What Is a Goodwill Impairment?
Goodwill impairment is an accounting charge that companies record when goodwill's carrying value on financial statements exceeds its fair value. In accounting, goodwill is recorded after a company acquires assets and liabilities, and pays a price in excess of their identifiable value.
Goodwill impairment arises when there is deterioration in the capabilities of acquired assets to generate cash flows, and the fair value of the goodwill dips below its book value. 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.
How Goodwill Impairment Works
Goodwill impairment is an earnings charge that companies record on their income statements after they identify that there is persuasive evidence that the asset associated with the goodwill can no longer demonstrate financial results that were expected from it at the time of its purchase.
Goodwill is an intangible asset associated with the purchase of one company by another. Specifically, goodwill is recorded in a situation in which the purchase price is higher than the sum of the fair value of all identifiable tangible and intangible assets purchased in the acquisition and the liabilities assumed in the process. The value of a company’s brand name, solid customer base, good customer relations, good employee relations, and any patents or proprietary technology represent some examples of goodwill.
Because many companies acquire other firms and pay a price that exceeds the fair value of identifiable assets and liabilities that the acquired firm possesses, the difference between the purchase price and the fair value of acquired assets is recorded as goodwill. However, if unforeseen circumstances arise that decrease expected cash flows from acquired assets, their fair value can be lower than what was originally paid for them, and a company must book a goodwill impairment.
- Goodwill impairment is an accounting charge deducted from earnings for a company that has acquired another company but can no longer justify the goodwill cost.
- Goodwill is an intangible asset that accounts for the excess purchase price of another company based on its proprietary or intellectual property, or brand recognition, etc., which is not easily quantifiable.
- A test for goodwill impairment aligned with accepted accounting standards must be undertaken on annual basis.
Changes in Accounting Standards for Goodwill
Goodwill impairment became an issue during the accounting scandals of 2000–2001. Many firms artificially inflated their balance sheets by reporting excessive values of goodwill, which was allowed at that time to be amortized over its estimated useful life.
While bull markets previously overlooked goodwill and similar manipulations, the accounting scandals and change in rules forced companies to report goodwill at realistic levels. Current accounting standards require public companies to perform annual tests on goodwill impairment, and goodwill is no longer amortized.
Annual Test for Goodwill Impairment
U.S. accounting principles require companies to review their goodwill for impairment at least annually at a reporting unit level. Events that may trigger goodwill impairment include deterioration in economic conditions, increased competition, loss of key personnel, and regulatory action.
The definition of a reporting unit plays a crucial role during the test; it is defined as the business unit that a company's management reviews and evaluates as a separate segment. Reporting units typically represent distinct business lines, geographic units or subsidiaries.
Goodwill impairment is identified in two steps. First, a company must compare the fair value of a reporting unit to its carrying value on the balance sheet. Because observable market values are rarely present to determine the fair value of a reporting unit, management teams typically use financial models for fair value estimation. If the fair value exceeds the carrying value, no impairment exists, and companies are not allowed to write up their goodwill. If the fair value is less than the carrying value, the company must perform the second step by applying the fair value to the identifiable assets and liabilities of the reporting unit. The excess balance of the fair value is the new goodwill, and the carrying value of the goodwill must be reduced by booking a goodwill impairment charge.
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:
- A preliminary qualitative assessment
- Stage one of a quantitative assessment
- Stage two of a quantitative assessment