Question

A major Fortune 500 company (nonregulated) acquired a small company for $1B three years ago. When the parent company purchased this organization, it paid a 50% premium (of the then stock price) and recorded about 35% of the purchase price as goodwill. The amount of goodwill remains a significant asset on the company’s books and records.

The subsidiary company is about to announce in a press release that, because of competitive pressures in the market place, it needs to reduce its current year forecasted sales and net income by 30% and 40& respectively. The company’s executives believe this decrease will continue in future years. The CEO of the company asked you to prepare a paper explaining to the board of directors and executive management what type of complications this would have on the company’s books and records.

1. What promulgated accounting literature should the company follow? Explain your rationale.

Answer 1

The provisions of IAS 36: Impairment of Assets requires a company to test for impairment of goodwill anually. Reduced forecast for sales and net income due to increase competition indicates impairment in the value of acquired goodwill, which was recorded upon acqusition of a small company. Since, goodwill forms a significant items in the financial statements of the company, testing for impairment of goodwill is material for the company.

To test for impairment, goodwill must be allocated to each of the company's cash-generating units. Since, the acquired goodwill is directly in connection to the cash generating unit that was acquired, entire goodwill shall be allocated to the acquired business.

A cash-generating unit to which goodwill has been allocated shall be tested for impairment by comparing the carrying amount of the unit, including the goodwill, with the recoverable amount of the unit.

• If the recoverable amount of the unit exceeds the carrying amount of the unit, the unit and the goodwill allocated to that unit is not impaired; and
• If the carrying amount of the unit exceeds the recoverable amount of the unit, the entity must recognise an impairment loss

Recoverable amount is higher of an asset's fair value less costs of disposal and its value in use. Value in use is the present value of the future cash flows expected to be derived from an asset or cash-generating unit.

If, based on the reduced projections of the net income and corrsponding future cash flows of company, the recoverable amount is determined to be less than the carrying amount amount of the unit, the impairment amount shall be reduced from goodwill. This impairment shall be expensed to statement of profit and loss of the company.

If the value of impairment is determined to be material, then the company will also have to disclose the event and circumstances that led to impairment and detailed information about the estimates used to measure recoverable amounts of cash generating unit.