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A phrase used in finance regarding company budgets is goodwill impairment, and the terms are a label used to identify property the company bought for more than it was worth or bought and saw the fair market value of the goods fall below what was paid. This accounting term is part of the Generally Accepted Accounting Principles (GAAP) that modern businesses use.
The Financial Accounting Foundation shares that GAAP are an essential part of business financial reporting as they allow investors to make sound decisions, and they also help keep businesses operating in a transparent and clear manner.
When Does Accounting Goodwill Occur in Business?
Companies track their goodwill adjustments on a yearly basis to determine the long-term impact of investments and acquisitions. If a company’s balance sheet shows goodwill impairments occurring with relative frequency, it may mean that the company isn’t making intelligent purchases.
Adjusting the value of an asset downward impacts the overall worth of the company, so conducting examinations of the company’s balance sheet each year ensures the company isn’t overstating its worth. Goodwill adjustments are also how a business will record the purchase of another business after it agrees to pay more for the company than it is worth.
Such investments may prove profitable in the long-term, but they are recorded as goodwill when they happen and reduce the overall worth of the company. The company won’t amortize or depreciate the asset or acquisition as they might with other tangible items, but GAAP rules will require that the company reexamines the asset regularly.
Goodwill Adjustment Example
A company’s net worth may change based on the assets it acquires during the year, and a goodwill adjustment may result. For example, Company A decides to buy Company B for 15 million dollars, but Company B is only worth 10 million dollars. In some circumstances, it might make sense for Company A to pay extra for the acquisition. At the close of the year, Company A would record an adjustment of 5 million dollars on the official balance sheet.
Alternatively, a goodwill entry may stem from a company’s purchase of another company or set of assets after which that acquisition’s value falls significantly. For example, the acquired company experiences a drop in sales that reduces its fair market value to half what it once was. The parent company would record this drop in value on its balance sheet using GAAP.
Measuring Goodwill on the Balance Sheet
Recording goodwill helps the company’s decision-makers make future investments, as well as decide when it might be time to sell an underperforming asset. The digital age has ushered in a variety of intangible assets where values frequently increase and decrease with market conditions. Goodwill adjustments are all but necessary in this type of business environment.
PriceWaterhouseCoopers explains that there are close to a dozen tests and habits a business should use when determining whether to apply a goodwill adjustment to the balance sheet. Those methods include starting impairment testing at an early date, complying with all disclosure agreements, and reconciling the conclusion to external market data.
Goodwill impairment is relatively simple to understand when it occurs, but the reporting process under GAAP tends to require an in-depth study of accounting or a formal education within that industry. Understanding the general principle of goodwill impairment and the impact it might have on a business will help an entrepreneur, business owner, or investor make sound decisions when interacting with a company as a stockholder or business partner.