How it works (Example):
Generally, anoccurs when a company (1) pays more than for a set of assets and (2) later lowers the value of those assets.
For example, Generally Accepted Priciples (GAAP) require companies to "test" goodwill every year for impairments. For example, let's assume that Company XYZ purchases Company ABC. The 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 on its balance sheet.
After the acquisition, Company ABC's sales fell 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 falls to $8 million.
A year has now passed, and for Company XYZ, this means comparing the fair value of Company ABC, now a subsidiary, to its carrying amount on XYZ's (including goodwill). If the fair value of Company ABC is less than the carrying 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 has an 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 therefore goes from $5 million to $3 million, and its total assets fall correspondingly.
Why it Matters:
When a company records an, it is telling the that the value of the acquired assets has fallen below what the company originally paid for them.