What is goodwill?
Goodwill is an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually recognized and separately identified.
It is recorded and recognized in the balance sheet as long-term assets when a company purchases another company and owns more than 50% of shares.
How to perform an impairment test for goodwill?
The examination of goodwill impairment involves the following steps:
- Assess qualitative factors such as increased costs, deterioration of macroeconomic conditions, declining cash flows, change in management, possible bankruptcy. Such factors help to review if further impairment testing is needed to be carried out.
- Compare the fair value of the unit to it carrying amount and include goodwill in the carrying amount as well. If the fair value is greater than the carrying amount, then there is no impairment loss.
- Calculate impairment loss as to the difference of carrying amount is greater than the fair value but limited to the value of carrying amount of goodwill.
Stage 1: Preliminary qualitative assessment:
The company must ensure whether the goodwill reflected in the books would exceed its fair market value. It is to be checked on the basis of macroeconomic developments, political and legal changes, the existence of current competitors, management, and the structure of the company.
If this assessment shows that the goodwill in the balance sheet will not exceed its fair market value, then no further testing is required. But if it exceeds, then a preliminary qualitative assessment is required.
Stage 2: Quantitative assessment:
It consists of calculating the fair value of the reporting unit on which goodwill is based and then comparing the fair value with the book value of goodwill shown in the balance sheet. The company must calculate the relative impact of all factors that may materially affect the value of goodwill.
If this assessment reveals goodwill does not exceed the fair value, then the company must proceed to the next stage of the quantitative assessment.
Stage3: Quantitative assessment:
The company checks the value of individual assets and liabilities of the entity to find its fair value. On the basis of this analysis, if the company determines the goodwill to exceed the fair value, then excess goodwill is treated as an impairment to goodwill. This value is ultimately shown as an impairment loss in the books of accounts.
Journal entry for impairment of goodwill:
| Account | Dr | Cr |
| Goodwill impairment expense (P&L) | XXXX | |
| Goodwill (BS) | XXX |
Proportionate goodwill and impairment review:
When goodwill has been calculated on a proportionate basis, it is necessary to gross up goodwill to carry the impairment test. Any impairment loss that arises is first allocated against the recognized and unrecognized goodwill in the normal proportion that the parent and its non-controlled entity share profits and losses.
Any amount which has been written off against the goodwill in the books will not affect the consolidated financial statements and the branch entity.
If the total impairment loss is more than the amount allocated against recognized and goodwill of books, the excess goodwill be allocated against any other assets on a pro-rata basis. This loss will be shared between the parent and non-controlling entity in the normal proportion of their usual sharing of profits and losses.
Gross goodwill and impairment review:
When goodwill has been calculated in gross, any impairment loss will be allocated between the parent and NCI in the normal proportion of their profit and loss sharing ratio.
Example of impairment review of proportionate goodwill:
The year-end impairment review is being conducted on a 65% owned subsidiary. At the date of the review, the carrying amount of assets of the subsidiary was 200 million, goodwill attributable to the parent was 250 million, and the recovery amount of the subsidiary was 400 million.
Now it is necessary to gross up the goodwill so
Gross goodwill= 250*100/65=384.62 million
Now for the purpose of impairment review, the goodwill of 384.62 million and net assets of 200 million form the carrying amount of cash-generating unit.
Impairment review:
Carrying amount of:
| Net assets | 200 million |
| Goodwill | 384.62 million |
| Total | 584.62 million |
| Recoverable amount | 400 million |
| Impairment loss | 184.62 million |
The impairment loss, in this case, is less than the total of recognized and unrecognized goodwill, so in this case, goodwill is only impaired, not other assets.
Only the parent’s share of goodwill impairment loss will be recorded, i.e.65% of 184.62 million=120.003 million.
Impairment review of gross goodwill:
Example:
At the year-end impairment, a review is conducted on a 70% owned subsidiary. The carrying amount of net assets was 600 million and gross goodwill of 450 million out of which (60 million allocated to NCI) and the recoverable value of the subsidiary as 700 million.
The impairment review of goodwill is actually the impairment review of goodwill and net assets of NCI as a Cash generating unit for which we can calculate the recoverable value.
Carrying amount:
| Net assets | 600 million |
| Goodwill | 450 million |
| Total | 1050 million |
| Recoverable amount | 700 million |
| Impairment loss | 350 million |
This impairment loss will be used to write down the value of goodwill so that goodwill will appear in books at 450-350=100 million
In the PL statement, an impairment loss of 350 million will be charged as an extra-operating expense.
How to perform an impairment test for goodwill?
- Start impair testing early. Goodwill can be tested earlier at the beginning. If any impairment indicator arises between the testing date and balance sheet date, the impairment assessment should be updated.
- Comply with the disclosure requirements such as
- Key assumptions on which management bases its cash flow projections
- The period over which cash flows have been projected
- The growth rate used to extrapolate cash flow projections beyond the period covered by budgets.
- Allocate goodwill to the appropriate Cash generating units: Goodwill doesn’t generate cash flow independently, so the recoverable value can’t be independently measured. So, goodwill acquired in the acquisition is allocated from the acquisition date to each of the Cash generating units that are expected to take advantage of the synergy.
- Make sure that the cash flows are consistent with the assets being tested. They must match with each other.
- Reconcile the final result by comparing it with the external market data and check whether the economic assumptions made earlier still make sense.
- Pay attention to market capitalization. If the market capitalization is lower than the value in use, then the assumptions made about the market environment can be challenged.
- Cash flows used in the impairment calculations should be reasonable: Forecasts made in the previous months need to be rechecked and reassessed. Forecasts should be made on the latest management budgets. Greater weightage should be given to evidence sourced from outside.
- Value in use should comply with the standard.
