What it is:
How it works (Example):
For example, let's assume that Company XYZ purchases Company ABC. The book value of Company ABC's assets is $10 million, but for various good reasons, Company XYZ pays $15 million for Company ABC. Because Company XYZ paid $15 million for $10 million worth of assets, Company XYZ records $5 million of goodwill as an asset on its balance sheet.
After the acquisition, Company ABC's sales fall by 40% over the year because Company XYZ changed its product line, which proved unpopular. Also, a competitor introduced a newer, lighter, faster, and cheaper product. As a result, Company ABC's fair market value falls to $8 million.
A year has now passed, and for Company XYZ, this means comparing the fair value of Company ABC to the book value on XYZ's financial statements. If the fair value of Company ABC is less than the book value (that is, if Company XYZ were to sell Company ABC today, it wouldn't get a price equal to or greater than its recorded value), Company XYZ must make a goodwill impairment.
In this example, Company XYZ would compare Company ABC's current fair market value of $8 million plus the $5 million of goodwill (a total of $13 million) to the $15 million it has recorded as Company ABC's value on its books. The difference between the two is $2 million, and Company XYZ must therefore reduce the goodwill on its books by that amount. The goodwill entry on its balance sheet goes from $5 million to $3 million, and its total assets fall correspondingly.
Why it Matters:
When a company records a goodwill impairment, it is telling the market that the value of the acquired assets has fallen below what the company generally paid for them.
Goodwill can represent a large amount of a company's net worth, and acquisitions (especially in the age of technology) often involve the purchase of things that by and large are intangible. But overinflating goodwill can mislead investors, and simply amortizing goodwill (which used to be the procedure) can also create artificial values for the asset. To find a more accurate value and therefore provide more meaningful and accurate financial statements, companies must therefore test their goodwill by comparing the actual value of the assets in question to their recorded value and adjusting for the difference every year.