Goodwill Impairment

Goodwill Impairment is a deduction from the earnings that companies record on their income statement after identifying that the acquired asset associated with the goodwill has not performed financially as expected at its acquisition. The goodwill impairment testing is an annual exercise that companies need to perform to eliminate worthless goodwill.

US GAAP requires a goodwill Impairment Test wherein the balance sheet goodwill should be valued at least once annually to check if the balance sheet value is greater than the market value and if there is any resulting impairment. It should be written off as impairment charges in the Income Statement.

Goodwill impairment occurs when the recorded value of goodwill on a company's balance sheet exceeds its fair market value. Goodwill represents the intangible value associated with a business, including its brand reputation, customer relationships, and intellectual property.

The goodwill impairment made headlines in 2002 as companies disclosed massive goodwill write-offs by adopting new accounting rules (AOL reported $54 billion and McDonald's reported $99 million) to sort the misallocation of assets made during the dot com bubble between 1995 and 2000. Most recently (2019),  Kraft recorded impairment charges of $15.4 billion for carrying amount of goodwill.

The process of goodwill impairment begins with companies conducting an annual or more frequent impairment test. This test compares the carrying value of goodwill to its fair value, which is determined by estimating the present value of future cash flows generated by the acquired assets. If the carrying value exceeds the fair value, the goodwill is considered impaired.

Goodwill impairment expense accounting is essential for maintaining accurate financial reporting, reflecting the economic realities of a company's intangible assets. The process ensures that financial statements provide a true and fair view of a company's overall value, aiding stakeholders in making informed decisions about its financial health and prospects.

Let us understand the formula that shall act as the basis of our understanding of the concept of goodwill impairment testing:

Identifying the causes of goodwill impairment is crucial for companies to account for timely goodwill impairment expenses and adjust the recorded goodwill value, maintaining transparency and accuracy in financial reporting. Let us understand potential causes through the explanation below.

• A general economic decline can reduce the value of acquired assets and negatively impact a business's cash flow, leading to potential goodwill impairment.
• Changes in industry conditions, such as increased competition or shifts in market dynamics, can affect the expected future cash flows associated with goodwill.
• A significant drop in the company's stock price may indicate investor concerns or a loss of confidence, prompting a reassessment of goodwill value.
• If assets acquired through a business combination fail to perform as anticipated, the associated goodwill may be overstated, leading to impairment.
• Shifts in regulations affecting the business or industry can impact the estimated future cash flows, affecting the value of goodwill.
• A deterioration in customer relationships or a loss of key customers may reduce the anticipated cash flows from acquired intangible assets, triggering impairment.
• Rapid technological advancements may render acquired technology or intellectual property obsolete, affecting the value of associated goodwill.
• Legal challenges, such as lawsuits or regulatory fines, can adversely affect a company's financial performance and contribute to goodwill impairment.

Goodwill can be affected by the deterioration of the economic condition, change in government policies or regulatory norms, competition in the market, etc. These events directly impact the business and hence can affect goodwill. The goodwill impairment test is needed when any such events affect the goodwill.

The two common methods  are as below:

• #1 - Income Approach – Estimated future cash flows are discounted to a single current value.
• #2 - Market Approach – Examining the assets and liabilities of companies who are a part of the same industry.

Goodwill impairment testing is a multi-step process; it requires an assessment of the current situation, identification of the impairment, and calculation of the impairment. It is further explained below:

1. Assessment of the Current Situation

The current condition of the acquired business needs to be assessed to understand whether impairment testing is needed. As mentioned above, events like a change in government policies, change in management, or fall in the share price, possible The current condition of the acquired business needs to be assessed to understand whether impairment testing is needed. As mentioned above, events like a change in government policies, change in management or fall in the share price, or possible bankruptcy would trigger deterioration of the financial condition. A company must assess the fair value of the company or the reporting unit in the first half of a fiscal year as to whether or not an adjustment for impairment needs to be recorded.

2. Identification of the Impairment

The current fair market value of the reporting unit should be compared to the carrying amount. If the carrying value is greater than the current fair market value of the reporting unit, then the impairment needs to be calculated. The reporting unit's carrying amount should include goodwill and any unrecognized intangible assets. There is no goodwill impairment if the current fair market value of the reporting unit is greater than the carrying amount, and there is no need to conduct the next step.

3. Calculation of the Impairment

By comparing the current fair market value of the reporting unit to the carrying amount, if the carrying amount is greater, this would be the impairment that needs to be calculated. The maximum impairment value will be the carrying amount, as it cannot exceed this value.

Now that we have a considerable understanding of the concept and its intricacies, let us also understand the practicality of the goodwill impairment expenses through the examples.

Example #1

A simple example would be buying a vintage bike. You buy it by reading all the reviews on the internet regarding the brand and the model, and you are convinced to buy it at a higher rate than its actual value owing to its popularity among the masses. After a year or so, you realize the cost involved in maintaining the bike is far more than what you spend on the fuel. That’s when you realize that the bike is not performing as per the expectation set at the time of purchase.

Similarly, companies are required to conduct an impairment test annually with respect to the goodwill of an acquired company.

Example #2

XYZ Inc. acquired the assets of ABC Inc. for $15 million; its assets were valued at $10 million, and goodwill of $5 million was recorded on its balance sheet. A year later, XYZ Inc. assesses and tests its assets for impairment and concludes that ABC Inc.’s revenue has been declining remarkably. Due to this, the current value of company ABC Inc.’s assets has gone down from $10 million to $7 million, thereby resulting in an impairment to the assets of $3 million. Eventually, the value of the asset of goodwill drops down from $5 million to $2 million.

Let’s see how impairment impact is recorded on the income statement, balance sheet, and cash flow statement.

Balance Sheet

Goodwill reduces from $5 million to $2 million.

Income Statement

An impairment charge of $3 million is recorded, which reflects a reduction in the net earnings by $3 million.

Cash Flow Statement

In a cash flow statement, expenses that reduce taxable income are included. An impairment charge is a non-cash expense that is non-tax deductible, and so they do not affect the cash flow statement.

Understanding the tax treatment for goodwill impairment testing is crucial for financial planning, as it impacts a company's taxable income and potential tax savings. It requires careful consideration of jurisdiction-specific rules and regulations to optimize the utilization of tax benefits associated with impairment losses. Let us understand how through the explanation below.

• In many jurisdictions, goodwill impairment is tax-deductible, allowing companies to offset the impairment loss against their taxable income.
• When goodwill impairment is recognized for financial reporting purposes but not yet deductible for tax purposes, a deferred tax asset is created. This asset represents potential future tax savings.
• The deferred tax asset is amortized over time, reflecting the gradual utilization of the tax benefit. This amortization is recorded as a tax expense on the income statement.
• Tax authorities may impose limitations on the deductibility of goodwill impairment, such as specific caps or carryforward restrictions, impacting the timing and extent of tax benefits.
• Tax treatment of goodwill impairment can vary internationally, subject to local tax regulations and accounting standards. Companies operating in multiple jurisdictions must navigate these complexities.

This article has been a guide to what is Goodwill Impairment. Here, we explain its formula, examples, causes, methods, and tax treatment. You can learn more about financing from the following articles –

• Intangible Assets Examples
• Calculate Goodwill
• Value Goodwill
• Negative Goodwill Definition