With the advent of Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (SFAS) No. 142 in December 2001, U.S. GAAP prohibited the depreciation or amortization of goodwill. With the boom in acquisition activity of the dot-com era, the FASB believed that goodwill was economically not a wasting asset. That is, the true nature of goodwill should be something that is infinitely lived. As such, it is important for accountants to understand the proper method of accounting for goodwill under SFAS 142.
Creation of Goodwill
Goodwill arises from business combinations. When an acquiring company pays more than the fair value of a business being acquired, the excess that is paid is called goodwill and capitalized onto the balance sheet. While goodwill is an intangible asset, it is usually a large enough asset that it is recorded as a separate line item in the financial statements.
Impairment Test: Step 1
Goodwill is tested for impairment in a two-step process. In step 1, the carrying amount or book value of the reporting unit is compared to the fair value of the reporting unit. The reporting unit is the same as the business acquired in many cases. If the fair value is greater than the book value, no impairment is present and the test ends. If the fair value is less than the book value, the company proceeds to step 2
Impairment Test: Step 2
In step 2, the book value of goodwill is compared to the implied fair value of goodwill. To determine the implied fair value of goodwill, the company will calculate a hypothetical business combination, where by using the step 1 calculations, the company uses the fair value of the business as a comparison to the fair value of all of the individual assets and liabilities. This difference is the implied fair value of goodwill, which is then compared to the book value of goodwill. If the book value of goodwill is greater than the implied fair value, impairment has occurred. If not, then no impairment has occurred and the test ends.
If the results of step 2 show that the company has suffered an impairment of goodwill, then the company will post a journal entry to adjust the goodwill balance to equal the implied fair value of goodwill. This entry usually consists of a debit to impairment loss and a credit to goodwill.