In: Accounting
Learning Team: Goodwill
Discuss with your team the following case study:
Client X contacted you for clarification and recommendations regarding the instances when goodwill should be adjusted for impairment.
Write a team consensus response of 525 to 700 words to include the following:
Provide detailed rational of why goodwill must be adjusted for impairment.
List the tests for impairment.
Explain the meaning of a non cash impairment charge.
1
A Goodwill Impairment occurs when a company
A) pays more than book value for a set of assets (the difference is the goodwill)
&
B) must later adjust the book value of that goodwill.
Goodwill is an asset, but it does not amortize or depreciate like other assets. Instead, GAAP rules require companies to "test" goodwill every year for impairments.
For example,
Let's assume that Company XYZ purchases Company ABC. The book value of Company ABC's assets is $10 million, but for various good reasons, Company XYZ pays $15 million for Company ABC. Because Company XYZ paid $15 million for $10 million worth of assets, Company XYZ records $5 million of goodwill as an asset on its balance sheet.
After the acquisition, Company ABC's sales fall by 40% over the year because Company XYZ changed its product line, which proved unpopular. Also, a competitor introduced a newer, lighter, faster, and cheaper product. As a result, Company ABC's fair market value falls to $8 million.
A year has now passed, and for Company XYZ, this means comparing the fair value of Company ABC to the book value on XYZ's financial statements. If the fair value of Company ABC is less than the book value (that is, if Company XYZ were to sell Company ABC today, it wouldn't get a price equal to or greater than its recorded value), Company XYZ must make a goodwill impairment.
In this example, Company XYZ would compare Company ABC's current fair market value of $8 million plus the $5 million of goodwill (a total of $13 million) to the $15 million it has recorded as Company ABC's value on its books. The difference between the two is $2 million, and Company XYZ must therefore reduce the goodwill on its books by that amount. The goodwill entry on its balance sheet goes from $5 million to $3 million, and its total assets fall correspondingly.
When a company records a goodwill impairment, it is telling the market that the value of the acquired assets has fallen below what the company generally paid for them.
Goodwill can represent a large amount of a company's net worth, and acquisitions (especially in the age of technology) often involve the purchase of things that by and large are intangible. But overinflating goodwill can mislead investors, and simply amortizing goodwill (which used to be the procedure) can also create artificial values for the asset. To find a more accurate value and therefore provide more meaningful and accurate financial statements, companies must therefore test their goodwill by comparing the actual value of the assets in question to their recorded value and adjusting for the difference every year.
2
An impairment test measures whether a balance sheet item is worth the amount stated on the balance sheet. The balance sheet amount should be reduced if the impairment test indicates a lower value.
Impairment testing can be applied for both commercial (audit) accounts and tax accounts. Different countries, accounting standards and tax jurisdictions may have different rules on what is to be tested, when and how. Many countries have adopted IFRS (international financial reporting standards). For this reason, most of the discussion in this article refers to that set of accounting standards.
Impairment test reporting should include a plain language summary of all approaches and assumptions applied. The reader of the report should be able to replicate all calculations based on the information in the report. Commercial impairment tests are often reviewed by a company’s auditors, who involve valuation specialists in reviewing the impairment tests. These specialists can be expensive and their time is often divided over many projects. Review times can be lengthy. If the reporting is clear, this will minimize time and expense of the audit review.
With impairment testing, the devil is in the details. Common mistakes includes the calculation of Carrying Amount, discount rates and terminal value approaches. Simple mathematical errors are also common. Checks should be built into the valuation model. If an income approach value far exceeds the market approach value, there must be a defendable explanation. Take the time to prepare comprehensive impairment testing documentation. This will reduce time and expense with your company’s auditors and will simplify future impairment tests.
3
Non-cash charges are expenses that can be found in a company's income statement, but they are not accompanied by a cash outflow. These are accounting expenses that can represent meaningful changes to a company's financial standing without affecting short-term capital in any way. Depreciation, amortization, depletion, stock-based compensation and asset impairments are common expenses that reduce earnings but not cash flows.
Investors need to distinguish between cash and non-cash expenses, because they have very different ramifications for financial health and valuation. Non-cash expenses from accrual accounting are different from non-recurring charges related to special events. One-time charges may not reflect a company's actual operations over the period when they are recognized.
Non-cash charges are necessary for companies that use accrual basis accounting. Depreciation, amortization and depletion are expensed throughout the useful life of an asset that was paid for in cash at an earlier date. The company's profits did not fully reflect the cash outlay for the asset at that time, so it must be reflected over a set number of subsequent periods. These charges are made against accounts on the balance sheet, reducing the value of items in that statement. Depreciation is generally associated with property, plant and equipment (PP&E). Amortization reduces intangible assets, such as capitalized development expenses. Depletion reduces the value of natural resource holdings
Non-cash charges can also reflect one-time accounting losses that are driven by changing balance sheet items. Such charges are often the result of changes to accounting policy, corporate restructuring, changing market value of assets or updated assumptions on realizable future cash flows.