. Some of them are comprehended in the below section for your understanding.

  • It is very important to perform regular monitoring for managing the impairment of goodwill. You must keep a close eye on both internal performance indicators and external market conditions that could have an impact on the value of the goodwill. 
  • Conducting timely assessments is also very significant in the management process. You must perform quantitative and qualitative assessments to identify any potential triggering events that lead to impairments and determine whether the goodwill carrying amounts exceed the fair values.
  • The next countermeasure in the management of impairment is the implementation of robust valuation techniques. It is important to use reliable valuation methods to assess the fair value of the reporting units and ensure accuracy in the financial reporting.
  • Maintaining transparency is seen as a significant step towards the management of impairment of the goodwill value. It is a best practice to clearly disclose the reasons for any impairment of the goodwill value, the methods used for its valuations, and the potential impact on the company’s financial statements. Transparency and trustworthiness are important factors that are overlooked by the business stakeholders and it increases their confidence levels. 

 

FAQs-

1. What Amount Is Recorded As An Impairment Loss?

  • All the assets of the company should be measured carefully and properly at their fair value in the market before testing them for impairment. In case the goodwill assets have been identified and assessed as impaired, then the entire amount of impairment must be considered as a loss. An impairment is registered as a loss in the income statement and as a reduction value of the goodwill account in the company’s balance sheet.
  • This recorded amount of loss is basically the difference between the current fair market value of the goodwill and its carrying amount. It is advisable that the asset’s value should not be decreased below zero i.e. the maximum value of impairment loss account should not exceed the carrying amount of the asset.

 

2. What Are The Financial Reporting Implications Of Impairment Of Goodwill Value?

There are several factors that indicate the impairment of goodwill in the financial reporting. It results in a non-cash expense reported on the income statement and indicates a reduced net income value. On the balance sheet, the carrying costs of goodwill are decreased to its fair value. It will have an impact on the equity and potentially affect the financial ratios and the perceptions of the investors. 

 

3. Will The Impairment Affect The Taxes?

The impairment of the value of goodwill is usually not tax-deductible. However, it might affect the different tax liabilities and assets which will have an impact on the company’s overall tax positions and deductions.

 

4. Why Is Goodwill Impairment Important For Investors?
The goodwill value impairment process offers investors helpful insights into the future and healthy prospects of a company’s acquisitions. Significant or frequent impairment charges might indicate the underlying issues within the company’s strategic decisions or market conditions. In this way, the investors can either withdraw from the mergers and acquisitions process or prepare a buying price according to the impaired value of the goodwill. Either way, it is very significant for the investors.

 

Conclusion

In conclusion, the process of goodwill impairment is a complex but critical aspect of financial reporting. With a proper understanding of its causes, consequences, and best procedures for management, the companies will be able to navigate through the challenges related to the impairment of goodwill. The goodwill amortization is replaced by impairment testing for public companies. However, it has been widely used by private companies that are looking for simple accounting processes. Understanding its modern application is essential for financial reporting and strategic financial management. Regular monitoring, transparent reporting, strategic planning, and powerful valuation methods are vital elements of an effective impairment management strategy of goodwill. 

 

3 Responses

Leave a Reply

Your email address will not be published. Required fields are marked *

Contact Us!