Goodwill Impairment - Qualitative vs. Quantitative Assessment
Summit Holdings, a public company, has one reporting unit (Consumer Brands) with a carrying amount of $180 million, including $70 million of goodwill, at October 1 (its annual impairment testing date). At the prior year test, the fair value exceeded carrying amount by 8%. During the year, Summit's market capitalization fell below book value, a key customer (22% of revenue) terminated its contract, and the industry price index declined 15%. Management performs a qualitative assessment under ASC 350-20-35-3C and concludes it is not more likely than not that fair value is below carrying amount, citing a recent third-party valuation that used a 12% discount rate and 4% perpetual growth. The controller asks whether the qualitative conclusion can be supported and what the auditor should do.
1. Evaluate whether management's qualitative assessment is supportable under ASC 350.
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Framework. ASC 350-20-35-3C lists events and circumstances to consider, including:
- Deterioration in general economic conditions or the entity's industry.
- Cost factors (e.g., loss of a key customer).
- Overall financial performance (declining cash flows, market capitalization below book value).
- Entity-specific events (litigation, change in management, loss of key personnel).
- A sustained decrease in share price.
Application.
- Market capitalization below book value: a classic indicator that fair value may be below carrying amount.
- Loss of a customer representing 22% of revenue: a significant adverse event directly affecting projected cash flows.
- Industry price index down 15%: macro deterioration.
These three factors, individually and collectively, strongly suggest it is more likely than not that fair value is below carrying amount. Management's reliance on a third-party valuation does not cure the problem - the valuation's assumptions (12% discount rate, 4% perpetual growth) must be tested for reasonableness against current conditions. A 12% discount rate may be too low given heightened risk, and 4% growth may be optimistic.
Conclusion. Management's qualitative conclusion is not supportable. A quantitative impairment test should be performed.
2. Describe the quantitative test and the audit procedures the auditor should perform.
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Quantitative test (ASC 350-20-35-4). Compare the fair value of the reporting unit to its carrying amount. If fair value is less, recognize an impairment loss equal to the excess of carrying amount over fair value, not to exceed the carrying amount of goodwill.
Illustration. If fair value is determined to be $150 million and carrying amount is $180 million, the impairment is $30 million (limited to the $70 million goodwill balance).
Audit procedures:
- Evaluate the valuation specialist's work - assess competence, objectivity, and the reasonableness of the income approach (discount rate, growth rate, projections).
- Test the discount rate against market data (WACC, comparable-company betas) and consider whether a company-specific risk premium is warranted given the lost customer.
- Challenge cash flow projections - compare to historical results and management's post-loss-of-customer forecasts; perform sensitivity analysis.
- Reconcile the reporting unit's carrying amount to the consolidated financial statements.
- Consider whether the reporting unit definition is still appropriate given organizational changes.
- Evaluate subsequent events through the report date.
- Assess disclosure under ASC 350-20-50, including the method, assumptions, and amount of impairment.
Document the conclusion and any disagreements with management.