The impairment testing process for goodwill is one of those...

The impairment testing process for goodwill is one of those areas of rubbery accounting that is fraught with subjectivity.

At the core of the process is usually a 3-5 year forecast of cash flows based on company assumptions around growth, profit margins and capital spend.

The second layer is the assumptions around terminal growth rate and the discount rate. Moving either of these by just one or two percent can have a huge impact on the PV which supports the carrying value of goodwill because they have an outsized effect on the terminal value, which is generally >50% of the PV of the CGU's cash flows.

The table below shows an example of a company that thinks it will have $10m in Free Cash Flow in 5 years' time. After that it makes the following assumptions:

Case 1: Growth of 2%, and a WACC/Discount Rate of 11% (conservative)
Case 2: Growth of 3% , and a WACC/Discount Rate of 9% (slightly more aggressive)

	Column 1	Column 2	Column 3	Column 4	Column 5
0	FCF @ t+5	g %	WACC %	TV	PV(TV)
1	10	2%	11%	113.3	67.3
2	10	3%	9%	171.7	111.6

As you can see, the present value (i.e. TV or terminal value discounted back 5 years to today) is over 65% higher in Case 2, just by changing those two rubbery assumptions by 1% and 2%.

Because companies tend to overpay for acquisitions and use aggressive assumptions to support the high carrying values of goodwill paid when they first do the deal, a lot of the time you get these massive write-downs when they have to temper the overly optimistic assumptions toward something more closely resembling reality - and it sometimes only takes a small change in outlook to precipitate this.

The problem is management (particularly the deal hungry!) tend to capitalise too much optimism into the future, especially when going through a good patch - and this leads to paying inflated prices for assets that arguably you wouldn't pay for in the middle of the cycle.

Could go on about agency issues and moral hazard here, but already in TLDR territory!