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As we enter the final stretch of the fiscal year, many companies are gearing up for a familiar yet crucial task—their annual goodwill impairment test. For most, this isn’t a process to be taken lightly. Goodwill often represents a significant portion of a company's balance sheet, particularly for businesses that have been active in mergers and acquisitions. But first, let’s take a step back to understand what we’re dealing with.
What is goodwill?
Goodwill is an asset representing the future economic benefits arising from other assets acquired in a business combination or an acquisition by a not-for-profit entity that are not individually identified and separately recognized.
In simpler, economic terms, it includes the established reputation of a business, excellence of management, future growth potential, culture, and the worth of a company’s identity as well as the value of inseparable but important intangible assets, such as a skilled workforce and other value derived from the ongoing operation of the business. Goodwill embodies the belief that an established business will continue to recognize and effectively capitalize on new opportunities, generating a higher return on its combined net assets than would be possible if those assets were acquired separately.
However, goodwill recorded on the balance sheet isn’t a set it and forget it asset. Under U.S. GAAP, companies are required to test goodwill for impairment at least annually, and more frequently if there are indicators of impairment—known as triggering events. This test is crucial because goodwill can lose value over time, especially when external market conditions shift or internal changes occur. Testing goodwill regularly ensures that a company’s financial statements reflect reality and aren't overstating its value.
10 key considerations for goodwill impairment testing
Now, let’s break down the process of goodwill impairment testing, starting with the 10 key considerations, common pitfalls, and best practices to keep in mind as you embark on your annual assessment.
1. Identify reporting units properly
One of the first steps in goodwill impairment testing is identifying the reporting units to which goodwill is assigned. Reporting units represent the unit of account for impairment testing of goodwill. Reporting units are typically aligned with operating segments (or a component of an operating segment) of the business, where the CODM makes resource allocation decisions. However, businesses evolve over time—through mergers, acquisitions, and internal reorganizations—so it's critical to reassess how reporting units are defined each year.
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Common pitfall |
Misidentifying reporting units or failing to re-assess them after organizational changes can lead to improper goodwill allocation. This misstep often results in inaccuracies in impairment tests, potentially overstating or understating the value of goodwill in a specific unit. |
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Best practice |
Review reporting units annually, especially after significant changes to the business, such as acquisitions or reorganizations. The goal is to align your reporting units with how your CODM makes operational decisions, allocates resources, and evaluates the business. A change in reporting units that results from changes in facts and circumstances of the reporting entity is a change in estimate under ASC 250. This means the change is accounted for prospectively and previously issued financial statements are not reconsidered. |
2. Leverage the qualitative test first
U.S. GAAP offers companies the option to perform a qualitative assessment, also known as “Step 0,” to determine if it’s more likely than not that goodwill is impaired. The qualitative assessment acts as a screen for determining if it is necessary to perform the quantitative test. While the screen can allow companies to possibly avoid a more detailed and time-consuming quantitative test, it requires careful judgment, as skipping over potential impairment indicators can lead to issues down the road. A reporting entity always has the option to bypass the qualitative assessment for a reporting unit and proceed directly to the quantitative impairment test.
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Common pitfall |
Over-relying on the qualitative test without fully assessing all relevant indicators of impairment. Companies sometimes rush through this step to avoid a more robust quantitative analysis, but this can result in overlooking early signs of impairment. Also, performing the qualitative test too late could be problematic if the screen results in needing to perform a quantitative analysis. |
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Best practice |
An entity should consider the totality of evidence in reaching its conclusion about the likelihood that the fair value of a reporting unit is less than its carrying amount. Use qualitative factors—such as market trends, industry conditions, and company-specific developments—to assess the likelihood of impairment. Consider both external and internal factors thoroughly, including negative evidence. If negative indicators are present, don’t hesitate to move forward with the quantitative test. Entities must gather enough evidence to conclude that it is more likely than not that the fair value of a reporting unit or indefinite-lived intangible asset equals or exceeds its carrying amount. The depth of the analysis will depend on the specific facts and circumstances. Documentation is crucial for this assessment and should include:
The analysis should classify each identified event or circumstance as positive, neutral, or negative evidence. More detailed evidence is typically required as the likelihood of fair value falling below the carrying amount increases. The results of the qualitative test do not need to be definitive that the reporting unit is impaired before proceeding to the quantitative test. Even if the screen fails the more likely than not assessment, a reporting entity may still conclude that there is no impairment in the quantitative analysis. |
3. Stay in tune with market conditions
Goodwill valuation is closely tied to the future cash flows a reporting unit is expected to generate. Therefore, market conditions—both at the macro and industry levels—play a critical role in the goodwill impairment process. When economic conditions are favorable, impairment might seem unlikely. However, during downturns or times of heightened competition, the risk of impairment increases significantly.
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Common pitfall |
Focusing too much on internal performance metrics and neglecting broader market trends and assumptions from a market participant perspective. Changes in economic conditions, industry competition, or customer behavior can drastically affect the value of goodwill, and overlooking these trends can result in missed impairments. |
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Best practice |
Regularly monitor macroeconomic indicators and industry trends that could signal potential goodwill impairment. Keep an eye on sector-specific risks, competitor performance, and broader market dynamics, such as interest rate changes or shifts in consumer behavior. The key drivers of fair value in a discounted cash flow model require significant judgment and should be from a market participant perspective. By staying proactive, you can recognize warning signs early and adjust accordingly. |
4. Keep an eye on internal changes
Internal events such as restructuring, management changes, or the loss of key personnel or major customers can have a significant impact on a reporting unit’s cash flow potential. When major shifts occur within the company, they can alter the future cash flows that the unit is expected to generate, making it essential to reassess the goodwill tied to that unit.
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Common pitfall |
Failing to recognize that major internal changes may necessitate an earlier goodwill impairment test, rather than waiting for the annual assessment. Significant operational shifts or losses in major revenue streams are often strong indicators of goodwill impairment risk. |
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Best practice |
Be vigilant about internal shifts, particularly after major events like restructuring, loss of key personnel, or operational realignments. When a restructuring or reorganization occurs at the reporting entity and reporting units change, it is important to consider whether that change is an indicator of impairment that would require impairment testing. Also, internal changes can diminish a reporting unit's ability to meet cash flow projections and raise the risk of goodwill impairment. Factors such as recent operating losses at the reporting unit level, downward revisions to forecasts, or restructuring actions or plans may be a trigger suggesting there is evidence that more likely than not a reporting unit’s fair value is below its carrying amount. Don’t wait for the annual testing period—interim testing may be warranted in cases of significant internal disruption. |
5. Use realistic projections
Projections of future cash flows are at the heart of many goodwill impairment tests when an income approach is used to measure fair value. Overly optimistic cash flow projections can mask potential impairments, making the company’s financial statements appear stronger than they actually are. On the flip side, overly conservative projections can lead to premature impairment.
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Common pitfall |
Using overly optimistic cash flow projections that don’t account for current market conditions or don’t reflect current market participant assumptions. This is a common issue, especially when pressure to meet investor or board expectations drives forecasting decisions. |
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Best practice |
Make sure your cash flow projections are grounded in realistic assumptions based on historical data, current market trends, and attainable business goals based on market participant assumptions. Expected future cash flows typically originate from a recent business plan or internal budget for the reporting unit being assessed. To align these cash flows with a market participant perspective, management’s forecasts are compared to industry analysts' projections, competitor data, third-party economic forecasts, and other macroeconomic factors. Adjustments may be necessary if internal forecasts differ from what a market participant might reasonably achieve. These adjustments ensure that the valuation aligns with the income approach premise, which bases the fair value of a reporting unit on its expected future cash flows. Reporting entities should also be mindful to avoid overly aggressive growth rates or profit margins that may not reflect actual performance. Involve cross-functional teams—such as finance, operations, and strategy—to ensure projections are well-rounded and credible. |
6. Validate discount rates and assumptions
The discount rate applied in goodwill impairment testing is crucial as it impacts the present value of future cash flows when an income approach is used for fair value measurements. This discount rate represents the return investors would expect from an investment with similar cash flow amounts, timing, and risk profile. The rate should reflect the current risk profile of the reporting unit and external market conditions. A small change in the discount rate can drastically alter the impairment results, so it’s important to get this step right.
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Common pitfall |
Applying a discount rate that doesn’t reflect the current risk profile of the reporting unit or market conditions. A rate that’s too low may artificially inflate the value of future cash flows, reducing the chance of impairment when it may be warranted. |
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Best practice |
Regularly revisit the discount rate to ensure it reflects both current market risks and the specific risk profile of the reporting unit and engage a valuation specialist to support your assumption. Since a directly observable market rate is uncommon, entities typically construct a market participant discount rate that accurately accounts for the risks tied to the reporting unit's cash flows as of the measurement date. The most common approach is to estimate the appropriate rate using the reporting entity’s weighted-average cost of capital (WACC). Consider using a range of discount rates to test the sensitivity of your results. Always document the rationale for selecting your discount rate. If a WACC approach is used, support selection of key components of that calculation include:
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7. Accurate fair value measurement
When performing the quantitative test, the fair value of the reporting unit must be carefully measured. This involves selecting the appropriate valuation methodology, whether it’s the discounted cash flow (DCF) approach, a market-based method, or a combination of techniques.
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Common pitfall |
Relying on only one valuation method can lead to biased results in some cases. For example, focusing solely on the DCF method without considering market comparables and ignoring publicly quoted market prices of equity securities for a reporting unit could give an incomplete picture of fair value. |
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Best practice |
If a reporting unit has publicly traded equity securities, their market prices are generally the most reliable indicator of fair value. When such prices are unavailable, the choice of valuation methods depends on the key value drivers, input reliability, and how a market participant would assess and price the reporting unit. Entities should contemporaneously document their chosen methods, key assumptions, and consistent application. Often, multiple valuation methods, such as market and income approaches, are appropriate. If multiple approaches are used, their results should be considered, weighted appropriately, and corroborated. |
8. Don’t overlook triggering events
While goodwill impairment tests are required annually, as previously highlighted certain events during the year can also trigger the need for an interim impairment test. These triggering events can arise suddenly and warrant immediate attention.
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Common pitfall |
Ignoring triggering events because they happen between annual testing cycles. Failure to address these events when they occur can lead to late recognition of impairments or create last minute fire drills to perform the assessments. |
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Best practice |
Continuously monitor for potential triggering events. Some key factors to consider include:
Keep in mind this list is not exhaustive. Remember the threshold for an interim test is when a reporting unit trips the ‘more likely than not’ that its goodwill is impaired. More likely than not suggests at least 50% certainty. If you conclude you meet the threshold, do not delay performing the impairment assessment as a quantitative test will likely need to be performed since the factors for evaluating the qualitative test for annual impairment testing are the same as a trigger based test. |
9. Document everything
Goodwill impairment testing involves many judgments and assumptions, and failing to properly document these decisions can lead to problems during audits or regulatory reviews. Thorough documentation not only supports your reasoning but also ensures compliance with accounting standards.
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Common pitfall |
Insufficient documentation of the assumptions, methodologies, and judgments made during the testing process. This can lead to difficulties during audits or make it challenging to defend impairment conclusions. |
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Best practice |
Maintain detailed records of every step in the goodwill impairment testing process. This includes documenting fair value methods selected, key assumptions, discount rates, cash flow projections, and the rationale behind any decisions made. Comprehensive documentation will also make it easier to revisit the impairment test in future periods. |
10. Consider private company accounting alternatives
Certain have accounting alternatives that allow them to simplify the goodwill accounting process. Under US GAAP, private companies and not-for-profit entities (NFPs) can simplify their goodwill accounting through two optional accounting policy alternatives:
Goodwill Amortization Alternative:
- Allows private companies and NFPs to amortize goodwill from acquisitions over a 10-year (or less) useful life and use a simplified one-step impairment test.
- Applies to all existing and newly recognized goodwill, including goodwill from business combinations, joint venture formations, equity method accounting, and fresh-start accounting.
Goodwill Triggering Event Evaluation Alternative:
- Allows private companies and NFPs to assess goodwill impairment triggering events only at the end of their annual or interim reporting periods, rather than continuously.
- Applies to goodwill accounted for under ASC 350-20 and is optional, enabling entities to follow standard goodwill impairment guidance if preferred.
Private companies and NFPs may elect either or both alternatives independently. These options aim to reduce the complexity of goodwill accounting for eligible entities.
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Common pitfall |
Private companies may not be aware of the PCC alternatives and continue to perform annual impairment tests unnecessarily, adding complexity and cost to the process. |
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Best practice |
If you’re a private company, consider the PCC accounting alternatives for goodwill. By electing to amortize goodwill over time, you reduce the need for annual impairment testing, streamlining the process and lowering costs to comply. Before making any elections and implementing the elections, ensure you consult to make sure this approach is right for your company, including any implications of an election. For example, if your company has plans to become a public business entity (PBE) in the near future, any such private company alternative elections would need to be unwound to comply with US GAAP for PBEs. |
Final thoughts
Goodwill impairment testing is a delicate balancing act with many factors to consider along the way. As companies prepare for their annual tests, keeping an eye on these key considerations, avoiding common pitfalls, and following our best practices can make all the difference in ensuring accurate financial reporting and smoother year-end audit.
If you’re looking for more support on technical accounting guidance or valuation assistance with your goodwill impairment testing, don’t hesitate to reach out to us at Embark. We’re here to make sure you get it right, every time.
