What is a Goodwill Impairment?

Readers familiar with accounting likely agree that goodwill impairment can be a complex topic.

This article clearly explains what goodwill impairment is, when it happens, how to calculate the loss, and the impact on financial statements.

You'll learn key aspects like the impairment test process, recording the journal entry, disclosure rules, effects on the income statement and balance sheet, and real world examples.

Introduction to Goodwill Impairment in Accounting

Goodwill is an intangible asset that represents the excess value of a business over the fair market value of its identifiable net assets. It arises when one company acquires another company.

Understanding Goodwill as an Intangible Asset

Goodwill is considered an intangible asset because it is not a physical asset and does not have a definite useful life. It represents things like brand recognition, customer loyalty, talent of the workforce, and patents or proprietary technology. When one company acquires another, they typically pay more than the target's book value to gain these valuable intangibles. The premium paid over book value gets recorded as goodwill.

For example, if Company A buys Company B for $1 million, but Company B's assets minus liabilities is only worth $800,000 on paper, the extra $200,000 gets recorded as goodwill. This goodwill sits on Company A's balance sheet as an intangible asset.

The Concept of Impairment in Financial Reporting

Impairment refers to a permanent reduction in the value of an asset on a company's balance sheet. When goodwill becomes impaired, it means the value originally recorded has declined. This often happens when the expected cash flows or earnings power of the acquisition decreases.

Under accounting rules, companies must assess goodwill for impairment annually or whenever events trigger that the recorded goodwill may be overvalued. If an impairment test determines that goodwill has declined in value, the company must take an impairment charge or write-down on their income statement as a non-cash expense.

Circumstances Leading to Goodwill Impairment

There are various situations that can trigger impairments of goodwill, including:

A significant, adverse change in the business climate
Failure to achieve expected synergies from an acquisition
Changes in regulations that impact earnings potential
Overestimation of growth opportunities during initial purchase
A substantial decrease in expected cash flows or income

Taking timely goodwill impairment charges is important for providing investors with an accurate picture of a company's true asset values and profitability.

What is an example of a goodwill impairment?

Here is an example of how a goodwill impairment can occur:

Company BB acquires Company CC

Company BB acquires Company CC for $10 million. Of that $10 million purchase price, $3 million is allocated to tangible assets like equipment and inventory, $2 million is allocated to identifiable intangible assets like patents and trademarks, and the remaining $5 million is recorded as goodwill.

Impairment test a year later

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 $10 million to $7 million, resulting in an impairment of $3 million.

Goodwill impairment calculation

Of that $3 million impairment, $2 million is allocated to the tangible and identifiable intangible assets pro rata based on their carrying values. The remaining $1 million impairment must be recorded as a goodwill impairment expense. This $1 million goodwill impairment reduces the goodwill on Company BB's balance sheet from $5 million to $4 million.

In summary, due to the decline in Company CC's financial performance, Company BB has to record a $1 million non-cash goodwill impairment charge. This reflects the decrease in the value of the goodwill asset on Company BB’s balance sheet.

Is impairment of goodwill good or bad?

A goodwill impairment indicates that a company overpaid for an acquisition in the past, and that the acquired assets are now worth less than the purchase price. This generally signals issues in the business combination and that expected synergies did not materialize as planned.

Some key points on goodwill impairments:

Impairments reduce net income and equity on the balance sheet, negatively impacting financial ratios. This can alarm investors and put downward pressure on stock prices.
Frequent and large impairments indicate poor capital allocation decisions and M&A execution. This erodes confidence in management's ability to value deals and integrate acquisitions.
Impairments directly hit the income statement as a non-cash operating expense. While cash flow is unaffected, profitability measures take a hit in the period of impairment.
Impairments have no direct tax implications. However, since impairments reduce net income, they lower taxable income and cash taxes paid.
After an impairment, future amortization expenses are lower. But this is small consolation for the immediate earnings hit.

In summary, goodwill impairments are almost always an unfavorable development for a company. They destroy equity value and signal issues in judgment, deal analysis, and post-merger integration that management needs to address. While non-cash in nature, impairments directly reduce net income and highlight the previous bad decision to overpay for an acquisition.

What is the rule for impairment of goodwill?

The key accounting rule for impairment of goodwill is that goodwill must be tested for impairment at least annually. Specifically, companies are required to compare the fair value of a reporting unit that contains goodwill to its carrying value on the balance sheet.

If the carrying value exceeds the fair value, an impairment charge must be recognized to write down the goodwill to its implied fair value. This impairment charge is recorded as an operating expense on the income statement.

Some key points on goodwill impairment rules:

Goodwill impairment testing must be performed annually, as well as whenever events or changes in circumstances indicate the carrying value may exceed fair value. This is known as a "triggering event."
The test involves comparing the fair value of a reporting unit to its carrying value. Reporting units are components of a business one level below the business segments used for segment reporting.
If the carrying value exceeds fair value, the company must calculate the implied fair value of goodwill and recognize an impairment charge for the difference between the carrying amount and implied fair value.
Goodwill impairment charges are non-cash expenses that reduce net income. However, they do not impact cash flows or change tangible assets.
Once an impairment is recognized, the reduced carrying value of goodwill becomes the new accounting basis. Subsequent reversals of goodwill impairment charges are not permitted under GAAP.

In summary, the central requirement is an annual goodwill impairment test to detect and measure any excess of carrying value over fair value in a timely manner. Impairment charges are then recorded to reduce goodwill to its revised implied fair value.

How do you calculate goodwill impairment loss?

Goodwill impairment loss is calculated by comparing the fair value of a reporting unit to its carrying value. Here are the key steps:

Determine the fair value of the reporting unit. This can be done using valuation methods like discounted cash flow analysis or market-based approaches.
Compare the fair value to the carrying value (book value) of the reporting unit. The carrying value includes assets like goodwill.
If the carrying value exceeds the fair value, there is a potential goodwill impairment. The impairment loss is calculated as the difference between the carrying value and the fair value.
Record the goodwill impairment loss as an operating expense on the income statement. This reduces net income for the period.
Reduce the goodwill asset account on the balance sheet by the impairment loss amount. This decreases total assets.

For example, if a reporting unit has $100 million in total assets including $20 million in goodwill, and its fair value is determined to be $80 million, there would be a $20 million goodwill impairment loss. The entry would be:

Goodwill impairment loss = $20 million  
Goodwill = $20 million

The $20 million loss would hit the income statement as a non-cash charge. And goodwill on the balance sheet would decline from $20 million to $0.

In summary, goodwill impairment changes reflect that past acquisition value has decreased relative to current fair market value. The accounting adjustment is critical for accurate financial reporting.

The Goodwill Impairment Test Process

Goodwill impairment testing is an important process in accounting to ensure that the value of goodwill is accurately stated on the balance sheet. Here is an overview of the key steps involved:

Step 1: Assessment of Fair Value Versus Carrying Value

The first step is to determine the fair value of the reporting unit and compare it to the carrying value on the balance sheet. The carrying value includes goodwill. If the fair value exceeds the carrying value, no impairment exists. However, if the carrying value exceeds the fair value, there may be impairment.

Step 2: Calculating and Recording Goodwill Impairment Loss

If impairment exists, the next step is to calculate the impairment loss. This involves allocating the fair value of the reporting unit to all assets and liabilities, as if the unit was acquired in a business combination. If the implied fair value of goodwill is lower than the carrying value, an impairment loss must be recognized. A corresponding entry reduces goodwill on the balance sheet and records the loss as an operating expense.

Assumptions and Estimates in the Impairment Test

The impairment test relies heavily on management's assumptions and estimates regarding future cash flows, growth rates and discount rates - all of which impact fair value. These estimates involve a high degree of judgment and uncertainty. Small changes can significantly impact results.

Periodic Review and Impairment Testing

Testing must be performed at least annually. Additionally, goodwill must be tested between annual tests if events or changes in circumstances indicate that impairment may exist. These triggering events could include economic downturns, increased competition, or loss of key personnel.

In summary, the goodwill impairment test is a two-step process involving fair value analysis and recognizing any resulting impairment charges. Judgment is required, so assumptions must be reasonable and supportable.

Recording Goodwill Impairment in Financial Statements

The Goodwill Impairment Journal Entry Explained

When a company determines that the goodwill on its balance sheet has become impaired, meaning its fair value has declined below its carrying value, an accounting journal entry must be recorded to reflect this impairment loss.

The journal entry will debit Impairment Loss Expense and credit Goodwill. For example:

Impairment Loss Expense     100,000  
     Goodwill                       100,000

By crediting the Goodwill account, the carrying value on the balance sheet is reduced down to the new fair value. The offsetting debit hits the income statement as a non-cash impairment loss expense, reducing net income for the period.

Disclosure Requirements for Impaired Goodwill

Under accounting standards, companies are required to disclose significant details regarding any goodwill impairment in the footnotes of their financial statements. Specifically, information must be provided on:

The nature and amount of impairment losses recognized during the period
The reporting unit(s) affected
The method of determining fair value
The reason(s) why the fair value declined below carrying value

These disclosures provide transparency into the impairment and its business impact.

Impact of Goodwill Impairment on Operating Expense

Since goodwill impairment hits the income statement as a non-cash operating expense, it reduces a company's profitability metrics for the period such as operating income, EBITDA, net income, and EPS.

However, some analysts and investors may add back the impairment loss expense when evaluating underlying company performance, since it does not directly reduce cash flows.

Regardless, the write-down of goodwill can signal challenges with acquisitions or company value that merit close attention.

Tax Treatment of Goodwill Impairment

For tax purposes, goodwill impairment losses were deductible up until the TCJA tax reform law took effect in 2018. However, now impairment write-downs are no longer deductible for federal income tax purposes.

At the state level, the rules vary in terms of the deductibility of goodwill impairment. Companies should consult their tax advisor to determine the tax implications based on their state and situation.

Goodwill Impairment and Its Financial Statement Impact

Goodwill impairment occurs when the carrying value of goodwill on a company's balance sheet exceeds its fair value. This results in a write-down of goodwill to its new fair value, recorded as an impairment loss on the income statement. Here is a closer look at how goodwill impairment impacts key financial statements:

Effects on the Income Statement

Goodwill impairment is recorded as a operating expense, decreasing net income for the period
The impairment loss is typically very large, often in the hundreds of millions of dollars
Reduced net income decreases earnings per share (EPS)

For example, if a company has net income of $100 million and an impairment loss of $50 million, net income becomes $50 million. With 50 million shares outstanding, EPS declines from $2 per share to $1 per share.

Consequences for the Balance Sheet and Carrying Value

Goodwill is reduced on the asset side of the balance sheet by the impairment amount
There is no cash impact, but the asset write-down decreases total assets
Shareholders' equity is reduced by the loss amount, as retained earnings decline

If goodwill declines by $50 million due to impairment, assets decrease by $50 million and shareholders' equity falls by $50 million. The company's net worth takes a hit from the write-down.

The Non-Cash Nature of Goodwill Impairment on Cash Flows

Goodwill impairment does not affect cash flows or liquidity directly
It is a non-cash accounting adjustment recorded through accrual accounting
Cash flow statement remains unchanged, though investors may see higher risk

Since goodwill impairment does not involve cash spending, net cash from operations is unaffected. But it signals potential issues, making investors wary.

Goodwill to Assets Ratio Post-Impairment

Goodwill divided by total assets indicates what % of assets is intangible
An impairment loss decreases both goodwill and total assets
But the ratio increases, indicating company reliance on unproven assets

For example, a company has $100 million of goodwill and $500 million of assets, giving a 20% goodwill to assets ratio before impairment. After a $30 million write-down of goodwill, goodwill declines to $70 million while total assets fall to $470 million. The ratio rises to 15% - flagging higher risk.

In summary, goodwill impairment negatively impacts the income statement and balance sheet. It signals potential trouble for future earnings and profitability, raising uncertainty and risk for investors. The reduction in goodwill and hit to equity can significantly weaken a company's financial position.

Alternatives to Recording Goodwill Impairment

There is an ongoing debate around whether the current impairment-only model for goodwill is the best approach. Some argue that systematically expensing goodwill through amortization should be reintroduced.

The Case for and Against Goodwill Amortization

Arguments For:
- Amortization would provide a more consistent approach to allocating goodwill costs over time
- Reduces reliance on management estimates and assumptions in impairment testing
Arguments Against:
- Arbitrary amortization period that may not reflect actual useful life
- Still requires impairments in addition to amortization
- Increases operating expenses on income statement

Amortization of Intangible Assets: A Comparative Analysis

Unlike goodwill, most other intangible assets are amortized over their useful lives:

Patents - Amortized over legal life
Brands - Typically 3-15 years
Customer relationships - Up to 10 years

This contrasts with goodwill, which is not amortized at all. Reintroducing amortization for goodwill would align its accounting treatment more closely with other intangibles. However, determining an appropriate useful life for goodwill can be challenging.

International Variations in Goodwill Accounting

Accounting for goodwill differs across global standards:

IFRS - Allows amortization again, though still sparingly used
US GAAP - Strictly prohibits amortization

Allowing amortization provides more flexibility for companies to better match goodwill expenses to the periods they are consumed.

Should Goodwill Amortisation Be Reintroduced?

There are good arguments on both sides. Amortization would likely reduce reliance on difficult-to-estimate impairments and smooth out effects on the income statement. However, challenges remain around determining an appropriate amortization period for the inherently subjective nature of goodwill value. Most experts believe impairment will still be required even if amortization is reintroduced. There are no easy answers, and the debate is likely to continue evolving.

Consolidation and Goodwill Impairment Considerations

Impairment of Goodwill on Consolidation

When a parent company acquires a subsidiary, the amount paid above the net fair value of the subsidiary's identifiable assets and liabilities is recorded as goodwill. This goodwill is then allocated to the subsidiary and tested for impairment at that level on an annual basis or more frequently if impairment indicators arise.

At the consolidated level, goodwill impairment recognized by an individual subsidiary is also reflected in the consolidated financial statements. However, additional goodwill impairment may need to be recognized at the consolidated level to account for synergies that may have justified a larger premium when the parent acquired the subsidiary but are no longer realized.

Testing goodwill for impairment in consolidated statements can be complex due to the allocation across multiple reporting units and judgments on synergies. Companies need robust processes and controls around their goodwill impairment testing approaches.

Intercompany Transactions and Goodwill Impairment

Intercompany transactions between a parent and subsidiary can impact goodwill impairment testing. For example, if a subsidiary begins selling products to affiliates at reduced margins, its discounted cash flows may be lower, triggering goodwill impairment. However, from the parent's perspective, consolidated cash flows have not changed.

Companies should carefully assess changes in intercompany transactions as part of their goodwill impairment review process. Adjustments may need to be made to subsidiary cash flows to normalize margins to third-party levels before using them in impairment testing models.

Summary of Statement No. 141 and Goodwill Impairment

FASB's Statement No. 141 provides guidance on accounting for goodwill in business combinations. Key provisions related to impairment include:

Goodwill should be tested for impairment at the reporting unit level annually or more frequently if indicators arise.
Impairment is recognized when the carrying value exceeds the fair value of a reporting unit.
Impairment losses should not exceed the total goodwill allocated to a reporting unit.
After an impairment loss, adjusted carrying value becomes the new accounting basis of the goodwill.
Impairment losses should be reported as operating expenses on income statements.

Understanding Statement No. 141 provides important context around accounting for goodwill impairment in consolidated statements.

Goodwill Impairment Examples and Case Studies

Goodwill impairment can have significant impacts on a company's financial statements. Analyzing real-world examples provides helpful context for understanding goodwill accounting treatments.

Real-World Goodwill Impairment Scenarios

Several high-profile companies have recorded substantial goodwill write-downs in recent years:

Kraft Heinz took a $15.4 billion goodwill impairment charge in 2019 due to falling sales and profits. This followed the company's overly optimistic valuation of acquired brands.
GE wrote down over $40 billion of goodwill from 2018-2020 resulting from overly high purchase prices and declining performance of several business units.
HP Inc. wrote off $885 million of goodwill in 2020 on its acquisition of Autonomy due to accounting irregularities and market changes.

In many cases, goodwill impairments relate to shifts in business conditions, unrealistic growth assumptions, or paying too high a premium for acquisitions.

Hypothetical Goodwill Impairment Calculations

Consider a hypothetical scenario where Company A acquires Company B for $50 million. Company B has identifiable net assets worth $20 million, so Company A records $30 million in goodwill.

Five years later, Company B's fair value falls to $30 million. Company A would calculate and record the goodwill impairment as follows:

Original goodwill: $50 million acquisition price - $20 million identifiable net assets = $30 million goodwill
Carrying value (net book value) of Company B: $20 million identifiable net assets + $30 million goodwill = $50 million
Fair value of Company B: $30 million
Impairment loss = Carrying value - Fair value = $50 million - $30 million = $20 million
Remaining goodwill on books after impairment = Original goodwill - Impairment loss = $30 million - $20 million = $10 million

By recording this $20 million goodwill impairment charge, Company A reduces goodwill to $10 million to reflect Company B's decreased valuation.

Lessons Learned from Goodwill Impairment Cases

Key takeaways from historical goodwill impairment cases include:

Conservative growth estimates and acquisition prices help avoid future write-downs
Monitoring shifts in business conditions allows early detection of potential impairments
Impairment charges directly reduce net income but not cash flows
Detailed impairment testing procedures are essential for accurate financial reporting

Applying insights from previous goodwill impairments can strengthen valuation processes and minimize financial statement volatility.

Summary of Essential Points on Goodwill Impairment

Recap of Goodwill Impairment Triggers and Tests

Goodwill impairment can be triggered by events or changes that negatively impact the fair value or future cash flows of a business unit. Some common triggers include:

A significant, prolonged decline in the unit's financial performance or expected future cash flows
An adverse change in the business climate
Increased competition or loss of key personnel
A substantial decline in the company's share price

Once impairment indicators are identified, companies must test goodwill for impairment. There are two steps in the impairment test:

Compare the fair value of the reporting unit to its carrying value. If the fair value is less than carrying value, goodwill may be impaired.
Calculate the implied fair value of goodwill by deducting the fair values of all assets and liabilities from the fair value of the reporting unit. Compare this to the carrying value of goodwill to determine the impairment amount.

Key Takeaways on Accounting for Goodwill Impairment

Goodwill impairment is recognized as a non-cash expense on the income statement
The carrying value of goodwill on the balance sheet is written down by the impairment amount
Recognizing impairment does not directly impact cash flows, but may signal future declines
Impairment testing and measurement relies heavily on management estimates and assumptions
Accounting standards aim to capture economic impairment of goodwill as early as possible

Adhering to GAAP impairment guidelines improves transparency but may increase income statement volatility.

Financial Statement Implications Revisited

Goodwill impairment negatively impacts net income in the period of impairment. However, as a non-cash expense it does not directly reduce cash flows. The balance sheet is impacted through the write down of goodwill carrying value.

Lenders and investors may view impairment as indicative of management's inability to realize the expected value from acquisitions. Thus, transparency around impairment measurement assumptions and business performance drivers is important.

Future Outlook on Goodwill Impairment Practices

Simplifying the complex two-step impairment testing methodology could improve consistency and comparability across firms. However, the subjectivity of assumptions in estimating reporting unit fair value raises questions about reliability.

Debates continue around reinstating goodwill amortization to gradually charge impairment to income over time. But amortization lacks a strong conceptual basis and does not capture the economic reality of goodwill impairment.

Overall standards are likely to remain focused on representing impairment losses in a timely manner. However, transparency and judgment in the measurement process must also improve.