Goodwill Impairment Testing: A Comprehensive Guide

Performing goodwill impairment testing can be a complex and challenging process for many companies.

This comprehensive guide breaks down everything you need to know about goodwill impairment testing in a clear, step-by-step manner.

You'll learn what goodwill is, why impairment testing is required, the regulatory framework, the step-by-step testing process, key valuation assumptions, how to account for impairments, and more.Whether you're new to goodwill impairment or looking to brush up, this guide has you covered.

Introduction to Goodwill Impairment Testing

This section provides an overview of goodwill impairment testing, including defining goodwill, explaining why impairment testing is required, and outlining key concepts involved.

What is Goodwill?

Goodwill represents intangible assets acquired when one company purchases another for more than the fair value of its net identifiable assets. Goodwill may include things like brand reputation, customer relationships, and intellectual property.

Why Test Goodwill for Impairment?

Testing for goodwill impairment ensures that the goodwill value reported on the balance sheet does not exceed its fair value. This provides investors an accurate picture of company value. Impairment testing is required under accounting standards like GAAP and IFRS.

Impairment Testing Concepts

Key concepts in impairment testing include:

• Carrying value: The goodwill balance recorded on the balance sheet.
• Fair value: The amount goodwill could be sold for in an arm's length transaction.
• Cash generating units (CGUs): The smallest identifiable group of assets that includes the goodwill and generates cash inflows.
• Discount rates: Required rate of return used to estimate the present value of future cash flows from the CGU.
• Impairment charges: Expenses recorded to write-down goodwill to its fair value if it is overstated on the balance sheet.

Properly testing and recording goodwill impairment ensures financial statements accurately reflect company value.

How do you do a goodwill impairment test?

You need to compare an asset's carrying amount with its recoverable amount (higher of fair value less costs of disposal and value in use) to determine if a goodwill impairment exists. Here are the key steps:

• Identify the cash-generating units (CGUs) that have goodwill allocated. Goodwill needs to be tested at the CGU level.
• Determine the carrying amount of each CGU, including the goodwill.
• Estimate the recoverable amount of each CGU based on the higher of the fair value less costs of disposal and the value in use. Common valuation methods include discounted cash flow models and market approach.
• Compare the carrying amount to the recoverable amount for each CGU.
• If the carrying amount exceeds the recoverable amount for a CGU, an impairment loss must be recognized. The impairment loss is allocated first to reduce the carrying amount of goodwill, and then pro-rata to other assets based on their carrying amounts.
• The impairment loss is recognized as an expense on the income statement. The carrying amount of goodwill on the balance sheet is reduced accordingly.
• Appropriate disclosures of impairment testing, key assumptions and outcomes need to be made in the financial statements.

In summary, goodwill impairment testing involves determining recoverable values for CGUs annually and recognizing any excess of carrying amounts over recoverable values as impairment losses. Assumptions like discount rates and cash flow projections significantly impact outcomes.

What is the new guidance for goodwill impairment?

In 2017, the Financial Accounting Standards Board (FASB) issued simplified guidance for testing goodwill for impairment. The key changes include:

• Elimination of Step 2 from the goodwill impairment test. Previously, if a company failed Step 1, they would have to perform Step 2 to measure the actual impairment charge. Now, failing Step 1 automatically triggers an impairment charge equal to the excess carrying value over fair value.
• The impairment charge is calculated by subtracting the fair value of the reporting unit from its carrying amount. This simplified the process and eliminated the complexities of Step 2.
• Companies still have the option to perform Step 2 if they believe the results will be less than the full impairment charge from Step 1. However, Step 2 is no longer required.

The revised guidance removes the complexities of having to hypothetically value the reporting unit in Step 2. Companies failing Step 1 will now take a more timely impairment charge based solely on the excess of carrying value over fair value. This streamlines the process while still achieving the core objective of recognizing impairment charges on a timely basis.

What is the two step goodwill impairment test?

The two step goodwill impairment test is an accounting procedure companies must perform annually to determine if the goodwill on their balance sheet is impaired.

The first step compares the fair value of a reporting unit to its carrying amount on the balance sheet. If the fair value is lower than the carrying amount, goodwill may be impaired and step two must be performed.

In step two, companies calculate the implied fair value of goodwill by subtracting the fair values of all assets and liabilities of the reporting unit from the overall fair value determined in step one. This implied goodwill value is then compared to the carrying amount. If the implied fair value is lower, an impairment must be recognized as a charge against earnings.

The goodwill impairment charge would be the difference between the carrying amount on the balance sheet and the implied fair value calculated in step two. This reduces the goodwill asset to its revised fair value.

Recognizing goodwill impairment is critical for providing investors transparency into potential overpayments from previous acquisitions. It also allows companies to reset goodwill to updated market-based amounts.

What is the ASC 350 test for goodwill impairment?

The ASC 350 test refers to the accounting standards in ASC 350-20 for testing goodwill for impairment.

Goodwill is an intangible asset that arises when a company acquires another company for more than the fair value of its net assets. Goodwill represents things like the value of the acquired company's customer base, brand name, talent, etc.

Since goodwill is not a physical asset and has an indefinite life, companies are required to test it at least annually for impairment. Impairment refers to a reduction in the value of an asset.

The ASC 350 goodwill impairment test involves:

• Comparing the fair value of a reporting unit that contains goodwill to its carrying amount. Reporting units are components of a business, like divisions or subsidiaries.
• If the carrying amount exceeds the fair value, there is likely goodwill impairment and step 2 must be performed.
• Step 2 calculates the actual impairment charge by comparing the implied fair value of goodwill to its carrying amount.

Essentially, the ASC 350 test determines if the goodwill asset is overvalued on a company's balance sheet compared to its current fair value. If so, an impairment must be recognized to reduce goodwill to its implied fair value.

The key point is that the ASC 350 test focuses specifically on testing goodwill for impairment, not other assets. So it is done after completing impairment tests for assets like inventory, fixed assets, and other intangibles.

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Regulatory Framework for Goodwill Impairment Testing

This section outlines the accounting rules and standards for goodwill impairment testing, including the differences between US GAAP and IFRS.

Annual Testing Requirement

For public companies, goodwill impairment testing must be performed at least annually at the reporting unit level. Testing is often conducted in Q4 prior to issuing the annual financial statements.

• Goodwill must be tested for impairment on an annual basis, regardless of any indicators of impairment
• For public companies, testing must occur by the end of the fiscal year
• Impairment testing is performed at the reporting unit level, which is generally an operating segment or one level below
• The most common approach is to test goodwill in Q4 before issuing year-end financial statements

Trigger-Based Interim Testing

In addition to annual testing, goodwill must also be tested between annual tests if a triggering event occurs that more likely than not reduces fair value below carrying value.

• Goodwill must also be tested between annual tests if certain trigger events occur
• Triggers include significant declines in operating results, changes in the business climate, or a decision to sell or dispose all or a portion of a reporting unit
• Interim impairment testing evaluates if triggers reduced fair value below carrying value
• Determines if an interim goodwill impairment charge is required

Goodwill Impairment Testing IFRS vs. US GAAP

Outlining the key differences in impairment testing requirements between International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (GAAP).

• IFRS: One-step goodwill impairment test by comparing carrying value to fair value of a cash generating unit (CGU). Impairment charge is difference between carrying amount and fair value.
• US GAAP: Two-step goodwill impairment test. Step 1 compares fair value of a reporting unit to its carrying amount. If failed, Step 2 calculates and recognizes impairment charge.
• IFRS allows reversal of previous goodwill impairments in certain situations, while reversals are prohibited under US GAAP.
• IFRS focuses on cash generating units (CGUs) while US GAAP uses reporting units for testing.

Overall, while differences exist, both IFRS and US GAAP aim to recognize goodwill impairments when carrying values exceed fair values at the appropriate unit of account level.

Goodwill Impairment Testing Steps

This section will explain the detailed step-by-step process for testing goodwill for impairment, including the application of the goodwill impairment formula.

Step 1: Determine Reporting Units

The first step is to determine the reporting units, which are business units below the company level that goodwill is tested at. Common criteria for identifying reporting units include:

• Having discrete financial information available
• Being managed by a segment manager
• Operating as a profit center

For example, a company may have an consumer products division and a commercial products division that would be deemed separate reporting units.

Step 2: Assign Goodwill to Reporting Units

Next, the existing goodwill balance recorded on the balance sheet must be reasonably allocated to each reporting unit identified in the first step. This is typically done based on the relative fair values of the reporting units.

For example, if the consumer products division makes up 60% of the total fair value of reporting units, 60% of the total goodwill would be assigned to that reporting unit.

Step 3: Calculate Fair Value of Reporting Unit

Then, the fair value of each reporting unit must be determined, generally using discounted cash flow models or market-based approaches. All assets and liabilities of the reporting unit are considered in this valuation.

Key inputs into the valuation typically include:

• Projected cash flows: Multi-year financial projections
• Terminal value: Value beyond the discrete projection period
• Discount rate: Reflects the riskiness of the cash flows

The goal is to estimate the price a market participant would pay for the reporting unit as a standalone business.

Step 4: Compare Fair Value to Carrying Value

The fair value is then compared to the carrying value of the reporting unit on the balance sheet to determine if an impairment exists.

If the fair value exceeds carrying value, no impairment is recorded. If carrying value exceeds fair value, proceed to Step 5.

Step 5: Measure Impairment Charge

If fair value is below carrying value, an impairment charge must be recorded for the difference, allocated first to reduce goodwill of the reporting unit.

Any excess over the goodwill balance is then allocated to other assets of the reporting unit pro-rata based on their carrying values.

This impairment charge reduces the carrying value of the related assets on the balance sheet. It is recorded as an operating expense on the income statement.

Goodwill Impairment Formula and Calculations

Understanding the Goodwill Impairment Formula

The formula used to calculate goodwill impairment is:

Impairment Loss = Goodwill Carrying Value - Fair Value of Reporting Unit

Where:

• Goodwill Carrying Value: The value of goodwill on the balance sheet
• Fair Value of Reporting Unit: The total fair value of the business unit being tested

If the fair value of the reporting unit exceeds its carrying value, there is no impairment. But if the carrying value is higher, there is an impairment loss equal to the difference between the two values.

The fair value of the reporting unit is calculated based on discounted future cash flows, using estimates like revenue growth rates, profit margins, and discount rates. Determining these inputs requires significant management judgment.

Performing the Calculations

To demonstrate how the impairment test is performed, let's look at an example:

• Goodwill carrying value: $5 million
• Estimated fair value of reporting unit: $4 million

Impairment Loss = $5 million - $4 million = $1 million

There is a $1 million goodwill impairment because the carrying value exceeds the fair value by $1 million.

This $1 million would be recorded as an impairment expense on the income statement, and the goodwill asset on the balance sheet would be written down to $4 million.

Performing these calculations in practice is more complex, but this example demonstrates the basic methodology. Excel is commonly used, as seen next.

Goodwill Impairment Test Example Excel

Below is a link to download an Excel template that provides a detailed example of the goodwill impairment test calculations:

Goodwill Impairment Test Template.xlsx

The template contains inputs, assumptions, discounted cash flow projections, and the final impairment test determination. It shows how the analysis would be structured in Excel, helping demonstrate the mechanics behind the test.

Reviewing the example calculations in Excel can aid in interpreting the financial reporting standards and applying them properly in practice when evaluating goodwill for impairment.

Key Assumptions in Impairment Testing Valuation

This section examines some of the key assumptions made when determining the fair value of a reporting unit for goodwill impairment testing under US GAAP.

Cash Flow Projections

Projected future cash flows are a critical assumption in discounted cash flow models used to estimate fair value. These projections involve significant judgement around:

• Revenue growth rates - Estimates should consider historical performance, industry trends, competitive landscape, and overall economic conditions. Overly optimistic growth assumptions can result in inflated fair values.
• Profit margins - Need to reflect company and industry historical averages and expectations of future profitability based on business plans. Declining margins over time may indicate impairment.
• Capital investments - Level of capital expenditures and working capital needed to support projected revenue growth should align with company strategy and industry norms.

Discount Rates

Choosing an appropriate discount rate to apply to projected cash flows also impacts fair value estimates. Common approaches include:

• Weighted average cost of capital (WACC) - Reflects company's costs to raise debt and equity financing, weighted by capital structure. Changes in capital markets can impact WACC.
• Rate of return analysis - Compares discount rate to expected returns based on market data of comparable public companies and acquisitions in the industry.

Higher discount rates reduce present values and increase likelihood of impairment. Rates should be periodically reassessed.

Growth Rates

The terminal growth rate used to estimate cash flows beyond the discrete projection period can significantly change valuation conclusions. Consider:

• Long-term inflation - Terminal growth rates above expected inflation may be difficult to sustain long-term.
• Industry growth prospects - Align terminal rate with realistic industry growth rates based on external market data and projections.
• Avoid perpetuity - Projecting increasing cash flows in perpetuity risks overstating terminal value. Terminal growth should trend toward economy-wide growth over time.

Conservative growth assumptions reduce risk of inflated fair value estimates. Sensitivity analysis can assess impact of changes in key assumptions.

Accounting for Goodwill Impairments

This section explains how to record goodwill impairment charges and related disclosures under US GAAP and IFRS accounting standards.

Recording the Goodwill Impairment Journal Entry

To record a goodwill impairment charge, debit the impairment expense account and credit the goodwill asset account. For example:

Impairment Expense     100,000  
   Goodwill                 100,000

The amount of the impairment is the difference between the carrying value of goodwill and its fair value. Companies should test goodwill for impairment annually or whenever events or changes in circumstances indicate that goodwill may be impaired.

Key steps for recording goodwill impairments:

• Calculate the fair value of the reporting unit with the goodwill using discounted cash flow analysis or other valuation methods
• Compare the fair value to the carrying value on the balance sheet
• If lower, record impairment for difference between carrying value and fair value
• Disclose details of impairment calculation and assumptions in financial statement footnotes

Tax Impacts

Unlike normal operating expenses, goodwill impairment charges are not tax deductible, so there is no tax benefit. The after-tax cost of a goodwill impairment is the full pre-tax amount.

Disclosures

Under both US GAAP and IFRS, companies are required to disclose detailed information around goodwill impairment testing and results. Typical disclosures include:

• Description of impairment testing methodology
• Key assumptions used in determining fair value
• Changes in goodwill balance from prior year
• Details of any impairment losses recognized

Goodwill Impairment IFRS Disclosure Requirements

Specific items that must be disclosed under IFRS when a material goodwill impairment loss is recognized:

• Events and circumstances leading to impairment
• Reportable segments impacted
• Amount of impairment loss and method of determination
• Line items in income statement displaying impairment losses
• Changes in goodwill allocation across segments

Robust financial statement disclosures around goodwill impairment provide transparency into the assumptions and judgments underlying the amounts recognized.

Conclusions

In summary, goodwill impairment testing requires judgement, but is critical for providing investors transparency into potential overpayment from acquisitions. This guide has covered the key concepts, rules, valuation approaches, and accounting treatments for businesses navigating goodwill impairment evaluations.

Key Takeaways

The major takeaways include:

• Businesses are required to test goodwill for impairment at least annually. This involves determining the fair value of the reporting unit and comparing it to the carrying value.
• The fair value is typically calculated using a discounted cash flow model or a multiple of earnings approach. The assumptions used can significantly impact the results.
• If the fair value is less than the carrying value, an impairment must be recognized. This directly reduces net income on the income statement.
• Impairment losses cannot be reversed in future periods, even if fair values recover. This makes assumptions used very important.
• Goodwill impairment has a major impact on financial reporting. Transparency into impairment testing is critical for investors to understand acquisition economics.

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