Understanding the Accounting Treatment of Goodwill: Amortization vs. Impairment Testing

When discussing the treatment of goodwill in accounting, it is often a common misconception that goodwill is amortized. In reality, goodwill is not amortized but rather subjected to annual impairment testing. This article will provide a comprehensive understanding of the differences between goodwill amortization and impairment testing, along with the relevant accounting standards and practices.

Amortization of Goodwill vs. Impairment Testing

Unlike other types of intangible assets, goodwill is not amortized. Instead of a systematic reduction in value over time, goodwill is periodically tested for impairment. This means that the value of goodwill is not systematically reduced unless there is evidence of a decline in its value due to specific events or changes in market conditions.

Relevance to Accounting Standards

US GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards) both have specific requirements for the treatment of goodwill:

US GAAP: Under US GAAP, goodwill is no longer amortized but is subjected to annual impairment testing or more frequently if indicators of impairment are present. IFRS: According to IFRS, goodwill is also not amortized, but the treatment may vary slightly in terms of the methods and procedures used.

Impairment Testing for Goodwill

During impairment testing, several key steps and calculations are involved to determine whether goodwill is impaired. Here, we will outline the relevant procedures and terminology as per US GAAP:

Recoverability Test

The recoverability test is the first step in the impairment testing process. An asset is considered to be impaired if the recoverable amount is less than the net book value. The recoverable amount is defined as the higher of the asset's fair value less costs to sell and its value in use. The net book value, on the other hand, is the original cost of the asset less any accumulated amortization and impairment losses.

The recoverability test involves the following two components:

Estimate the recoverable amount: This involves calculating the fair value less costs to sell and the value in use. The higher of these two should be considered as the recoverable amount. Compare with net book value: If the recoverable amount is less than the net book value, the asset is considered impaired.

Actual Loss Calculation

If goodwill is found to be impaired, the actual loss is calculated through the following formula:

Impairment Loss Net Book Value - Fair Market Value

This loss is then recognized in the income statement and recorded in the carrying amount of the goodwill on the balance sheet.

Practical Considerations and Examples

Let's consider an example to illustrate the process of impairment testing:

A company acquires Company A for $10 million in cash. The fair value of Company A is assessed at $12 million, and goodwill is calculated as:

Goodwill $10 million (purchase price) - $8 million (book value of identifiable net assets) $2 million

Years later, the company determines that the fair value of Company A is $7 million, and the fair value less costs to sell is $6.5 million. The recoverable amount is $7 million (the higher of the two values).

The net book value of goodwill is also $2 million.

Since the recoverable amount ($7 million) is less than the net book value of goodwill ($2 million) under the value in use test, goodwill is considered impaired. The actual impairment loss would be:

Impairment Loss $2 million (net book value) - $7 million (recoverable amount) $0 million (in this hypothetical case, no impairment loss is recognized as the recoverable amount is less than the net book value in the example)

In a more applicable scenario, if the recoverable amount were less than the net book value, the impairment loss would be recognized and the carrying amount of goodwill adjusted.

Conclusion

It is essential for financial professionals, auditors, and investors to understand the difference between goodwill amortization and impairment testing. Goodwill is not amortized but rather tested annually or more frequently to ensure that its carrying amount on the balance sheet reflects its current fair value.

By following the procedures and guidelines as per US GAAP and IFRS, companies can accurately assess and report the value of goodwill, ensuring transparency and reliability in financial reporting.