Business combinations are accomplished when one entity (investor) acquires "control" over the net assets of another entity. The transaction is accounted for using the purchase method of accounting, in which the company identified as the acquirer allocates the purchase price to each asset acquired (and each liability assumed) on the basis of its fair value.

Valuation

Any excess of cost over fair value of net assets acquired is recorded as goodwill, under both IFRS and US GAAP.

Goodwill is the present value of future earnings in excess of a normal return on net identifiable assets. It stems from such factors as a good reputation, loyal customers, and superior management. Any business that earns significantly more than a normal rate of return actually has goodwill.

Goodwill is recorded in the accounts only if it is purchased by acquiring another business at a price higher than the fair market value of its net identifiable assets. It is not valued directly but inferred from the values of the acquired assets compared with the purchase price. It is the premium paid for the target company's reputation, brand names, customers or suppliers, technical knowledge, key personnel, and so forth.

Goodwill only has value insofar as it represents a sustainable competitive advantage that will result in abnormally high earnings. Analysts need to be aware of the possibility that the goodwill recognized by accountants may, in fact, represent overpayment for the acquired company. Since goodwill is inferred rather than computed directly, it will increase as the payment price increases. It is only after the passage of time that analysts will be able to evaluate the extent to which the purchase price was justified.

Impairment

Goodwill is not amortized; instead it is tested for impairment at least annually, in a two-step process.

1. The fair value of a reporting unit is compared to its carrying amount (goodwill included) at the date of the periodic review. If the fair value at the review date is less than the carrying amount, then the second step is necessary.

2. The carrying value of goodwill is compared to its implied fair value (and a loss recognized when the carrying value is the higher of the two). To arrive at an implied fair value for goodwill, the FASB specifies that an entity should allocate the fair value of the reporting unit at the review date to all of its assets and liabilities as if the unit had been acquired in a combination with the fair value of the unit as its purchase price. The excess of that fair value (purchase price) over the fair value of the identifiable net asset is the implied fair value of goodwill.

Financial Impacts of Impairment

The impairment loss is reported pretax as a component of income from continuing operations. Once recognized, the impairment loss cannot be restored.

Some impacts on current financial statements:

• Lower fixed assets and total assets.
• Both net income and tax expense are reduced due to the impairment loss.
• Tax payable: the impairment loss is not recognized for tax purposes until the property is disposed of. It leads to a deferred tax asset (a future tax benefit), not a current refund.
• Stockholders' equity is reduced, and thus the debt-to-equity ratio is increased.
• Impairment write-down has no effect on cash flows, since it is a non-cash charge.
• Asset turnover ratios tend to increase due to the lower asset base.
• Return on assets and return on equity are reduced because of the impairment loss.

The write-down affects future financial statements and ratios in the same way as it affects the current period, except in the following aspects:

• Future depreciation expenses are reduced due to the reduced book value of the asset.
• As a result, future net income and profit margin increases. Note that impairment loss is a one-time loss, and does not affect the income statements of future periods.
• Future return on assets and return on equity will both increase because of higher future profitability and a lower asset and equity base.