To understand goodwill impairment first we need to understand what goodwill is. When a company makes an acquisition, the company they are acquiring has a certain fair value for its assets and liabilities. Goodwill is an intangible asset. It represents the difference between the accounted value of the company’s assets and liabilities and the price paid for the acquisition.
Goodwill impairment happens when the value of the acquired business declines. The intangible value of the acquisition declines. So the company has to book that change in value. So essentially due to the decline in value of the acquired business, the company has to report a decline in its asset value.
Why is goodwill impairment loss recognized?
Goodwill is nothing more than the difference between the net asset value of the acquired company, and the acquisition cost. When a business deteriorates, its ability to generate earnings declines. The intangible value of the acquisition is lower. That is why companies need to record goodwill impairment charges.
When is a goodwill impairment loss recognized?
Every year, companies that follow the US generally accepted accounting principles (GAAP) have to review the value of their goodwill. If the accountants determine that the company’s ability to generate profits is now lower than at the time of the acquisition. The company will have to book the decreased value of its intangible assets.
How is the goodwill impairment sum determined?
Accountants might use different approaches when determining the goodwill impairment. It involves valuing the business at fair market value. This is a highly subjective task. As different people will certainly value businesses in very distinctive ways. If the accountants determine that the fair value of the company is lower, according to the current market conditions. The goodwill impairment will be the difference between the acquisition cost, and the fair value of the business.
There are two methods that are usually used to determine if a goodwill impairment is applicable to a certain company. Both are based on valuation metrics.
Discounted cash flow model
One of the most used methods is the discounted cash flow model. If the present value of the company’s discounted cash flows is lower than at the time of the acquisition. A goodwill impairment will have to be recorded.
Another common way to assess a company’s fair market value is by comparing it with peers. Looking at companies in the same industry, and comparing their assets and liabilities. Combining that with a deep analysis of each company, and its ability to generate future profits. If for some reason a company has had a steep discount to its peers since the time of the acquisition, a goodwill impairment charge might be applied.
Reasons why a company might have a goodwill impairment charge
When an acquisition is made, the price is usually higher than the net tangible value. The acquirer expects a certain amount of earnings and revenues. If the company’s ability to generate earnings based on its intangible assets declines, a goodwill impairment loss will have to be recognized. There are several situations that can force a company to report a goodwill impairment. Most of these reasons will have to do with the declining ability of the company to generate profits going forward. Let’s look at a few examples:
If for some reason a company has its reputation affected by an event, its goodwill value might depreciate. In this type of situation, the company’s ability to generate future profits and cash flows might be impaired. For that reason, the parent company will have to report the decrease in goodwill value, through a goodwill impairment.
A worsening economic situation, either within the company or at a macro level can also impact the earning ability of a company. This is another situation where a goodwill impairment charge might be applicable.
Any changes to the competitive landscape in a particular industry might affect a company. If the changes in the competitive landscape of the business might affect its ability to earn future profits. If the conditions changed since the acquisition date, a goodwill impairment might be recorded.
Deteriorating competitive advantages
Deteriorating competitive advantages is closely related to the competitive landscape. Any changes to a company's ability to retain its market share can also impact its goodwill value. This is usually related to the company’s products and services not being able to distinguish themselves from the competition.
Declining geographic segment
A company might also experience a declining geographic segment. This can put additional pressure on the parent company, and directly influence its earnings. A declining geographic segment can happen for several reasons. Independently of the reasons, the intangible value of the company's assets declined.
Supply and demand
A company might also experience difficulties when it comes to sourcing products or services. It might also be affected by lower demand for its products or services. If this type of scenario affects the company’s ability to generate profits, a goodwill impairment charge might be applicable.
A company might also be affected by new legislation. If the legislative frame has changed and directly affected the company’s future prospects, it might be forced to record the decline in its intangible value. Legislation changes constantly, and between the acquisition and today, the legislation might be entirely different.
Regulatory action against the company
Regulatory action against the company can also result in an impairment charge. This type of situation can deeply affect the company’s reputation and the perception of its clients. If that happens, it will be subjected to goodwill impairment.
The decline of intangible assets
If for some reason a company has seen its intangible asset value decline, that can also lead to a goodwill impairment charge. If the value of its patents, trademarks, copyrights, or its brand name decline, that would force the company to book a goodwill impairment.
Another important factor in some companies is their employees. In some companies, there are employees that are essential to the company’s success. If for any reason, the company loses one of its valuable employees, a goodwill impairment might be justified.
As we have seen a lot can go on between the date of the acquisition and a particular date in the future. The assessment of a company’s value at one point in time can drastically change over time. This is why goodwill impairment is used. Any changes to the intangible value of a company will need to be recorded on its books.
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