Goodwill: What It Represents and How It Is Tested

Introduction

In the second quarter of its 2024 fiscal year, Walgreens Boots Alliance wrote down the goodwill of VillageMD, the primary care business it had invested billions in building and acquiring, by $12.4 billion. The company cited lower-than-expected long-term performance, plans to close about 90 more clinics, slower growth in patients and recent Medicare reimbursement changes, along with lower valuation multiples for peers and higher discount rates. By the end of the fiscal year, the goodwill left in the VillageMD reporting unit was $1.5 billion. The charge used no cash; it recorded that the premium Walgreens had paid for the business was no longer supported by what the business was expected to earn.

Goodwill is the part of an acquisition price that cannot be attributed to any identifiable asset. It is often one of the largest assets on an acquirer's balance sheet, it is not amortized by public companies, and its only route to the income statement is an impairment. That makes the impairment test one of the most consequential judgments in accounting for companies that grow by acquisition, and its result one of the clearest signals of whether a deal has worked. How goodwill is created at closing is covered in goodwill creation and bargain purchases; once the deal has closed, the question becomes whether that premium still holds up.

When a company acquires a business, it records the identifiable assets and liabilities at fair value; the remainder of the price is goodwill. That remainder typically reflects several things that cannot be recognized separately: expected synergies from combining the businesses, the value of an assembled workforce, the going-concern value of a business that already works as a whole, and, at times, simply a premium paid in a competitive auction. Pfizer, for example, described the goodwill from its Seagen acquisition in its 2023 annual report on Form 10-K as representing expected synergies, intangibles that do not qualify for separate recognition and the going-concern element of Seagen's business.

Under Accounting Standards Codification (ASC) 350, public companies reporting under US GAAP do not amortize goodwill. Instead, they test it for impairment at least once a year, and between annual tests whenever events suggest it may be impaired. The rationale is that goodwill does not wear out on a predictable schedule; it loses value when the acquired business underperforms, and an impairment test is meant to capture that loss when it happens.

Reporting unit

The level at which goodwill is tested for impairment under ASC 350: an operating segment or one level below it, a component with discrete financial information that management reviews. Goodwill from each acquisition is assigned to the reporting units expected to benefit from it.

The test is performed for each reporting unit. A company may start with an optional qualitative assessment, sometimes called step zero, considering factors such as macroeconomic conditions, industry trends, cost pressures, the unit's financial performance and changes in the company's share price. If it concludes that it is not more likely than not that the unit's fair value is below its carrying amount, no further testing is needed that year.

Otherwise, it performs the quantitative test. Since Accounting Standards Update (ASU) 2017-04, this is a single step: the company compares the reporting unit's fair value with its carrying amount, including goodwill, and if the carrying amount is higher, it records an impairment equal to the excess, capped at the amount of goodwill allocated to the unit. Deloitte's summary of the elimination of Step 2 explains that the change removed the earlier requirement to calculate an implied fair value of goodwill through a hypothetical purchase price allocation. Two reporting units with $500 of goodwill show how the cap works:

Unit A's goodwill is reduced by $300, leaving $200. Unit B's shortfall of $600 exceeds its goodwill, so the whole $500 is written off and the remaining $100 shortfall is not recognized against goodwill; the unit's other long-lived assets are tested under the rules in impairment of long-lived assets, which come first.

Estimating the Reporting Unit's Fair Value

Fair value is usually estimated with a discounted cash flow model, a market approach based on multiples of comparable companies or transactions, or a weighting of the two. Each brings its own sensitivities: the discount rate and terminal growth assumptions in a discounted cash flow, the choice of peers and multiples in a market approach. Companies also reconcile the combined fair values of their reporting units to their market capitalization, allowing for a reasonable control premium, as a check on the estimates. When a company's market value has fallen well below the total of its units' estimated fair values, that reconciliation becomes hard to defend, and impairments tend to follow.

Tax and Minority Effects

Two details shape the earnings effect. Goodwill from a stock acquisition is usually not deductible for tax, so its impairment reduces net income by the full amount with no tax benefit. Goodwill from an asset purchase is generally amortized over 15 years for US tax, so its impairment brings a deferred tax benefit that softens the hit to net income, and ASU 2017-04 has the company build that tax effect into the measurement of the loss. And where the acquirer owns less than all of the business, US GAAP records goodwill for the whole of it, including the minority's share, so part of any impairment is allocated to the noncontrolling interest. Walgreens' $12.4 billion charge was recorded before the noncontrolling interest in VillageMD; the company reported that, net of tax and the noncontrolling interest's share, it cost Walgreens shareholders $5.8 billion. The minority presentation is covered in noncontrolling interest.

The Private Company Alternative

Private companies may elect a simpler model introduced by ASU 2014-02: they amortize goodwill on a straight-line basis over ten years, or less if a shorter life is more appropriate, and test it for impairment only when a triggering event occurs. Targets that have used the alternative show goodwill that is lower, and earnings that are lower by the amortization, than they would under the public company model, which matters when a public buyer compares a private target's statements with its own.

Walgreens' fiscal 2024 annual report shows how the drivers of a goodwill impairment combine. The company revised its long-term forecast for VillageMD downward in the second quarter, reflecting clinic closures, slower growth in patient panels and multi-specialty productivity, and Medicare reimbursement changes. At the same time, the market inputs to fair value moved against it: valuation multiples for comparable companies fell and discount rates rose. Each of those factors lowers the fair value estimated in a discounted cash flow or market multiple approach, and together they cut it far below the unit's carrying amount.

The company also recorded a $332 million impairment of CareCentrix goodwill in the fourth quarter after revising that unit's forecasts, bringing total goodwill impairments in its healthcare segment to about $12.7 billion for the year.

For analysis, goodwill raises three questions. First, how exposed is the balance sheet? Goodwill as a share of total assets or equity shows how much of a company's book value rests on past acquisition premiums. Second, how close are the reporting units to impairment? Companies are expected to disclose when a unit's fair value exceeds its carrying amount by only a small margin, and those headroom disclosures are early warnings. Third, what does an impairment say about the deal? A write-down soon after an acquisition suggests the buyer overpaid or the integration failed; one many years later may simply reflect a changed market.

The treatment of impairments alongside restructuring charges and gains in adjusted figures is covered in one-time items.

A goodwill impairment does not change a company's cash flows, its enterprise value or its debt. It changes the record of what the company has earned on the capital it invested in acquisitions, and that record, read across several deals, is one of the most direct tests of a management team's capital allocation that the financial statements provide.