Goodwill is often misunderstood. What exactly is behind this intangible asset on the balance sheet? And why is the goodwill impairment test so closely related to business valuation?
Auditors and accounting managers in corporate groups alike often grapple with these questions. This article provides a comprehensive overview of key topics, including initial and subsequent accounting, special issues related to badwill, the methodical implementation of impairment tests, and sensitive assumptions in goodwill impairment testing.
In a company's development, a difference often arises between the net asset value (based on acquisition costs) and the future-oriented capitalized earnings value. This difference, reflecting the intangible value of the company, is known as goodwill.
Original goodwill encompasses various intangible assets, including:
Generally, goodwill cannot be capitalized in the balance sheet due to its difficulty in measurement. However, this changes when companies are acquired. If one company takes over another, the buyer often pays more than the book value of the acquired company.
The difference between the purchase price and the book value is known as derivative goodwill, which is reported in the consolidated balance sheet of the acquiring company.
We will now explain how derivative goodwill arises as the difference between the purchase price and the carrying amounts of the acquired company, including valuation differences and non-capitalizable intangible assets.
The acquisition method is used for business combinations under International Financial Reporting Standards (IFRS).
IFRS 3 outlines how acquired assets and assumed liabilities are measured and recognized in the acquiring company's balance sheet. A key part of this process is determining and recognizing goodwill.
To determine goodwill, a purchase price allocation is performed. This involves allocating the purchase price to acquired assets and assumed liabilities. The procedure is carried out in several steps:
It's crucial to note that goodwill is not a separately valued asset in the initial valuation. Instead, it's a residual value. It arises as the difference between the purchase price and the total of all identifiable assets and liabilities assumed, which are recognized at fair value.
Therefore, goodwill reflects the intangible value that cannot be directly allocated to individual identifiable assets.
A company consolidation usually results in 'positive goodwill': the purchase price is higher than the fair value of acquired assets minus assumed liabilities. However, in rare cases, 'badwill' can occur.
This happens when the purchase price of a company is lower than the fair value of its identifiable assets. While this might seem counterintuitive, as companies aren't typically sold below their value, there are two main reasons for badwill to occur:
Lucky buy: In some cases, a company is acquired at a particularly favorable price. This can be due to the buyer's negotiating skills or a short-term financial emergency on the seller's part.
Expected future losses: However, it's more common for a lower purchase price to be paid as compensation for expected future losses or restructuring costs. This means the buyer anticipates future burdens and accounts for them in the form of a lower purchase price.
According to International Financial Reporting Standards (IFRS), badwill must be recognized immediately in profit or loss. This means it's recognized as income in the income statement. Provisions for future losses, such as restructuring, cannot be formed, even if they were considered when determining the purchase price.
When accounting for a company for the first time, goodwill is initially determined at the level of the entire acquired company. It must then be allocated to cash-generating units (CGUs). This allocation is required by IAS 36.
A CGU is the smallest identifiable unit of a company that independently generates cash flow. In simpler terms, it's the smallest part of the company that functions economically independently. In practice, a CGU often corresponds to a business segment, as presented in segment reporting.
Allocating goodwill to CGUs ensures that it's assigned to the parts of the company that actually benefit from the intangible assets it represents. This is crucial for subsequent impairment tests.
Goodwill is generally allocated to CGUs based on economic relationships and information availability. Goodwill is allocated to CGUs that benefit from the synergies and intangible assets arising from the company's consolidation. The allocation should be made in a way that is reliable and understandable.
Under national accounting standards like the German Commercial Code (HGB), initially determined goodwill is amortized. However, International Financial Reporting Standards (IFRS) use the 'impairment-only approach.'
This means, unlike HGB, there's no scheduled amortization of goodwill. Instead, goodwill is tested for impairment annually and always on the same date, determined at the time of initial consolidation.
In addition to annual reviews, impairment tests must be conducted immediately if triggering events occur (e.g., negative business development, impairment of other assets).
The impairment-only approach for goodwill under IFRS ensures that goodwill remains on the balance sheet as long as it represents economic value for the company. Annual impairment tests guarantee that the carrying amount of goodwill always reflects current economic circumstances.
Impairment occurs when the carrying amount of an asset, or its value shown in the balance sheet, is less than its recoverable amount. This recoverable amount is the higher of the net realizable value and value in use:
This means that if an asset is worth less than its balance sheet value, it is impaired.
Goodwill impairment reduces profit in the income statement and the company's equity. Once written off, an impairment is generally not reversible.
Goodwill impairment indicates that the intangible value of a company is lower than initially assumed. Recognizing this impairment in profit or loss is crucial for IFRS-compliant accounting, ensuring a realistic presentation of the company's financial position.
While goodwill is a residual figure in the purchase price allocation at initial measurement, it becomes independent in subsequent measurement. It's no longer just the difference between the purchase price and the fair value of identifiable assets but is measured as a separate asset.
The value in use is generally the decisive valuation criterion for subsequent goodwill valuation. This is because the net realizable value is often unreliable, as goodwill as an intangible asset cannot usually be sold separately.
Various forward-looking methods are available for determining the value in use:
Determining the value in use is associated with several challenges. Forecasting future cash flows is subject to significant uncertainty. Additionally, choosing the correct discount rate is crucial for the valuation outcome. Finally, allocating goodwill to a specific CGU can be difficult.
According to International Financial Reporting Standards (IFRS), particularly IAS 36, the subsequent reversal of an impairment loss on goodwill is generally not permitted.
IAS 36.124 explicitly states that once an impairment of an asset (including goodwill) has been recognized, it cannot, in principle, be reversed in a subsequent period. Even if economic circumstances change favorably, increasing the asset's value, this higher value cannot be reflected in the balance sheet.
IAS 36.125, in conjunction with IAS 38, addresses the treatment of intangible assets. IAS 38 states that internally generated goodwill may not be capitalized. This means that costs for developing intangible assets that could lead to goodwill must be recognized directly as an expense in the income statement.
These regulations aim to ensure reliable and comparable accounting. The prohibition on reversing impairment losses on goodwill and the non-capitalization of internally generated goodwill prevent "excessive optimism" in asset valuation.
Goodwill is a residual figure in the initial measurement. This means it's entirely dependent on the purchase price allocation and underlying assumptions. However, in subsequent measurement, goodwill becomes independent.
It develops a "life of its own" and is reviewed separately for value stability. The other assets and liabilities from the initial valuation play a secondary role.
Two particularly sensitive assumptions in goodwill valuation are:
Planning calculation for the CGU
The basis for measuring goodwill is a detailed planning calculation for the cash-generating unit (CGU) to which the goodwill is allocated. This planning typically includes:
Any change in these assumptions can significantly impact the calculated value of goodwill. For example, more optimistic growth assumptions can lead to a higher calculated value, while more pessimistic ones can result in a reduction in value.
Cost of Capital
The cost of capital represents the risk-adjusted interest rate at which the future cash flows of the CGU are discounted. It reflects the interest rate expectations of investors and is influenced by various factors:
A change in the cost of capital leads to a corresponding change in the present value of future cash flows - and thus to an adjustment of the calculated goodwill value. A higher cost of capital leads to a lower present value, and vice versa.
The assumptions made when measuring goodwill are of crucial importance. In particular, the planning of future cash flows and the calculation of the cost of capital are associated with uncertainties. These can lead to different valuation results and make it difficult to compare company valuations.
Goodwill is an intangible asset that arises when companies are acquired. It's a crucial component of company valuation but is complex and associated with uncertainties.
A goodwill impairment test ensures that the balance sheet value of goodwill reflects current economic circumstances.
At initial measurement, goodwill is a residual value resulting from the difference between the purchase price and the fair value of acquired assets. In subsequent measurement, it's considered a separate asset and is tested annually for impairment.
The planning calculation for the associated cash-generating unit (CGU) and the calculation of the cost of capital are crucial in this process.
The valuation of goodwill depends on numerous assumptions, particularly the forecast of future cash flows and the determination of the cost of capital. These assumptions are subject to uncertainties and can lead to different valuation results.
If the carrying amount of goodwill exceeds its recoverable amount, an impairment must be recognized. This impairment directly impacts the company's profit and equity.
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