Question

What would be the potential impact on the net income, return on assets, and debt-to-asset ratio if ALL of a company’s “goodwill” on the balance sheet is considered impaired and of no value?  (if goodwill is of zero value, the company has to write off the value as a loss and remove goodwill from its total assets)

Answer 1

Goodwill is created in business accounting when an acquiring entity purchases another entity for more than the fair market value of its assets. Per accounting standards, goodwill should be carried as an asset and evaluated yearly for any possible goodwill impairment charge. Private companies may be required to expense a portion of the goodwill, periodically, on a straight-line basis, over a ten-year period, reducing the recorded value of the asset.

Companies should assess whether or not an adjustment for impairment to goodwill is needed within the first half of each fiscal year. This impairment test may have a substantial financial impact on the income statement, as it will be charged directly as an expense or written off until the asset of goodwill is completely removed from the balance sheet.

If goodwill has been assessed and identified as being impaired, the full impairment balance must be immediately written off as a loss. An impairment is recognized as a loss on the income statement and as a reduction in the goodwill account. The amount that should be recorded as a loss is the difference between the current fair market value of the asset and its carrying value or amount (i.e., the amount equal to the asset’s recorded cost). The maximum impairment loss cannot exceed the carrying amount – in other words, the value of the asset cannot be reduced below zero or recorded as a negative number.

Impact of Impairment

1. On Net Income

If the company decides it has too much goodwill, then goodwill is impaired. The company writes down goodwill by reporting an impairment expense. The amount of the expense directly reduces net income for the year. So a $10,000 goodwill impairment expense means a $10,000 reduction in net income.

2. Return on Assets

If the goodwill amount is written down after the acquisition, it could indicate that the buyout is not working out as planned. In short, goodwill impairment is a message to the markets that the value of the acquired assets has fallen below the amount that the company initially paid.

In the initial period following an asset impairment, a firm’s:

· Asset Turnover Ratio will rise because the asset base is lower.

· Debt-to-Equity ratio will rise because the impairment has lowered the value of equity.

· Profit margins will show a one-time dip due to the write-down expense (assuming all needed write-downs have taken place).

· Book value of equity will drop.

In the future accounting periods, after the asset impairment has been recognized, a firm’s:

· Future depreciation expense will decline because the book value of the depreciable asset base is now lower.

· Future profitability should rise because depreciation expense is lower.

· Return on Assets (ROA) and Return on Equity (ROE) should rise because the firm is more profitable and has a lower asset base.

3. Debt to Assets Ratio

When Goodwill is impaired it is completely written off from the financial statements. Thus assets get reduced to that extend. Thus debt to assets ratio would increase as the result of impairment.