During the infamous dotcom bubble in the late-1990s, many companies overpaid for their acquisitions. When the bubble collapsed, companies had to record these overpayments on their balance sheet as a loss called a goodwill impairment charge. Perhaps the most famous goodwill impairment charge was the $98.7 billion reported in 2002 for the AOL Time Warner, Inc. merger. This was, at the time, the largest loss ever reported by a company.

Goodwill is an intangible asset arising from the acquisition of one company by another. When an acquiring company purchases a company for more than its book value, the excess over book value is included as goodwill on the acquirer's balance sheet. Many investors consider goodwill to be among the most difficult assets to value. To begin with, there are many possible justifications for goodwill: intangible assets such as strong customer relations, intellectual property, or a popular brand are just some of the factors that can contribute to goodwill. As such, it is often difficult to understand what exactly is supporting any given goodwill asset. Only adding to the difficulty posed by goodwill is the fact that—whether deliberately or inadvertently—goodwill is often exaggerated. Such exaggerations can mislead investors by causing companies’ assets to appear artificially robust. In this article, we examine how to accurately quantify a company’s goodwill.

From Boom to Bust: The Story of Goodwill

One of the tell tale signs of a stock market bubble is when companies begin overpaying for acquisitions. When this happens, the difference between the price paid to acquire the target company and the fair market value of that company is stated as an asset called goodwill on the acquirer’s balance sheet. (Learn more in Breaking Down the Balance Sheet.)

Under United States generally accepted accounting principles (GAAP​), the acquiring company must periodically adjust the stated value of the goodwill asset held on its balance sheet and claim the difference as a loss. This loss adjustment is called an impairment charge and it can have a devastating effect on a company’s value. Remember the $98.7 billion AOL Time Warner impairment charge? It was followed by a devastating decline in the company’s stock valuation: a fall from $226 billion to $20 billion.

Partly as a result of such scandals, regulators now require companies to perform annual goodwill impairment tests to determine if a company’s stated goodwill exceeds its fair market value. When these tests result in goodwill being reduced, the company states the reduction on its financial statements as a “loss due to goodwill impairment.” (Learn more in Impairment Charges: The Good, The Bad And The Ugly.)

With this background in mind, we can now take a look at the basic steps involved in a goodwill impairment test.

Getting to Know The Goodwill Impairment Test

The basic procedure governing goodwill impairment tests is set out in the Accounting Standards Codification (ASC) of the Financial Accounting Standards Board (FASB) in ASC 350-20-35, “Subsequent Measurement.” You can access the codification directly online. A goodwill impairment test progresses in three broad stages: 1) a preliminary qualitative assessment, 2) stage one of a quantitative assessment, and 3) stage two of a quantitative assessment.

Step 1: Preliminary Qualitative Assessment

In the preliminary qualitative assessment, the company must determine whether the goodwill carried on its balance sheet is likely to exceed its fair market value. This determination must be based on all relevant factors like macroeconomic developments, political or regulatory changes, the emergence of new industry competitors, managerial or structural changes within the firm, and others. If the preliminary qualitative assessment shows that the goodwill carried on the company’s balance sheet is unlikely to exceed its fair market value, then no further testing is required. If the company concludes that its stated goodwill is likely to exceed its fair market value, then it must perform the first stage of a two-stage quantitative assessment.

Step 2: Stage One Qualitative Assessment

The first stage of this quantitative assessment consists of calculating the fair value of the reporting unit on which the goodwill is based, and then comparing that fair value to the amount of goodwill currently carried on the company’s balance sheet. A reporting unit is defined as an operating segment of the company that has individual business operations, generates its own financial documentation, and operates under the oversight and review of company management. In making this calculation, the company must weigh the relative impact of all factors that may have materially affected the value of the company’s goodwill asset. In essence, this stage of the quantitative assessment is a more precise version of the preliminary qualitative assessment.

If this assessment reveals that the value of goodwill stated on the company’s balance sheet does not exceed its fair value, then no further testing is required. If, on the other hand, the assessment reveals that stated goodwill does exceed its fair value, the company must proceed to stage two of the quantitative assessment.

Step 3: Stage Two Qualitative Assessment

In the second stage of the quantitative assessment, the company scrutinizes the value of the individual assets and liabilities of the reporting unit in order to determine its fair value. If, on the basis of this analysis, the company determines that the goodwill exceeds the fair value of the reporting unit in question, then the excess goodwill is defined as an impairment to goodwill. The value of this impairment is subsequently reported as a goodwill impairment charge in the company’s financial statements. (Learn more in How Does Goodwill Affect Financial Statements?)

Simplified Alternatives for Private Companies

Conducting goodwill impairment tests every year can be expensive and time consuming, particularly for smaller businesses that may have limited internal expertise and resources. In order to reduce the cost and complexity, the Financial Accounting Standards Board has recently introduced an alternative method of completing the goodwill impairment test. The catch is only private companies can use the alternative.

As set out in Accounting Standards Update 2014-02, the new method streamlines test processes. One of the most significant changes is that private businesses can perform goodwill impairment tests on as as-needed basis instead of every year. What does as-needed mean? The company need only run a goodwill impairment test if it deems that an event or change has had a material impact on the fair value of its stated goodwill. In addition, this update grants private businesses the ability to amortize their goodwill over a period of 10 years or less.

The Bottom Line

Given the difficulty of putting a dollar value on intangible assets like brands, customer relations, and proprietary technologies, it is no surprise that goodwill charges can be controversial. Indeed, as the above discussion shows, the valuation of goodwill can prove as difficult for managers as for investors. What is abundantly clear, however, is that overpaying for acquisitions can prove to be an immensely costly mistake. To mitigate the risk of being surprised by goodwill impairment charges, investors must scrutinize whether the company has a habit of overpaying for their acquisitions.

Disclosure: At the time of publication, Jason Fernando had no positions in any of the securities mentioned in this article. He does not intend to trade any of the securities mentioned in this article within 48 hours of publication.

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