Goodwill impairment is an important accounting concept for mergers and acquisitions. When an organization acquires and gains an asset, the total price of the acquisition will usually include both tangible and intangible assets. Goodwill is the excess amount that is paid over the tangible asset portion of the deal. For example, if a business buys another business for $10,000 and the sum of their tangible assets is only valued at $9,000, then the remaining $1,000 is goodwill.

GAAP requires that organizations create and record an intangible asset, such as goodwill, when an acquisition is made. Goodwill impairment arises when the fair value of the intangible asset, such as goodwill, drops below the amount recorded for it at the time of the acquisition.

Goodwill impairment can have a major negative impact on an organization’s bottom line. If the fair value of the intangible asset declines and the value of the asset is impaired, a charge must be taken against the earning of the organization to reflect this decrease in value. This charge is known as a goodwill impairment and it is an alarming sign for potential investors.

Goodwill impairment tests must be performed at least on an annual basis, as per GAAP standards. In the United States, this test is conducted according to the Statement of Financial Accounting Standards No. 142. Under the statement, a two-step test is used to determine whether a goodwill impairment has occurred.

In the first step, the value of the reporting unit, which is the component of the organization that is eligible for impairment testing, is compared to its recorded goodwill. The value of the reporting unit is calculated using either market prices of comparable businesses or a discounted cash flow analysis. If the fair value of the reporting unit is determined to be higher than the recorded goodwill, then the first step of the test is successfully passed, and no goodwill impairment has occurred. If it is lower, however, then further testing is required in the second step.

In the second step, an impairment is recorded if the fair value of the goodwill is determined to be lesser than the recorded value, based on the comparison. The amount of the impairment needs to be determined in order to adjust the value of the asset accordingly.

An important concept to remember about goodwill impairment is that it is a non-cash expense. This means that although an impairment loss is recorded, the actual cash outlay of the business does not change in such a transaction. However, such a recording does reduce the reported earnings of the business, which can have a long-term impact on the financial performance of the organization.

The concept of goodwill impairment is an extremely important tool in conducting business and investors should keep an eye out for its impact after major acquisitions. Goodwill impairment is a reminder that business enterprises are bound by economic forces that can be unpredictable and volatile. Companies must remain aware of these forces in order to continually adjust their operations to maintain a healthy financial position.