Goodwill is acquired and recorded on the books when an entity purchases another entity for more than the fair market value of its assets. Per accounting standards, goodwill is recorded as an intangible asset and evaluated periodically for any possible impairment in value.
Private companies in the US may elect to expense a portion of the goodwill periodically on a straight-line basis over a ten-year period or less, reducing the asset’s recorded value. This charge is called an amortization expense.
Companies should assess whether or not an adjustment for impairment to goodwill is needed each fiscal year. This impairment test may have a substantial financial impact on the income statement, as it will be charged directly as an expense on the income statement. In some cases, goodwill may be completely written off and removed from the balance sheet.
In accordance with both GAAP in the United States and IFRS in the European Union and elsewhere, goodwill is not amortized. In order to accurately report its value from year to year, companies perform an impairment test. Impairment losses are, functionally, like amortization.
How to Test if Impairment of Goodwill is Required
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. Some triggering events that may result in impairment are adverse changes in the economy’s general condition, increased competitive environment, legal implications, changes in key personnel, declining cash flows, and a 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 their present value
Market approach – Examining and comparing the assets and liabilities of companies in the same industry
What Amount should be Recorded as an Impairment Loss?
Business assets should be properly measured at their fair market value before testing for impairment. If goodwill has been assessed and identified as being impaired, the full impairment amount must be immediately written off as a loss. An impairment is recognized as a loss on the income statement and as a reduction in the goodwill account.
The amount that should be recorded as a loss is the difference between the asset’s current fair market value and its carrying value or amount (i.e., the amount equal to the asset’s recorded cost). The maximum impairment loss cannot exceed the carrying amount – in other words, the asset’s value cannot be reduced below zero or recorded as a negative number.
Company BB acquires the assets of company CC for $15M, valuing its assets at $10M and recognizing goodwill of $5M on its balance sheet. After a year, company BB tests its assets for impairment and finds out that company CC’s revenue has been declining significantly. As a result, the current value of company CC’s assets has decreased from $10M to $7M, having an impairment to the assets of $3M. This makes the value of the asset of goodwill drop down from $5M to $2M.
#1 Impact on Balance Sheet
Goodwill reduces from $5M to $2M.
#2 Impact on Income Statement
An impairment charge of $3M is recorded, reducing net earnings by $3M.
#3 Impact on 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 were a tax impact, but that would generally not be the case, as impairments are generally not tax-deductible.
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