Goodwill

Definitions

Goodwill

According to ASC 805, 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.

Goodwill typically arises from a business combination, which is covered in the investments material and revisited in more depth in the later chapter on consolidated financial statements. As a recap, below is an example journal entry following a business combination where goodwill arises.

Account	Debit	Credit	Financial statement element
Assets acquired (at fair value)	XXX		Assets
Goodwill	XXX		Assets (balancing)
Liabilities acquired (at fair value)		XXX	Liability
Cash		XXX	Asset
To record a business combination transaction with goodwill

In particular, there is goodwill when the price paid for the acquisition is more than the fair value of the acquiree’s assets and liabilities. Internally generated goodwill is not recognized. The goodwill is the balancing side of the journal entry serving as the excess between the purchase price (i.e., cash) and the net assets of the acquiree (i.e., assets less liabilities at fair value).

If the purchase price is less than the net assets acquired, then the transaction results in a net credit in a journal entry format. This represents a gain on bargain purchase which is an income statement item, as shown in the journal entry below:

Account	Debit	Credit	Financial statement element
Assets acquired (at fair value)	XXX		Assets
Gain on a bargain purchase		XXX	Gain (balancing)
Liabilities acquired (at fair value)		XXX	Liability
Cash		XXX	Asset
To record a business combination transaction with a gain on bargain purchase

Impairment of goodwill

Goodwill isn’t amortized, but it’s tested for impairment at least annually, or more often if there are signs its value might be slipping. What makes goodwill special is that it typically only exists because of an acquisition. That changes how we evaluate it: rather than looking at goodwill on its own, we focus on the reporting unit, which is the level of business at which the goodwill is managed and tested.

Definitions

Reporting unit

A reporting unit is defined as an operating segment (or one level below) that is regarded as a business with discrete financial info and for which management reviews results. Companies often must assign goodwill to these units and cannot test it at a higher (or legal-entity) level.

Once goodwill is assigned to reporting units, you follow the impairment sequence which is now the same as the impairment process for indefinite life intangibles:

Optional qualitative assessment

Before performing the quantitative test, a company may choose to apply a qualitative assessment. This step is not required but can reduce costs and effort if there are no signs of impairment.

The purpose of the qualitative test is to evaluate whether it is more likely than not (greater than 50% probability) that the fair value of a reporting unit is less than its carrying amount. If that threshold is not met, no further testing is required, and goodwill is considered unimpaired for the period.

Key factors to consider

ASC 350-20-35-3C and related guidance list several factors management should evaluate. These include, but are not limited to:

1. Macroeconomic conditions: Deterioration in general economic activity, capital markets volatility, changes in interest rates, inflation, or foreign exchange rates.
2. Industry and market considerations: Declining market share, reduced demand, competitive pressures, or unfavorable regulatory changes.
3. Cost factors: Increases in raw materials, labor, or other production costs that could negatively affect cash flows.
4. Overall financial performance: Declines in revenue, operating income, or cash flow compared with prior periods or forecasts.
5. Entity-specific events: Changes in management, restructuring plans, pending litigation, or loss of key customers.
6. Sustained decrease in share price or market capitalization: Particularly when the decline suggests the company is worth less than its net assets.

If, after weighing these factors, management concludes it is not more likely than not that fair value is below carrying amount, the analysis stops here. No impairment is recorded.

If it is more likely than not, the company must proceed to the quantitative test to measure any impairment loss.

Quantitative test

The quantitative test is required in either of the following situations:

• The company chooses not to perform the qualitative test; or
• The qualitative test indicates that it is more likely than not that the asset’s fair value is below its carrying amount.

This test involves the following process:

Compare the carrying value of the reporting unit (including goodwill) to its fair value.

If $\text{CV}>\text{Fair value}$, this means that the asset is impaired because the carrying value is currently overstated. Proceed to the next process.

If $\text{CV}<\text{Fair value}$, this means that the asset is not impaired because the future benefits are still estimated to be higher than the carrying amount in the books. In this case, there is nothing to do and the process ends here.

If applicable, write-down the reporting unit to its fair value, up to the amount of goodwill.

If the carrying value exceeds the fair value, the asset is written down to its fair value, and the difference is recognized as an impairment loss. As with finite-life intangible assets, fair value is defined as the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants on the measurement date (an “exit price”).

The impairment loss recognized equals the lesser of (a) the amount by which the reporting unit’s carrying amount exceeds its fair value, or (b) the total goodwill allocated to that reporting unit. Goodwill can never be written down below zero, and any excess beyond the goodwill balance isn’t recognized as a goodwill impairment loss. This lesser-of comparison is the only measurement step required under current guidance - the separate goodwill implied-value calculation once required as a second step has been eliminated.

The following journal entry can be booked:

Account	Debit	Credit	Financial statement element
Impairment loss - goodwill	XXX		Loss
Goodwill		XXX	Asset
To record impairment of goodwill

There is no specific requirement to credit the impairment to a contra-asset account.

In the CMA exam, you will not be required to compute fair value directly since this figure will be provided. Your task will be to use the given fair value to determine and record the impairment loss.

Example: Recognizing goodwill and testing it for impairment

River Co. acquires Bay Inc. for $1,000,000 cash. At the acquisition date, Bay’s identifiable assets have a fair value of $1,300,000 and its liabilities have a fair value of $500,000.

• Net identifiable assets acquired (fair value): $1,300,000 − $500,000 = $800,000
• Goodwill recognized: $1,000,000 − $800,000 = $200,000

Two years later, River tests the Bay reporting unit for impairment. The reporting unit’s carrying amount (including the $200,000 of goodwill) is $950,000, and its fair value is determined to be $820,000.

• Excess of carrying amount over fair value: $950,000 − $820,000 = $130,000
• Compare that excess to the goodwill balance: $130,000 is less than the $200,000 of goodwill, so the entire $130,000 is recognized as an impairment loss (if the excess had instead been, say, $250,000, the loss would be capped at the $200,000 goodwill balance, leaving goodwill at zero).

The following journal entry is recorded:

Account	Debit	Credit
Impairment loss - goodwill	$130,000
Goodwill		$130,000

Answer: Goodwill at acquisition = $200,000; impairment loss = $130,000.