When acquiring a company, the purchase price often exceeds the fair value of the net assets. This excess is recorded as goodwill. However, goodwill must be evaluated for impairment periodically.
Understanding the difference between goodwill impairment and asset impairment is key for accurate financial reporting. Getting this right allows investors to appropriately evaluate performance.
In this post, we will define goodwill and asset impairment, explain the rules and formulas for testing impairment, walk through journal entries, and examine real examples from major public companies. You will gain clarity on these complex accounting concepts for proper valuation and reporting.
Introduction to Goodwill and Asset Impairment
Goodwill and asset impairment are important concepts in accounting that relate to declines in the value of a company's assets. However, there are some key differences between them:
Defining Goodwill in Business Acquisitions
Goodwill arises when a company acquires another company for more than the fair value of its net identifiable assets. It represents intangible elements like:
- Brand reputation
- Customer relationships
- Proprietary technology
Goodwill is recorded as an intangible asset on the balance sheet.
Understanding Asset Impairment
Asset impairment refers to a reduction in the recoverable value of a company's assets below their carrying value on the balance sheet. This can apply to both tangible assets like property, plant and equipment as well as intangible assets like patents.
Asset impairment often occurs due to changes in market conditions or reductions in an asset's utility to the company.
Contrasting Goodwill and Asset Impairment
The key differences between goodwill impairment and asset impairment include:
- Applicability: Goodwill impairment relates specifically to goodwill assets, while asset impairment applies to a broader range of asset types.
- Accounting treatment: They follow different accounting rules for impairment testing and expense recognition under GAAP principles.
- Frequency: Asset impairment tends to be recognized more frequently than goodwill impairment.
In summary, while both relate to asset value declines, goodwill impairment is specialized for excess acquisition value while asset impairment applies to many asset types on the balance sheet. Their accounting treatment and testing procedures also differ.
What is goodwill and asset impairment?
Goodwill impairment occurs when a company acquires another company or asset for more than the fair market value, resulting in goodwill on the acquirer's balance sheet. Asset impairment occurs when the carrying value of an asset on the balance sheet exceeds its fair market value.
Key Differences
The key differences between goodwill impairment and asset impairment include:
- Origin - Goodwill impairment stems from an acquisition, while asset impairment relates to individual assets already owned.
- Calculation - Goodwill impairment compares carrying value to fair value of the acquired company as a whole. Asset impairment compares carrying value to fair value on individual assets.
- Frequency - Goodwill impairment testing is done at least annually. Asset impairment testing is done when a triggering event occurs indicating potential decline in value.
- Financial Impact - Both goodwill and asset impairment result in a non-cash charge reducing net income. However, asset impairment directly reduces individual asset values, while goodwill impairment reduces only goodwill.
Impairment Testing
For both goodwill and assets, impairment testing involves comparing the carrying value on the balance sheet to the current fair market value. If the carrying value exceeds fair value, impairment must be recognized on the financial statements.
The testing process and calculations differ slightly between goodwill and assets. However, the core principle remains consistent - ensuring assets are not overvalued on the balance sheet. Recognizing impairment charges early allows financial statements to better reflect the company's true financial position.
What is the rule for impairment of goodwill?
The basic principle for impairment of goodwill is that an asset is considered impaired when its carrying amount on the balance sheet exceeds its recoverable amount.
The recoverable amount refers to the higher of:
- Fair value less costs to sell
- Value in use
Where value in use is calculated as the present value of estimated future cash flows expected to arise from the asset.
If the carrying amount exceeds the recoverable amount, then the asset is impaired and must be written down to the recoverable amount. This write down is recorded as an impairment loss on the income statement.
For goodwill specifically, companies are required to test goodwill for impairment at least annually under accounting standards like GAAP and IFRS. The impairment test involves comparing the carrying amount of a reporting unit that contains goodwill to its fair value. If the carrying amount exceeds the fair value, goodwill is considered impaired.
The impairment of goodwill is a non-cash charge that reduces net income. However, it does not directly impact cash flows. The write down adjusts the carrying amount of goodwill to a more realistic level based on current financial conditions.
In summary, the key aspects of the rule for goodwill impairment are:
- Test goodwill annually for impairment
- Compare carrying amount to fair value of reporting unit
- Record impairment loss if carrying amount exceeds fair value
- Impairment reduces net income but not cash flows
What is an example of impairment of assets?
An example of an impairment of assets could be when a company faces damage to its property, plant, and equipment due to a natural disaster or sudden event.
For instance, if a manufacturing company has a factory and the equipment inside, and there is a major storm or flood that damages the building and equipment, the company would likely need to write down those assets on its balance sheet.
Specifically, the company would record an impairment charge to reduce the carrying value of the building and equipment to its new fair market value on the company's balance sheet. This would result in a non-cash impairment expense on the income statement in the period of the impairment.
The impairment charge helps reflect that the assets were damaged and are now worth less. Even though it is a non-cash expense, it reduces net income in the period and carries forward by reducing assets on the balance sheet.
By recording the impairment, the company is bringing the accounting records in line with the economic reality that the building and equipment are now less valuable assets due to the damage incurred. This is an important concept in accounting to represent assets accurately at their fair and realizable values.
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Why do companies do goodwill impairment?
Companies perform goodwill impairment testing to ensure that the value of goodwill on their balance sheets does not exceed its fair value.
According to accounting standards like GAAP and IFRS, goodwill is not amortized like other intangible assets. Instead, companies must assess goodwill for impairment annually, or more frequently if impairment indicators arise. This is done to:
- Accurately reflect goodwill value on financial statements
- Avoid overstating assets and equity on the balance sheet
- Recognize impairment losses timely if goodwill becomes impaired
- Provide investors transparency into potential goodwill write-downs
Essentially, goodwill impairment testing measures if the price paid for an acquisition is still justified by the cash flows it generates. If those cash flows decline significantly, it may signal that goodwill is overvalued on the books. Impairment charges then reduce goodwill to its current fair value.
While goodwill impairment results in non-cash charges on the income statement, it is an important exercise for companies to undertake. Performing rigorous impairment reviews enhances the accuracy of financial reporting and the reliability of goodwill balances. This benefits both management and investors when analyzing performance.
Examining Goodwill Impairment
Goodwill impairment is an important concept in accounting that requires companies to periodically evaluate the value of goodwill on their balance sheets. This section will provide an overview of key aspects of accounting for goodwill impairment.
Testing for Goodwill Impairment
Companies are required to test goodwill for impairment at least annually. Additional testing may be required if events or changes in circumstances indicate that the goodwill may be impaired. Testing involves comparing the fair value of a reporting unit to its carrying value on the balance sheet, including goodwill. If the carrying value exceeds the fair value, an impairment loss must be recognized.
Goodwill Impairment Journal Entry
If goodwill impairment is identified, a journal entry must record the impairment loss. This reduces goodwill on the balance sheet and records the loss as an operating expense on the income statement. For example:
Impairment Loss Expense 100,000
Goodwill 100,000
This entry reduces net income and equity on the financial statements.
The Goodwill Impairment Formula
The impairment loss is calculated as the excess of the carrying value over the fair value, limited to the total amount of goodwill. For example, if the carrying value is $1 million, the fair value is $700,000, and goodwill is $300,000, the impairment loss would be $300,000.
Goodwill Impairment and Consolidation
For consolidated financial statements, goodwill impairment testing must be performed at the reporting unit level. Impairments identified at the subsidiary level must be reflected in the consolidated financial statements. This can significantly impact the financial position and performance of the consolidated entity.
Goodwill Impairment under IFRS
Under IFRS, a one-step impairment test is performed comparing carrying values to the higher of fair value and value in use. Impairments cannot be reversed under IFRS. Key differences from US GAAP include the treatment of deferred taxes and the restriction on reversal of impairments.
Navigating Asset Impairment
This section provides guidance on recognizing and measuring impairment losses on assets other than goodwill.
Indicators and Implications of Asset Impairment
There are several potential triggers that may indicate an asset is impaired and should be tested for impairment, including:
- A significant market decline that brings the asset's fair value below its carrying value
- Changes in how the asset is used by the business that adversely impact its ability to generate future cash flows
- Evidence of physical damage or obsolescence of the asset
- Worse-than-expected financial performance of products associated with the asset
Identifying these impairment indicators is important because an impairment charge reduces the asset's carrying value on the balance sheet and also creates an impairment expense on the income statement. This negatively impacts key financial metrics like net income, EPS, and return on assets.
Calculating the Impairment of Tangible and Intangible Assets
To measure impairment, the asset's carrying value is compared to its recoverable amount. The recoverable amount is the higher of the asset's fair value less costs to sell and its value in use. Value in use is calculated as the present value of estimated future cash flows expected from ongoing use and ultimate disposal of the asset.
For tangible assets like machinery, fair value may be determined based on market prices for similar assets. For intangible assets like patents or trademarks, valuation models are used to estimate fair value.
The impairment loss is measured as the excess of carrying value over the recoverable amount. This impairment loss amount will be recognized as an expense on the income statement.
Accounting for Impairment Losses on Income Statements
Recording an impairment charge related to tangible or intangible assets creates a non-cash expense on the company's income statement, negatively impacting net income for the period.
Reporting standards require impairment losses to be displayed separately on the income statement, typically under a line item such as "Impairment of long-lived assets" or "Amortization and impairment of intangibles" to enable financial statement users to clearly see the impact.
Notes to the financial statements should also disclose details about any significant impairment charges, the events and circumstances leading to impairment, and assumptions used in estimating recoverable amounts.
Asset Impairment Journal Entry
The journal entry to record an asset impairment involves debiting impairment expense on the income statement and crediting the specific impaired asset account on the balance sheet to reduce its carrying value.
For example:
Impairment Expense 100,000
Accum. Depreciation - Equipment 100,000
This entry recognizes a $100,000 impairment charge related to equipment, creating a $100,000 impairment expense while directly reducing the equipment asset account.
Understanding indicators of impairment, methods of calculating losses, income statement presentation, and the related journal entries is key for properly accounting for write-downs of asset values.
Real-World Implications of Impairment
Goodwill Impairment Examples from Major Corporations
Several major corporations have experienced significant goodwill impairment charges in recent years. For example, in 2020 Verizon took a $4.6 billion goodwill impairment related to its media business, which includes Yahoo and AOL. This large write-down was attributed to increasing competition and reduced projections for future cash flows.
Another notable case is General Electric, which recorded a massive $22 billion goodwill impairment in 2018 on its power division. This stemmed from declining demand and increased liabilities in the fossil fuel power industry. The impairment eliminated over half of GE Power's goodwill and had a substantial impact on the company's financial statements.
These examples demonstrate how shifts in business conditions and future outlook can necessitate large goodwill write-downs. The non-cash charges reduce net income without directly impacting cash flows, but they signal underlying issues with overvalued goodwill or acquired businesses not meeting performance targets.
Asset Impairment in Various Industries
Asset impairment occurs across many different industries and for diverse types of assets. For instance, falling oil prices have led many energy companies to take impairment charges on their natural gas assets. This includes write-downs of extraction facilities, pipelines, and other equipment that has declined in value.
The retail industry faces frequent asset impairment with its store locations and other properties. As consumer shifts accelerate, retailers often close underperforming stores and record impairment to align the carrying values with diminished fair values. Brand names and other intangibles may also be written down after large mergers or acquisitions fail to produce expected performance.
In the technology industry, shifts in the competitive landscape can spur asset impairment as well. Declines in expected cash flows from software platforms, patents, or other tech assets can necessitate write-downs. This demonstrates the importance of monitoring asset valuations and cash flow projections, especially for intangible assets in dynamic industries.
Across sectors, asset impairment aims to accurately reflect reductions in fair value on the balance sheet. The specific assets affected are often closely tied to each company's unique operating context and industry trends. But in all cases, substantial impairments indicate that prior assumptions have not held up and that assets may be overvalued on financial statements. Recording these non-cash charges is vital for transparency and an accurate financial picture moving forward.
Conclusion: The Importance of Accurate Impairment Accounting
In summary, properly accounting for goodwill and asset impairments is critical for accurate financial reporting and informed decision-making. While the accounting treatments differ, timely recognition of impairments impacts the balance sheet and income statement, better reflecting a company's financial health.
Summarizing Goodwill vs. Asset Impairment
The key differences between goodwill and asset impairment include:
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Goodwill impairment recognizes a decline in value of an acquired company, while asset impairment reflects diminishing value of individual tangible/intangible assets.
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Goodwill impairment is a non-cash charge, only impacting the balance sheet. Asset impairment impacts both the balance sheet (reduced asset value) and income statement (impairment loss expense).
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Measurement approaches also differ. Goodwill impairment uses a quantitative test comparing carrying value to fair value. Asset impairment may use undiscounted or discounted cash flows to determine recoverability.
Properly distinguishing and recording impairments is vital for financial reporting transparency and accuracy.
Reflection on Impairment Accounting Standards
Accounting standards like GAAP and IFRS play an important role in ensuring consistency in impairment recognition and measurement. While revisiting goodwill amortization could improve representational faithfulness, overall these standards provide a solid framework for guiding impairment accounting. As the business landscape evolves, standards may need adjustment to keep pace. But they currently establish an effective, unified approach for recognizing and reporting asset and goodwill impairments.
Adherence to standards, paired with sound judgment and timely testing, allows impairments to be appropriately captured in financial statements. This enables stakeholders to realistically assess organizational health and performance.
