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Goodwill Impairment Testing

Many companies carry “goodwill” on their balance sheet as an asset. As a result, like all assets, goodwill must be valued correctly on the company’s balance sheet in order for it to provide accurate information to investors and the public. When the “carrying value” of goodwill is less than fair market value, the goodwill is “impaired” and its value must be reduced. Goodwill impairment testing is thus required annually by financial accounting standards in order to make sure the value of goodwill is accurately reported.

To ensure accurate financial information, the Financial Accounting Standards Board (FASB) requires regular annual re-evaluation of the value of goodwill to determine if the value of goodwill was overstated initially or if the value of goodwill has changed due to various market conditions. The re-evaluation process is referred to as goodwill impairment testing. This requirement has been codified by the FASB in Accounting Standards Codification (ASC) 350, as have the protocol for the method of testing and for responding to results. When this re-evaluation reveals that goodwill is not worth what it is listed as, it must be written down, which means that the carrying value must be adjusted to the new accurate valuation.

Attorneys whose clients are involved in business and/or have goodwill as an asset, must be informed of the requirements for a goodwill impairment test so that they can be in compliance with regulations. The law is evolving in this field so attorneys should take steps to ensure clients are following the most current regulations.

Goodwill impairment can have a significant impact on a company’s balance sheet. For instance, the New York Times reported that banks “wrote down” more than $25 billion in goodwill in 2008, leaving them with a remaining $291 billion of goodwill on their balance sheets. By the end of the first quarter in 2009, another $3.5 billion in goodwill value was lost. Banks were not the only companies forced to write down goodwill during these tumultuous economic times; Sprint also wrote down $30 billion from its purchase of Nextel.

When a company writes down goodwill, it can be an indication that the company overpaid for the acquisition. Writing down goodwill that is inaccurately valued gives investors a more realistic picture of the actual worth of the companies in which they are investing. For this reason, the Securities and Exchange Commission (SEC) is actively involved in monitoring the assertions companies make about goodwill impairment.

ASC §350 established a two-part goodwill impairment test to determine if goodwill is properly valued. To undertake this test, goodwill must first be allocated to a “reporting unit.” The reporting unit is the smallest cash-generating unit for which cash flow data, balance sheets, and other financial documentation is available. Once the goodwill has been allocated to a reporting unit, the fair value of the reporting unit (including goodwill) is determined in accordance with ASC 820.

  • Part One: The fair market value of the reporting unit including goodwill is compared with its carrying amount. If fair market value of reporting unit is equal to or exceeds its carrying amount, then the second step of the test is not necessary and goodwill does not need to be written down. (§350-20-35-4, 6) If the fair market value of the reporting unit does not exceed its carrying value, the next step is to compare the carrying value of the goodwill with its implied fair value (§350-20-35-10). This value is derived by performing a purchase price allocation in accordance with ASC 805, with the fair market value of the reporting as the value on the date of acquisition. Determining goodwill in this manner is necessary because, by definition, goodwill is equal to the gap between the value/purchase price and the tangible and identifiable intangible assets. (§350-20-35-10, 350-20-35-14-17)
  • Part Two: The impairment loss is equal to the difference between the accounting value of goodwill and the implied fair market value of goodwill. This loss must be acknowledged and the value of goodwill written down. The loss that is recognized cannot, however, be greater than the carrying value of goodwill. (§350-20-35-11) The adjusted value of goodwill following an impairment loss will be its new carrying value going forward. Reversing an impairment loss is not permitted once the loss has been acknowledged (§350-20-35-12-13).

The two-part test is an important process to determine whether the valuations presented on a company’s balance sheet are accurate. However, the test can be cumbersome. As such, in August of 2011, the FASB announced that changes had been approved to simplify the process of goodwill impairment testing. These changes were made in response preparers of financial statements who had indicated that the first step of the test was too costly too complex. The preparers requested instead to allow a qualitative approach to determine if goodwill impairment is necessary. Now the company may first assess qualitative factors such as market events and other relevant circumstances to determine if it is more than 50% likely, that the fair market value of a reporting unit is less than its carrying value.

Whether these changes will lessen the burden of goodwill impairment testing remains to be seen. While some believe that the test will simplify the process, as was the aim of the FASB, others indicate that the new requirement could pose additional complications because companies will now be left with the obligation to document their qualitative evaluation to protect themselves from a potential compliance problem.

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