Goodwill is an accounting concept used when dealing with acquisitions.The total value of the acquired firm's net identifiable assets is likely to be more than the purchase price.Goodwill is the difference between the purchase price and the firm's market value.It is important to test goodwill to make sure it is not overstated.A simple impairment test can be used to learn how to account for goodwill impairment.
Step 1: You can learn the definition of goodwill.
Understanding goodwill impairment is not easy.When a business buys another business for more than the fair market value, it's called goodwill.If the business is purchased for more than the fair market value, goodwill is created because accountants will determine what the open market is worth.Suppose Company A has a fair market value of $1 million.Company B will pay $2 million for company A.In doing so, Company B pays $1 million more than the fair market value of Company A, and therefore a million in goodwill is created.Company A is worth more than company B.There are a lot of reasons.Company A may have excellent growth prospects, strong profit margins, a competitive edge, or be an excellent fit with Company B's current business model.Company B will show $1 million in goodwill on its balance sheet after the purchase.
Step 2: The book value is the carrying value of a business.
When you pay more than the company's assets are worth, goodwill is created.The carrying value is what the company's assets are worth.Carrying value is the value of the business that is carried on the balance sheet.The carrying value of a business is the same as the cost that was paid for the business's assets.If a business originally paid $2 million for its assets, and has $1 million in debts, its carrying value would be a million.Sometimes the carrying value of a company will be less than what the market is willing to pay for it.The purchase price of a business minus the fair market value is known as goodwill.Assume the carrying value of a company is $1 million and the fair market value is 1.5 million.If someone is willing to pay $2 million, the goodwill will be $500,000 or less.
Step 3: Understand Goodwill Impairment.
You have to test Goodwill for impairment each year.The value of your business may go up or down depending on market conditions.Poor market conditions or performance can mean that the market value will be less than the carrying value recorded on the balance sheet.It is necessary to decrease or impair the goodwill on the balance sheet if this happens.Assume you bought a business for $2 million.The carrying value and fair market value are $1 million, but it was decided that you would pay $2 million due to the advantages the business has.If a new competitor appears in the market that reduces the business's sales, your business would be worth less if you tried to sell it.If the value of your business falls so that it is worth less than the carrying value, you need to reduce the goodwill by the difference between what the business is now worth and what is recorded on your balance sheet.Assume that the balance sheet shows a carrying value of $1 million, plus a million in Goodwill.If something bad happens to your business and it is only worth $500,000 on the open market, you would need to reduce or impair the goodwill.
Step 4: Determine the reporting unit.
Goodwill impairment is done on a reporting unit basis.A reporting unit is a segment of the business that can provide financial information.An example would be a firm called Vet Corporation that purchases veterinary practices in the hopes of increasing each practice's profits due to centralized management.A reporting unit is the practice the firm buys.Maybe Vet Corporation bought 10 veterinary practices.The reporting unit for each practice would be separate.If Vet Corporation ever decided to sell it, each practice would have its own carrying value and unique value in the market place.
Step 5: The fair market value of each reporting unit should be estimated annually.
The veterinary practice of Dr. Brown was recently purchased by Vet Corporation.To determine if impairment is necessary, you need to know what this practice is worth on the open market.Calculating what a business should be worth on the open market can be difficult, so you need the help of a financial analyst.The price that similar transactions have gone for in the market can give you a rough idea.Historical data can be used to assume average prices.If a similar vet practice recently sold for 10 times its profits, you can assume it would sell for the same price.The market value of Dr. Brown's practice would be $800,000.
Step 6: The carrying value of the reporting unit is compared to the market value.
The value of the company's assets, minus any debts, is the carrying value.The carrying value is assumed to be $900,000.The carrying value is $900,000 if you look on your balance sheet.Assets of $1 million, minus debts of $100,000, is what this means.There is no need for goodwill impairment if the market value is higher than the carrying value.The next step in the impairment test is determining the cause of the difference between the market value and carrying value.The market value is lower than the carrying value.
Step 7: The goodwill impairment can be recognized with the journal entry.
You can open accounting software to make journal entries.Goodwill needs to be impaired by $100,000.To record the journal entry, Vet Corporation should credit Goodwill for $100,000.The transaction does two things.The goodwill account is reduced by $100,000 by crediting goodwill.The goodwill asset account is reduced because the business is worth $100,000 less than recorded.A loss of $100,000 will appear on the income statement as an expense if you deduct Loss on Goodwill Impairment.The amount of goodwill on the balance sheet has to be reduced in order for the income statement to show an expense.Your profits will be $100,000 less for the year.