Goodwill impairment 101: Definition, causes, testing, and calculations

What is goodwill impairment?

Goodwill impairment is an accounting charge a company records when the book value of goodwill is higher than its fair value.

• It signals that an acquired business is worth less than the price once paid.
• Companies must test goodwill at least once a year under accounting rules.
• The charge lowers reported earnings in the period it is booked.

Goodwill is an intangible asset tied to one company buying another. It stands for value that can give the buyer an edge. This guide explains goodwill impairment in plain terms. It also covers the causes, the testing steps, and the basic math.

In practice, goodwill shows up when the purchase price is more than the net fair value of the target’s assets and liabilities. The buyer then records it under long-term assets. For example, common drivers of goodwill include brand reputation, a loyal customer base, strong relationships, great service, and proprietary technology. Because of these factors, a buyer may pay more than fair value.

What is goodwill impairment?

In short, goodwill impairment is an accounting charge companies record when the book value of goodwill is greater than its fair value. So when a company books an impairment, it reports a loss in that period.

Goodwill impairment can worry investors. This is especially true during downturns, when cash flows tend to fall. As a result, goodwill charge-offs during recessions are often unusually large. Because of this risk, many businesses build recession-proof strategies into their plans.

Causes of goodwill impairment: When and why does it happen?

Goodwill impairment happens when an acquired business loses its power to generate cash. This drop pulls the goodwill’s fair value below its book value. In other words, impairment arises when book value is greater than fair value. The impairment amount is simply the gap between those two figures. To spot warning signs early, buyers often run technical due diligence before and after a deal.

Goodwill impairment testing

A goodwill impairment test is required at least once a year at the reporting level. This follows the generally accepted accounting principles (GAAP). Companies must review the goodwill value on their statements. Then they record any impairments they find.

A reporting unit is a business segment that management tracks on its own. As a result, it plays a key role in the test. For example, reporting units often stand for geographic areas, distinct business lines, or subsidiary companies.

An annual test is the minimum. However, some events can trigger an extra test during the year. In that case, a company runs a goodwill impairment test beyond the yearly one. Here are events and indicators that may prompt a test:

• Adverse changes in economic conditions
• Increase of competition
• Changes in key personnel
• Legal implications
• Deteriorating cash flows
• Assets showing a pattern of declining market value

The basic procedure for these tests is set by the Financial Accounting Standards Board (FASB). An impairment test runs in three stages.

Step 1: Preliminary qualitative assessment

First, the company checks whether the goodwill on its balance sheet is likely to exceed its fair value. This review weighs all relevant factors, such as the events listed above. If book value is not likely to top fair value, no more testing is needed. But if the result points the other way, the company moves to the next step. That step is the first stage of a two-stage quantitative test.

Step 2: Stage one of quantitative assessment

Next, the company works out the reporting unit’s fair value. Then it compares that value to the goodwill carried on the balance sheet. During this stage, the company weighs every factor that may have hurt the goodwill’s value. As a result, if the recorded goodwill does not exceed its fair value, no more testing is needed. However, if it does exceed fair value, the company moves to the final step.

Step 3: Stage two of quantitative assessment

Finally, the company looks at the reporting unit’s assets and liabilities one by one. This step finds that unit’s true fair value. If the unit’s goodwill still exceeds its fair value, the excess counts as an impairment. The company then reports that amount as a goodwill impairment charge in its financial statements.

How do you calculate goodwill impairment?

The exact amount can be open to some judgment. That is because impairment is the gap between a reporting unit’s book value and its fair value. Fair value is hard to pin down. So the common approach is to build a projected cash flow model to estimate it.

Meanwhile, calculating goodwill itself is fairly simple. First, add up the net fair market value of the target’s assets and liabilities. Then subtract that total from the purchase price. As a result, the difference is the goodwill. For teams that want help with this work, outsourced accounting support can keep the numbers clean and current.

Frequently asked questions about goodwill impairment

Is goodwill impairment a cash expense?

No, it is a non-cash charge. It lowers reported profit but does not move cash out of the business. Still, it can affect how investors view the company.

Can goodwill impairment be reversed later?

Under GAAP, no. Once a company records a goodwill impairment, it cannot reverse it in a later period. As a result, the write-down is permanent.

How often must companies test goodwill?

At least once a year. However, a company must test more often if a trigger event points to a possible loss in value.

How is goodwill different from other intangible assets?

Goodwill has no separate identity you can sell on its own. In fact, it only appears through an acquisition. So this makes it different from assets like a patent or a leased asset that you can value directly. Careful bookkeeping, including clear treatment of items like deferred rent, keeps these values accurate.

Key takeaways

• Goodwill impairment is a non-cash charge booked when goodwill’s book value tops its fair value.
• It often rises during downturns, when acquired businesses generate less cash.
• Companies must test goodwill at least once a year, plus after trigger events.
• The test runs in three stages, from a quick review to a full fair-value check.
• Goodwill impairment cannot be reversed once it is recorded.