Impairment Testing of Goodwill (When to Test, How and Why)

Talking about goodwill can be a little intimidating for someone who doesn’t fully understand what it is. Now if we add another layer and discuss impairment testing of goodwill, that might be enough to scare some people off right away. The topics of goodwill and impairment can both be a bit confusing so putting them together creates a challenge. There can definitely be some level of complexity when companies or auditors deal with goodwill and goodwill impairment testing. We will look into the goodwill and its impairment in more detail in this article in order to demystify these topics.

lady testing goodwill impairment

Goodwill: What Is It?

A goodwill is considered to be an intangible asset, meaning it’s not a physical asset like an equipment or a vehicle. The goodwill is created when a company acquires another company at a value that is higher than the book value. The difference between the book value of a company versus the actual purchase price is the goodwill. When goodwill is generated, it is recorded in the assets of the acquirer.

Goodwill can be generated by a good client base, a reputable brand or for intellectual property owned by a company, just to name a few examples. Due to the high level of subjectivity, it can be difficult to determine the value of a goodwill or for a third-party to understand how goodwill was established.

Impairment: What Does It Mean?

Impairment is associated with the decrease in value of an asset, whether that’s a fixed asset or an intangible asset. Assets can never fully retain all of their value. Specific and unusual events can bring the valuation of an asset down. For example, bad economic conditions, new laws and regulations affecting a specific asset or simply consumers showing different sentiments toward an asset can result in a decrease in value. 

Accounting standards require the financial statements to reflect an accurate picture of a company’s financial health. As such, testing for assets’ impairment is a necessity to ensure that companies don’t carry overstated assets on the balance sheet. When testing for impairment, if the result is that the fair value of an asset is lower than the book value, an impairment loss would need to be accounted for in the income statement during the period the impairment has been discovered.

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Why Do We Test Goodwill Impairment?

It’s very easy for companies to overstate goodwill since there’s no straightforward guidelines on how much value we can put on elements that make a goodwill. For example, if goodwill is generated based on a good client list, that could be worth a lot to someone but not much to another. It’s also improper to treat goodwill as any other intangible assets where they would amortize the intangible asset on a straight line basis.

For goodwill, amortization isn’t appropriate since it doesn’t really paint a clear picture of its worth. We can’t simply assume that the same amortization expense every year represents the decrease in value of a goodwill. Testing for impairment is the most relevant way of determining whether a goodwill has decreased in value. It requires an actual analysis taking different factors into consideration in order to determine the value.

calculating goodwill impairment

When To Test Impairment of Goodwill?

Goodwill is subjective and has a higher risk of being overstated. To prevent any overstatement, goodwills need to be tested for impairment at least on an annual basis or as soon as there’s an event that could indicate an impairment of goodwill. This applies to both GAAP and IFRS.

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How Do We Perform Impairment Testing of Goodwill?

Impairment testing of goodwill requires multiple steps. These steps can differ between IFRS or US GAAP. We will describe the steps in the table below.

Goodwill is tested on cash-generating units (“CGU”) which is a group of assets that can independently bring cash inflows for a company. Goodwill is tested on reporting units which are usually operating segments of a company.
Goodwill impairment testing needs to be completed regardless of whether any qualitative assessment would indicate that the goodwill hasn’t decreased in value. As a first step, companies can perform a qualitative assessment by determining whether it is more likely than not that the reporting unit has a fair value that is lower than the book value. More likely than not means over 50% chance. If the qualitative assessment is that it’s not more likely than not that the fair value of the reporting unit is lower than the book value, companies do not need to carry on with quantitative assessments. 
A qualitative assessment means that a company will look at factors that can indicate a loss in value such as bad economic conditions, change in laws and regulations, loss of key personnel, etc.
Companies need to determine the recoverable amount of the CGU, which represents the higher of:The fair value minus the cost of disposal of the CGUThe value in use of the CGU which is essentially a discounted projected cash flow of the CGU without taking into consideration any enhancement of assets or restructuring.
Once the recoverable amount is determined, the company compares that to the book value. If the recoverable amount is higher than the book value, no impairment is taken but if the recoverable amount is lower than the book value, an impairment loss needs to be recorded.
The impairment is the difference between the recoverable amount of the CGU and the book value of the CGU.
In IFRS, if the impairment amount determined above is significant and is higher than the book value of the goodwill, then the impairment would first decrease the goodwill to zero and then prorate the remaining impairment to the CGU’s other assets until all assets are at zero.
If the first step results in an indication that the fair value of the reporting unit is more likely than not lower than the book value, as a second step, the company will calculate the fair value of the reporting unit and recognize an impairment represented by the difference between the calculated fair value of the reporting unit and the book value. The impairment cannot be greater than the book value of the goodwill so if there is a significant impairment, the goodwill would simply be brought down to zero.

To determine the fair value of a reporting unit, a company can use the income approach or the market approach.

Income approach is when a company discounts the estimated future cash flows to obtain the present value.

Market approach is when a company compares the assets and liabilities of similar companies within the same industry.
In both IFRS and US GAAP, remember that when a company records an impairment loss on the goodwill, it can never be reversed.

Goodwill Impairment Test: Final Thoughts

Testing impairment on goodwill is not the easiest task. It can be time consuming and difficult especially if it’s a big corporation. The fact that accounting standards dictate companies to perform an analysis at least annually or at the indication of an unusual event is even more demanding. When performing an impairment test, simply follow the step by step guidance and you’ll eventually get familiar as you do more analysis. Remember that this analysis is extremely important in order to have accurate financial statements free of overstatements since it can be very easy for companies to overstate goodwill due to its subjectivity. 

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