Why Is Impairment Testing Of Goodwill Necessary?

Are you an accounting student who has to conduct an impairment testing of goodwill? Do you often wonder what is impairment testing, why should you be concerned about it and how do you need to conduct the goodwill impairment testing? Then get a detailed explanation from the accounting assignment help provider at My Assignment Services and resolve all your doubts.

What actually is impairment?

Though you must be aware of what impairment is, there is no harm in recalling it, right? Impairment is when the value of the company assets drops. This directly affects the company’s stock prices.

Let me give an example of impairment. Imagine a company called ABC General has a factory which has a fleet of machines whose value is $100 million dollars. Machinery worth 100 million dollars gives the investors a strong belief that the company is performing well and values the stock on the basis of that.

But voila, a new technology comes in and the machinery used by ABC General becomes outdated. Thus, the value of the machinery reduces to $50 million. This is when ABC General declares that their assets have impaired. Due to this, the stock value of the company drops.

NOTE: Impairment is different from depreciation. Depreciation is when the value of the assets reduce over time due to age and wear. Impairment is when the asset’s value has been permanently reduced in the value books. Depreciation does not affect the stock price of the company but impairment does.

What is goodwill?

When a company buys acquisition into another company, they are expected to pay the fair value of the asset. But sometimes, the amount paid is more than the fair value in the hope that the asset will bring in economic benefits in the future. This additional payment made to the acquisition is called goodwill.

For example, Microsoft acquired Skype Technologies in 2011 for $8.5 billion which was 32 times more than the operating profits of Skype.

The $8.2 billion that Microsoft paid is the goodwill.

How to test goodwill for impairment?

Since goodwill is not a separate entity or asset, it is not possible to conduct an impairment testing for goodwill as an individual asset. There is no fair value of the goodwill and does not actually bring in anything to the company. Thus, it cannot be treated as an individual asset on which you can conduct an impairment testing.

Steps of impairment testing

Company A bought 100% shares in Company B for $200,000 while the fair value of the assets of Company B was $185,000.

Company B operates in -

1. Division 1 - net assets $70,000

2. Division 2 - net assets $50,000

3. Division 3 - net assets $80,000

The goodwill was allocated as -

1. Division 1 - $6,000

2. Division 2 - $4,000

3. Division 3 - $5,000

The value of Division 3 after 5 years was $67,000 with the asset values as -

1. Buildings - $50,000

2. Equipment - $15,000

3. Other assets - $6,000

Though our focus will be Division 3, goodwill test of Division 1 and 2 will also be conducted.

Carrying amount

Buildings = $50,000

Equipment = $15,000

Other assets = $6,000

Allocated goodwill = $5,000

Total carrying amount = $76,000

Recoverable amount

Fair value of Division 3 = $67,000

Value in use of Division 3 = $65,000

Impairment loss

= Fair value of division - Total carrying amount

= $67,000 - $76,000

= - $9,000

The goodwill allocated to Division 3 was $5,000 reducing the goodwill to net zero. The additional loss of $4,000 is as -

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