Goodwill Impairment
Goodwill impairment refers to a decrease in the value of goodwill that occurs when the fair value of a company (or a cash-generating unit) falls below its carrying value (the amount at which the company is valued on the balance sheet, including goodwill). Under U.S. GAAP and IFRS, companies are required to test for goodwill impairment at least annually, or more frequently if there are indications of impairment.
If a company determines that its goodwill is impaired, it must write down the value of its goodwill. This write-down is reflected as an impairment loss on the income statement, which reduces net income for the period. On the balance sheet, the carrying value of goodwill is reduced by the amount of the impairment.
For example, suppose a company has $10 million of goodwill on its balance sheet. After performing an impairment test, it determines that the fair value of the company (or the relevant cash-generating unit) is $8 million less than its carrying value. In this case, the company would record a goodwill impairment loss of $8 million on its income statement. The value of goodwill on the balance sheet would also be reduced by $8 million.
Goodwill impairments can signal that a company has overpaid for acquisitions or that a part of its business is not performing as expected. However, the determination of goodwill impairment can be subjective and requires management to make estimates and assumptions about future cash flows and other factors.
Example of Goodwill Impairment
Let’s say TechCompany purchased SmallFirm, another technology company, a few years ago for $500 million. At the time of purchase, SmallFirm’s net assets had a fair market value of $400 million. The excess of $100 million ($500 million purchase price – $400 million fair market value of net assets) was recorded as goodwill on TechCompany’s balance sheet.
Now, due to changes in the market and increased competition, SmallFirm’s business isn’t doing as well as expected. TechCompany decides to conduct an impairment test (as part of its annual review or due to these triggering events), which involves determining the current fair value of SmallFirm’s net assets, including goodwill.
Let’s say after conducting the impairment test, TechCompany determines that the fair value of SmallFirm is now only $450 million. Since the carrying value of SmallFirm on TechCompany’s books is $500 million (the original purchase price), the goodwill is impaired:
$500 million carrying value – $450 million fair value = $50 million goodwill impairment.
TechCompany must now write down the value of goodwill on its balance sheet by $50 million, from $100 million to $50 million. It also records a $50 million impairment loss on its income statement, which reduces its net income for the period.
This is a simplified example. The process of testing for goodwill impairment can be complex and requires significant judgment, such as estimating future cash flows and choosing an appropriate discount rate to calculate present values. It’s also important to remember that the test is typically performed at the level of a cash-generating unit, which could be smaller than the whole company.
