Account for Goodwill Impairment
Goodwill is an accounting concept that is used when dealing with acquisitions. When one company acquires another entire company, the purchase price is likely to exceed the total value of the acquired firm's net identifiable assets. This difference between the purchase price and the firm's market value is called goodwill. Every year, it is important to "test" goodwill to ensure that it is not overstated. Learning how to account for goodwill impairment is a matter of using a relatively simple impairment test.
Contents
Steps
Understanding Goodwill Impairment
- Learn the definition of goodwill. Understanding goodwill impairment is impossible without understanding goodwill. Goodwill is something that occurs when one business purchases another business for more than the fair market value of that business. In other words, accountants would determine what the business should be worth on the open market (or the fair market value), and if the business is purchased for more than this value, goodwill is created.
- For example, assume Company A has a fair market value of $1 million. Company B decides to pay $2 million to buy company A. In doing so, Company B pays $1 million more than the fair market value of Company A, and therefore, $1 million in goodwill is created (purchase price of $2 million minus fair market value of $1 million).
- Why is company B willing to pay $1 million more than Company A is worth? There are a variety of reasons. Company A may have excellent growth prospects, strong profit margins, a competitive edge, or be an excellent fit with Company B's current business model.
- After the purchase, Company B would show $1 million in goodwill on its balance sheet, and $1 million indicating the value of the business.
- Calculate carrying value (also known as book value) of a business. Recall that goodwill is created when you pay more than for a company than what the company's assets are actually worth. What the company's assets are actually worth is known as the carrying value. It is known as carrying value because this is the value of the business that is "carried" on the balance sheet.
- The carrying value of a business is equal to the cost that was originally paid for the business's assets, minus its debts. For example, if a business originally paid $2 million for its assets, and it has debts of $1 million, its carrying value would be $1 million.
- Sometimes the carrying value of a company will be worth less than its fair market value, or what the market is willing to pay for it. Recall that goodwill is equal to the purchase price of a business minus the fair market value. For example, assume the carrying value of a company is $1 million and accountants determine the fair market value is $1.5 million. If somebody is willing to pay $2 million, the goodwill created would be $500,000, or $2 million minus $1.5 million.
- Understand Goodwill Impairment. Each year, it is required that you test Goodwill for something known as impairment. Over time, the value of your business may fluctuate with market conditions, or with the performance of your business. Sometimes, poor market conditions or performance could mean that the market value will decrease below the carrying value recorded on the balance sheet. If this happens, it is necessary to decrease, or impair, the goodwill on the balance sheet to reflect the decrease in value.
- For example, assume you purchased a business for $2 million. Both the carrying value and fair market value in this case are $1 million, but it was decided for various reasons that you would pay $2 million due to strong advantages the business has. In this case, $1 million in goodwill is created
- If a new competitor appears in the market that strongly reduces the business's sales, your business would be worth less if you tried to sell it. If the value of your business falls so that it is worth less than the carrying value (in this case, $1 million), it is necessary to reduce the goodwill by the difference between what the business is now worth, and what it is recorded as being worth on your balance sheet.
- For example, assume the balance sheet indicates a carrying value of $1 million, plus $1 million in Goodwill. If something bad happens to your business and it is now only worth $500,000 on the open market, you would need to reduce, or impair the goodwill by $500,000.
Accounting for Goodwill Impairment
- Determine the reporting unit in question. Goodwill impairment is performed on a "reporting unit" basis. A reporting unit is a segment of the business that is autonomous enough to provide discrete financial information. For example, consider a firm called Vet Corporation that purchases veterinary practices in the hopes of increasing each practice's profits due to centralized management. Each practice the firm buys would be considered a reporting unit.
- In this case, perhaps Vet Corporation has purchased 10 veterinary practices. Each practice would be a separate reporting unit. This means that each practice would have its own carrying value, and own unique value in the market place if Vet Corporation ever decided to sell it.
- Estimate the fair market value of each reporting unit annually. Pretend that Vet Corporation recently purchased the veterinary practice of Dr. Brown. You must determine what this practice is now worth on the open market, so you can compare it to the carrying value to determine if impairment is necessary.
- Calculating what a business should be worth on the open market is complex, and therefore you should enlist the assistance of a chartered accountant or financial analyst.
- You can get a rough idea on your own by looking at the price that similar transactions have gone for in the market. You can also look at historical data to assume what average prices are. For example, if a similar vet practice recently sold for 10 times its annual profits, you can assume yours would sell for a similar price.
- Assume, for example, that it was determined the market value of Dr. Brown's practice was worth $800,000.
- Compare the market value of the reporting unit to its carrying value. The carrying value of the unit in this case is the value of the company's assets (or the value they were purchased for), minus any debts. Assume the carrying value of Dr. Brown's practice is $900,000.
- This means if you look on your balance sheet, you would see a carrying value of $900,000. This may mean assets of $1 million, minus debts of $100,000, for example.
- If the market value is higher than the carrying value, you can conclude that no goodwill impairment is necessary. If the market value is lower than the carrying value, you must proceed to the next step of the impairment test - determining the cause of this difference.
- In this example, the market value is lower than the carrying value by $100,000.
- Record the journal entry to recognize the goodwill impairment. Open whatever accounting software you are using to make the appropriate journal entries for the impairment. In this example, goodwill must be impaired by $100,000. To record the journal entry, Vet Corporation should debit Loss on Goodwill Impairment for $100,000, and credit Goodwill for $100,000.
- This transaction does two things. First, by crediting goodwill, the goodwill account is reduced by $100,000. This reflects the fact that the business is now worth $100,000 less than is recorded, so the goodwill asset account is reduced by this amount to account for the difference.
- By debiting Loss on Goodwill Impairment, you are recording the fact that a loss of $100,000 has occurred, which will appear on the income statement as an expense. This is because accounting rules require that any loss of goodwill not only reduce the amount of goodwill on the balance sheet, but also be recorded as an expense on the income statement. This means your profits would be $100,000 less for the year.
Tips
- Goodwill can only be impaired downwards; its value cannot be increased except through new acquisitions.
- The example calculations above will also work when expressed in other currencies.
Things You'll Need
- Accounting software
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Sources and Citations
- http://www.appraisaleconomics.com/goodwill-impairment.htm
- http://axiomvaluation.com/Documents/2004.04.27-GoodwillImpairmentPrimer.pdf
