When companies buy other companies or blocks of business they often overpay. The amount of this overpayment is referred to as “goodwill” in the accounting literature. As part of allowing this goodwill to occur it is necessary under the United State’s Generally Accepted Accounting Principles accounting standard to annually test if the company or block bought is living up to this goodwill.
The definition of this goodwill impairment testing is listed in Financial Accounting Standard (FAS) number 142 in paragraphs 18 through 40. As a Fellow of the Society of Actuaries with experience in this testing the following article will summarize the impairment testing process in the following steps.
Initial Step: Find the Goodwill
Goodwill resides with the entity purchased by basic principle. Finding which entity owns that entity can be tricky as it may not reside in the main holding company but in a subsidiary. Depending on where that subsidiary is domiciled it may mean that impairment testing is unnecessary if the financials for both companies are combined.
Step 1: Determine if Impairment is Possible
Once the legal entity encompassing the sale is identified it is necessary to determine if there could be a possible impairment. This is done by comparing the GAAP reserve held by the legal entity to the present value of future new business being generated by said company at a discount rate that is reasonably close to that used upon sale. For example if the reserve held is $1,000 million and the company is expected to generate $110 million in new business annually forever, then at the discount rate of say 10% the present value of future new business is $110/0.10 = $1,100. Since we’re generating more than reserves there cannot possibly be an impairment. This is known as comparing the carrying amount of the unit including its goodwill to the fair value. If the annual new business projected in our example were anything less than $100 million an impairment could exist and the tester must then proceed to step 2, if not then the test is complete and there is no impairment.
Step 2: Calculate the impaired amount (if any)
Say an impairment is possible, in our running example the reporting unit is reserved for $1,000 million and on purchase the goodwill represents $100 million of the total reserve. The second step compares the goodwill at sale to the present value of the business added by the transaction. If sales are projected to be $90 million annually, with $9 million of those sales attributed to add-in business from the purchased unit then the present value of goodwill is only $9/0.10 at a 10% discount rate, or $90 million and a $10 million impairment exists. In this case the company must write down it’s goodwill by $10 million and increase its reserves accordingly. These write downs are not allowed to exceed the total goodwill at sale, that is you can’t write down more than the goodwill initially claimed. The difficulty with this step is that it requires the tester to split the sales projection for the unit by completely new sales and sales as additions to existing products to attribute the relevant section to the purchased entity. To help you with your computation and other related expenses for this testing, it is advisable to hire reliable and professional accountants just like the accountants in Singapore. This will allow you to come up with accurate computation so you can prepare your budget for this activity.
Impairment testing is a necessary accounting step that must be performed annually whenever a company is purchased at a rate above its fair value. The process is generally easy in principle, with the common result being that step 1 indicates a potential loss with that loss being shown to be nothing in step 2. In cases where goodwill impairment does occur the write downs can be continuous and severe. The purpose of this exercise from the accounting point of view is to prevent companies from profiting through overpayment on purchases.