Goodwill Impairment: Test, Accounting, Example & Guide

"Goodwill" is a term that defines the company's reputation, trademark, brand loyalty, and customer commitment. It is an intangible asset, which is ideally not stated on the company's balance sheet but plays a major role in placing a company in a favorable market position. When the goodwill is achieved through a merger or acquisition, it might be recorded on the acquirer's financial statement. Its value is determined by comparing the costs of buying the business with the fair value of tangible assets, recognizable intangible assets, and liabilities acquired during the deal. TAG provides you with the understanding of goodwill in accounting meaning, and how is goodwill calculated.

What Is Goodwill Impairment?

Definition of Goodwill Impairment

Let's understand the impairment of goodwill meaning: it is defined as a process in which the recorded carrying value of a company on its balance sheet is greater than its recoverable amount. The term plays a significant role in presenting actual economic value and provides an accurate asset impairment review.

Goodwill vs Impairment Explained

Goodwill is the variance between a company's actual value and the price at which it can be purchased.

In simple terms, goodwill is an intangible asset, such as customer commitment, brand reputation, and a successful team, which is recorded on the company's balance sheet. Now, let's understand how goodwill and impairment are rated. An annual impairment review is required to measure goodwill that arises after the purchase of a subsidiary. This rule ensures that consolidated financial statements do not overstate goodwill.

Also, goodwill does not generate cash flows on its own and cannot be sold independently from the business. Therefore, a goodwill impairment test must be conducted on a component of a cash-generating unit to ensure which group of assets separately generates separate cash flows.

Usually, the cash-generating unit is considered a subsidiary. It means that the carrying amount after conducting an impairment review will ideally be the difference between the subsidiary's recoverable amount and its net assets and goodwill.

Goodwill is recorded at first, when a financial expert tries to assign impairment loss to specific assets associated with the cash-generating unit, unless there is an asset that is specifically impaired. Any additional impairment is distributed according to the carrying amount of each asset to other assets. If an asset is measurable, it cannot be recorded for less than its recoverable amount.

What Causes Goodwill Impairment?

Decline in Company Performance

A continuous fall in the company's financial performance is a significant cause that triggers goodwill impairment. If financial elements, such as income, profit, or cash flow, go below expectations, it reflects that the business acquisition is not producing the expected economic benefits. Hence, such an event leads to a decrease in the recoverable value of the reporting unit, which is now below its carrying amount. Therefore, companies must record goodwill to show the reduced valuation.

Economic or Market Changes

Additionally, economic conditions and market trends are also one of the reasons for goodwill impairment risk. Furthermore, economic downturns, inflation, increased interest rates, or modifications in consumer demands can impact and reduce the future cash flow of businesses. For instance, a business downturn or technological breakdown makes the historically valuable assets less attractive to competitors, resulting in goodwill impairment risk.

Poor Acquisition Decisions

Goodwill takes place when a company acquires another company and pays a premium amount more than the fair value of net intangible assets. In case the acquisition was overvalued or if synergies were overestimated, the anticipated benefits might not materialize. The variance between anticipated and actual performance can create goodwill impairment. Typical factors influencing goodwill impairment are unrealistic projections, poor due diligence, and integration issues.

Changes in Regulations or Competition

Alterations in regulations or increased competition are also some of the triggering factors for goodwill impairment. Implementation of new laws, tax regulations, or compliance standards increases expenses and also restricts the business functions. On the other hand, the emergence of new competitors or aggressive marketing strategies by current market players harm the share market and profitability. All such variables negatively impact future cash flows, which forces the revaluation of goodwill value.

Goodwill Impairment Test Explained

Step 1: Qualitative Assessment

The goodwill impairment testing starts with the preliminary qualitative assessment. In this first step, the company must determine whether the goodwill recorded on the balance sheet is expected to surpass its fair market value. This evaluation is ideally based on the pertinent factors, such as financial market trends, political or regulatory alterations, development of new industry competitors, operational or structural changes within the form, etc.

If the primary qualitative assessment indicates that the goodwill required on the balance sheet is not expected to surpass its fair value, then there is no need for additional tests. In case the reported company goodwill exceeds its fair market value, then the second step of quantitative assessment is carried out.

Step 2: Quantitative Assessment

The quantitative assessment of the goodwill impairment test is conducted in two stages. In the first stage, the fair value of the reporting unit on which the goodwill is based is calculated, and then it is compared with the amount of goodwill presently recorded on the company's balance sheet.

While calculating this, the business must consider the corresponding impact of various elements that might have significantly impacted the company's goodwill asset value. If this stage reveals that the goodwill stated on the company's balance sheet exceeds its fair value, then the company must conduct the next stage of quantitative assessment.

In the next stage, the company examines the value of each individual asset and liability to determine the fair value of the reporting unit. If the goodwill exceeds the fair value of the reporting unit in question, then the excess goodwill is identified as impairment to goodwill. The company's financial statement highlights the impairment value as a goodwill impairment charge.

Step 3: Measuring the Impairment Loss

In this last step, impairment loss is calculated if it exists. This process involves distributing the fair value of the reporting unit among all assets and liabilities if the unit has been purchased through a business merger.

If the estimated fair value of goodwill is less than the actual carrying value, then an impairment loss must be recorded. The loss is required as an operating expense, and the corresponding entry of goodwill is reduced on the balance sheet.

How to Calculate Goodwill Impairment

Formula for Goodwill Impairment

The basic formula used for goodwill impairment calculations is as below:

Goodwill Impairment = Carrying Amount of Goodwill − Fair Value of Goodwill

• Carrying amount of goodwill represents the recorded value of the company's goodwill on the balance sheet.
• The fair value of goodwill indicates the actual estimated value derived from revaluation.
• The goodwill impairment formula determines whether the actual recorded amount of goodwill is higher than its fair market value.

Example Calculation of Impairment Loss

Consider an XYZ company that manufactures equipment for the automobile service industry. It buys new-generation automated machines in order to create the latest gadgets while expecting a five-year lifespan of such machines.

Considering this, the company owner buys 40 machines, with each having a price of $200. Hence, the total purchase price was $8000.

In case, within one year after the date of purchase, 30 machines fail to function. Hence, the XYZ company conducted an asset impairment test. After evaluating the fault, the company found that the current projected value of the faulty machines was $100.

The company can use the goodwill impairment formula to calculate the goodwill impairment charge.

Goodwill Impairment Charge = ($200 × 30) − ($100 × 30) = $3000

Example of a Goodwill Impairment

Real-World Business Example

A real-world example of goodwill impairment is Nokia being acquired by Microsoft (A technological disruption).

In the year 2014, Microsoft acquired Nokia's smartphone section for $7.9 billion with the intention to expand the mobile market. But this strategy collapsed soon due to high competition from Apple and Android devices, in addition to no further interest in Microsoft Windows phones.

In 2015, after a year of acquisition, Microsoft recorded a $7.6 billion goodwill impairment, which was almost the full purchase price. The impairment showcases the sharp fall in Nokia's value as Microsoft found it difficult to remain competitive with the rapid technological shift and customer preferences. It reminds us about how quickly technological trends are evolving and the risks present in the acquisition.

Accounting Treatment of Impairment

When a financial analyst determines that goodwill is impaired, then it follows accounting treatments for such impairment structured by accounting standards such as IFRS and GAAP. Similar to other intangible assets, the goodwill is not amortized, but it is tested frequently if any sign of impairment is detected.

• Sign of impairment loss: There is a sign of impairment when the recorded amount of the reporting unit is greater than its recoverable amount. The variance between such values indicates the impairment loss.
• Recorded in the financial statement: The impairment loss is recorded as an expense in the income statement. Such losses decrease the company's net income over a period. At the same time, the carrying value of goodwill is reduced by the same amount on the company's balance sheet.
• No reversible effect on goodwill impairment: If the goodwill is deemed impaired, then such loss cannot be reversed in the future, even after the reporting unit value gets recovered.
• State key details on impairment: The companies must reveal the significant information on impairment, such as the amount of impairment loss, the cause behind such impairment, the methods applied to evaluate the recoverable amount, and the various predictions used in the impairment valuation method.

Goodwill Impairment Charge Explained

What Is a Non-Cash Goodwill Impairment Charge?

When the business identifies that the value of their goodwill recorded on the balance sheet is going down and is not reasonable for the present or anticipated future performance of the acquired business, then a non-cash impairment charge occurs. However, goodwill usually occurs only when the premium paid is more as compared to the fair value of net tangible assets.

Such an adjustment does not involve any type of physical cash outflows, and hence it is called a non-cash expense. Rather than this, it indicates a reevaluation of things such as loss of revenues, strong competition, economic recession, or unsuccessful incorporation of an acquisition.

How It Appears in Financial Statements

The goodwill impairment charge appears on the company's balance statements in the following manner, despite it being in the form of non-cash:

• Income Statement: Typically, the operating expense is considered a non-cash impairment charge. When the charge is significantly high, such a procedure reduces the periodic net income.
• Balance Sheet: The impairment charge decreases the worth of goodwill, which reduces the total assets and might significantly affect shareholders' equity.
• Cash Flow Statement: While using the indirect method, the non-cash impairment change is returned to net income in the operating section. This confirms that the cash flow is not undervalued.

Goodwill Impairment Under Accounting Standards

ASC 350 Goodwill Impairment Rules

Goodwill impairment is regulated by the Accounting Standard Codification 350 under the U.S. GAAP, which is set up by the Financial Accounting Standards Board. ASC 350 goodwill impairment rules state that the company has to evaluate the goodwill for impairment once a year or, if any triggering event is identified, conduct it on a more frequent basis.

However, it does not allow them to reverse the goodwill or permanent loss if they are identified. The main purpose of this rule is to confirm that goodwill indicates actual economic value instead of an overvalued premium on acquisition.

IFRS Impairment Guidelines

The International Accounting Standards Board addresses goodwill impairment under International Financial Reporting Standards (IFRS) in IAS 36.

• GAAP and IFRS mandate that the goodwill has to be tested at the cash-generating unit or group of CGU level.
• When the carrying amount is greater than the recoverable amount, an impairment loss is recorded, initially reducing the goodwill and then other assets included within the CGU.
• Unlike ASC 350, goodwill impairment losses cannot be reversed in subsequent periods under IFRS.

Risks and Importance of Goodwill Impairment

Goodwill Impairment Risk for Investors

Goodwill impairment leads to reduced reported earnings due to underperformance in the acquisition, which directly impacts the investors' confidence.

• Impairment risk is defined as the possible chance of exceeding the actual value of goodwill compared to its recorded value. Regular impairment tests are conducted on goodwill in order to find out whether its recorded value is greater than its recoverable amount.
• In case impairment is detected, it means the company has overpaid for the acquisition or may have experienced a fall in the value of its intangible assets.
• Investors must consider impairment costs, as they reflect warning signs or significant issues in the company's financial health or strategic decision-making. Because having a clear knowledge of the main cause of impairment costs can provide valuable insights into the company's performance and the probability of success of their acquisition strategy.

Importance of Goodwill Impairment Analysis

Goodwill impairment analysis plays a major role in financial reporting. The analysis provides an exact representation of the company's balance sheet value and a clear understanding of the outcomes of its acquisitions.

• By considering market fluctuations and underperformance, a goodwill impairment analysis ensures and provides the true value of acquired assets or companies.
• Frequent impairment assessment keeps the financial reporting transparent by avoiding inflated asset values and supplying stakeholders with reliable financial data.
• Goodwill impairment analysis reflects whether the acquisition has underperformed; this may cause the management team to reevaluate their strategy, and if multiple impairments occur, it indicates a sign of more profound issues.
• Goodwill impairment indicates significant risk or underperformance in acquisitions. This leads to lower reported earnings, resulting in a greater impact on stock prices and investors' confidence.
• Goodwill impairment lowers net income, retained earnings, and asset value despite being a non-cash expense. This leads to a high impact on financial metrics such as dividends or loan conditions.
• Goodwill impairment analysis is mandatory under accounting standards, such as IFRS and GAAP, to ensure that businesses don't overvalue goodwill and preserve their credibility with their investors and regulators.

Goodwill Impairment vs Amortization

Goodwill impairment and amortization are related to the fair value of the company's intangible assets, and they are ideally recorded on the company's balance sheet.

Goodwill refers to intangible assets such as patents, trademarks, and copyrights, or it is associated with the value of a company's name and public image. It also has an estimated lifespan and consequent depreciation, just like any other asset.

Amortization is used to demonstrate how intangible assets, such as company reputation, trademarks, and copyrights, decline in value over time. On the contrary, goodwill impairment takes place when an intangible asset is determined to be less valuable than what is recorded on the company's balance sheet after completion of amortization.

Both impairment of goodwill and amortization influence a company's net income and investor analysis, as they have a greater impact on financial valuations and investment decision-making.