Introduction:
Everyone knows that cash is the king whether it’s a small retail shop or a large multinational organization. How large accrual income a business may be, but it might not be able to operate its operations without holding sufficient cash.
Now, let’s have some brief idea of what happens in a typical cash flow statement, there are three main parts of a cash flow statement,
- Operations
- Investing
- Finance
Each of them tells you what exact amount is flowing into business (positive cash flow) and what exactly amount of cash is flowing from business (negative cash flow).
Also at the end of each part, a subtotal is calculated, of course at end of the statement three subtotals are summed up that lead to net cash flow for the period.
For the sake of standardization & comparability for readers of the statement, International Accounting Standard Board (IASB) has set an International Accounting Standard (IAS-07) that governs this statement and provides the structure and reporting pattern.
Now, let’s figure out some more things about the statement. In the beginning, there are some adjustments for the accruals (non-cash income or expenses) of the period, like depreciation of fixed assets, amortization of intangibles, impairment of goodwill, provisions, etc.
Effect of Goodwill on Cash Flow:
To understand how goodwill affects a cash flow statement, you first need to figure out what goodwill is??
You don’t need to worry about the goodwill it’s quite a simple thing. It’s an intangible asset.
How it’s measured??
When an entity acquires another entity or any of its asset(s) or group of assets (i.e. cash-generating unit). And for that, it pays a price significantly higher than the fair market value.
Goodwill = Consideration Paid – Market value of subject matter
After acquiring the business unit (or asset), the entity – which purchased the other entity or its assets – recognizes over its balance sheet this difference under the name of ‘goodwill’. So, have you seen how easy the concept of this thing is?
Now we’re gonna tell you some other aspects of the goodwill. Once it appears on the balance sheet of the entity it’s just the start of the story. Every year, the entity has to take a test.
Test the goodwill, if it’s impaired (damaged) or not, if so, the amount of impairment needs to be estimated, and book this amount as an expense. Of course, it’s purely an accrual (non-cash expense) entry.
Now let’s move to our topic which is the adjustment on the cash flow. As you guys have noticed impairment is booked as an expense and every expense reduces profit.
But an accrual does not affect the cash flow. That’s why when the accountant drafts the cash flow he/she adds back any impairment recorded during the period into a profit of the entity.
To illustrate the same concept, let’s have a practical case. XYZ is an entity having an opening balance goodwill of amount $ 2,000 as the period 20X9, and the impairment test comes positive with an amount of $ 450.
The income statement shows a net profit of $ 6,350 for the period 20X9. When a cash flow statement is prepared the amount of impairment i.e. $ 450 is added back to profit i.e. $ 6,350.
And hence adjusted profit is calculated avoiding the effect of accrual i.e. $ 6,800.
Conclusion:
It’s noteworthy that in various cases there may be no indication of goodwill. Definitely, in that case, no adjustment is required in the cash flow statement.
In some cases, there may be a reversal of impairment in a subsequent year, but in the case of purchased goodwill, it cannot be reversed.
Further, if an entity is having losses (instead of profits) the impairment is not added, rather it would be deducted from losses.
As you have noticed, goodwill is something that cannot be disassociated from the thing it comes with. Therefore, it cannot be sold apart from that thing (asset or business).
