If one company owns another company in its entirety, or controls more than 50% of its voting stock, the owned or controlled company is known as a subsidiary. When acquiring a subsidiary, there are two main components of the acquisition price the subsidiary's net asset value, and the premium paid over this amount, which is known as goodwill.
For example, let's say that a large company bought a small oil company for $30 million last year. If the net value of the company's assets (equipment, real estate, etc.) are $10 million, the other $20 million of the sales price is the goodwill amount, and is recorded as such.
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Goodwill is recorded on the balance sheet as a noncurrent asset, and is subject to an "impairment test" at least once per year. This means that the goodwill, or the premium paid for the subsidiary, is tested to determine whether or not the value of the goodwill asset has declined.
If the fair value of the goodwill is less than its carrying value (the value listed on the balance sheet), the difference is written off as an "impairment charge" on a company's income statement in order to adjust the goodwill listed on the balance sheet to reflect its fair market value.
An exampleUsing our hypothetical oil company discussed earlier, let's say that an analysis of the subsidiary's value is conducted, and it is determined that the value of the goodwill has fallen from $20 million to $15 million as a result of lower profits caused by falling oil prices.
In this case, the $5 million difference is an impaired goodwill expense, and is recorded as such on the company's income statement as a line item. Then, the impairment amount is subtracted from the previous goodwill asset listed on the balance sheet, which will now show $15 million to reflect the current market value of the subsidiary.
Why it's importantThe reason it's important to accurately account for impairment charges is to prevent financial statements from becoming inflated. For example, during the tech bubble, companies were actively acquiring other firms for huge premiums, and balance sheets often reflected this goodwill as an asset, even after the subsidiaries' values had clearly declined.
Finally, it's important to take goodwill and impairment charges with a grain of salt. Estimating a subsidiary's intangible assets isn't an exact science, and several different analysts could come up with slightly different valuation estimates.
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