Title: Goodwill Impairment — What It Is, How It’s Tested, and Practical Steps for Companies and Investors
Key Takeaways
– Goodwill impairment occurs when the carrying (book) value of goodwill exceeds its fair value; the excess is recorded as an impairment loss on the income statement.
– Goodwill arises when an acquirer pays more than the identifiable net assets of an acquired business.
– Under U.S. GAAP, public companies must test goodwill for impairment at least annually (by reporting unit) and whenever triggering events indicate potential impairment. The current testing model was simplified by FASB’s ASU 2017-04.
– Impairment losses reduce goodwill on the balance sheet and hit earnings; under GAAP goodwill impairment losses cannot be reversed.
– Companies must disclose the amount of any impairment loss, the events/changes that led to it, and how fair value was determined.
What Is Goodwill?
Goodwill is an intangible asset recorded in a business combination when the purchase price exceeds the fair value of identifiable acquired assets minus liabilities. Examples of the sources of goodwill include brand reputation, customer relationships, assembled workforce, proprietary processes, and synergies expected from the acquisition.
What Is Goodwill Impairment?
Goodwill impairment is the recognition of a loss when the fair value of the reporting unit that includes goodwill is less than that reporting unit’s carrying amount (which includes allocated goodwill). The impairment reflects that expected future economic benefits from the acquired business have fallen below prior expectations.
Why Impairment Happens (Common Triggers)
– Deterioration in macroeconomic or industry conditions
– Increased competition or loss of market share
– Unexpected decline in cash flows or profitability of the reporting unit
– Loss of key customers, contracts, or personnel
– Adverse legal or regulatory actions
– Changes in management strategy or business forecasts
Changes in Accounting Standards for Goodwill
– Historically, goodwill was tested under a two-step impairment model; that approach could be complex and resource-intensive.
– FASB’s Accounting Standards Update No. 2017-04 (Intangibles—Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment) simplified the process:
– Eliminated the second step of the two-step test under U.S. GAAP.
– Adopted a one-step approach: compare the fair value of a reporting unit to its carrying amount; impairment loss (if any) is the excess of carrying amount over fair value, limited to the carrying amount of goodwill.
– Companies may still perform an optional qualitative assessment first (commonly called “Step 0”) to determine whether a quantitative test is necessary.
– Under current U.S. GAAP, goodwill is not amortized (post-early-2000s standards).
How Often Must Companies Test for Goodwill Impairment in the United States?
– At least annually for each reporting unit containing goodwill (public companies).
– Additionally, companies must test whenever events or changes in circumstances indicate that the carrying amount may not be recoverable.
– The company’s fiscal year timing of the annual test is up to management (e.g., as of a set reporting date each year), but it must be performed at least once per year.
Annual Test for Goodwill Impairment — Overview
1. Identify reporting units: the level at which management evaluates segment performance (often a business line, geographical segment, or subsidiary).
2. Optional qualitative assessment: consider macro, industry, and company-specific factors. If the qualitative assessment indicates it is more likely than not (probability >50%) that fair value is less than carrying amount, proceed to quantitative testing.
3. Quantitative test (one-step under ASU 2017-04): estimate the fair value of the reporting unit and compare it to its carrying amount (including goodwill). If fair value < carrying amount, impairment loss = carrying amount − fair value, limited to the goodwill balance.
4. Record impairment: reduce goodwill and record impairment loss in the income statement.
Practical Steps for Companies — A Checklist to Perform a Goodwill Impairment Test
Preliminary
– Confirm reporting units and ensure goodwill is allocated appropriately to each reporting unit.
– Gather latest budgets, forecasts, and operational metrics for each reporting unit.
Step A — Consider Qualitative Factors (optional Step 0)
– Assess macroeconomic conditions (GDP, industry outlook).
– Assess industry-specific factors (pricing, competition, regulation).
– Review internal factors: decreased cash flows, customer loss, margin compression, personnel turnover, adverse litigation.
– If qualitative assessment suggests fair value likely exceeds carrying value, document rationale and no quantitative test needed. Otherwise proceed to Step B.
Step B — Quantitative Fair Value Measurement
– Choose valuation approach(es): income approach (discounted cash flow, often primary), market approach (comparables, multiples), and/or cost approach (less common).
– Estimate future cash flows for the reporting unit consistent with internal forecasts, adjusted for market participant assumptions.
– Select an appropriate discount rate (reflecting risk and market participant assumptions).
– If using market multiples, select appropriate comparables and adjust for differences.
– Calculate the reporting unit’s fair value (often a range; use midpoint/conservative estimate per policy).
Step C — Compare and Measure Impairment
– Compare fair value of the reporting unit to its carrying amount (assets, liabilities, allocated goodwill).
– If fair value ≥ carrying amount: no impairment.
– If fair value < carrying amount: impairment loss = carrying amount − fair value (max limited to goodwill balance in the reporting unit).
– Document assumptions, sensitivity analyses, and governance approvals.
Step D — Record and Disclose
– Journal entry example (illustrative): Dr Impairment Loss (Income Statement) xxxx; Cr Goodwill (Balance Sheet) xxxx.
– Disclose in notes: amount of impairment loss, events causing it, method(s) used to determine fair value, key assumptions and sensitivity (growth rates, discount rate), and reporting unit impacted.
Example of Goodwill Impairment (Illustrative Numeric Example)
– Company A acquires Company B for $500 million.
– Fair value of identifiable net assets at acquisition = $400 million.
– Goodwill recorded = $100 million (500 − 400).
– After several years, reporting unit carrying amount (net assets + goodwill) = $450 million (includes goodwill carrying amount of $100 million).
– A downturn reduces expected cash flows such that estimated fair value of reporting unit = $380 million.
– Impairment loss = carrying amount − fair value = 450 − 380 = $70 million.
– Impairment is limited to the goodwill balance; after recording, goodwill is reduced by $70 million to $30 million.
– Journal entry: Dr Goodwill Impairment Loss (IS) $70M; Cr Goodwill (BS) $70M.
How Do Companies Report Goodwill Impairment?
– Income Statement: The impairment loss is presented as an operating loss or as a separate line-item impairment loss, depending on company presentation.
– Balance Sheet: Goodwill is reduced by the impairment amount.
– Notes to Financial Statements: Required disclosures include amount of goodwill by reporting unit, amount of impairment loss, circumstances causing it, valuation methods and inputs, and sensitivity analysis of significant assumptions.
Special Considerations and Practical Issues
– Reporting Unit Definition: Correct identification of reporting units is critical—misallocation can understate/overstate impairment.
– Management Judgement: Fair value estimates involve significant judgement (forecasts, discount rates, multiple selections). Management bias can affect outcomes—robust governance and documentation are essential.
– No Reversals: Under U.S. GAAP, companies may not subsequently reverse a goodwill impairment loss if fair value recovers.
– Interaction with Taxes: Accounting treatment differs from tax treatment; tax consequences are jurisdiction-specific—consult tax counsel.
– Disclosure Expectations: Investors and regulators scrutinize goodwill and impairment testing, especially after large charges (e.g., AOL Time Warner’s $54.2B impairment in 2002).
Practical Steps for Investors and Analysts
– Check the magnitude: compare goodwill to total assets and equity—large goodwill relative to equity can signal vulnerability.
– Monitor impairment frequency: repeated impairment charges may indicate overpayment in acquisitions or structural business declines.
– Read disclosures: review management’s assumptions (growth rates, discount rates), sensitivity analysis, and narrative explaining triggers.
– Watch cash flows and margins: weakening cash generation in reporting units increases impairment risk.
The Bottom Line
Goodwill impairment is an important non-cash accounting charge reflecting that the economic benefits expected from an acquisition have declined. Current U.S. GAAP requires at least annual testing at the reporting-unit level and permits an optional qualitative screening. Companies should have a structured, well-documented process for testing and disclosing impairment; investors should monitor goodwill levels, management disclosures, and the assumptions underlying valuation analyses.
Sources and Further Reading
– Investopedia: What Is Goodwill Impairment? (source material provided) — https://www.investopedia.com/terms/g/goodwill-impairment.asp
– FASB Accounting Standards Update No. 2017-04, Intangibles—Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment
– Financial Accounting Standards Board, “Accounting for Goodwill Impairment” (historical guidance summary)
– SEC Form 10-K for the Fiscal Year Ended December 31, 2002: AOL Time Warner Inc. (example of a large goodwill impairment)
– KPMG discussion on goodwill amortization and impairment (historical context)
– Time, “What AOL Time Warner’s $54 Billion Loss Means” (contextual example)
Note: This article summarizes practical accounting concepts; companies should consult their auditors and accounting advisors for guidance tailored to their facts and circumstances and consult tax advisors for tax implications.