When testing goodwill for impairment, debt should be included in the reporting unit if (a) the debt relates to the operations of the reporting unit, and (b) the debt is likely to be transferred in the event the reporting unit is sold. This would be the case where the buyer would either assume the debt or, as more commonly done, pay off the debt on behalf of the seller at the time of closing. In most cases, the inclusion of long-term debt in a reporting unit would not impact the results of the impairment test, since the debt also will be subtracted from the calculated enterprise value to arrive at the fair value of equity. The result could be different if the fair value of the debt differs from its carrying amount.
The consideration as to whether debt should be included in a reporting unit is most important when the carrying amount of the reporting unit is negative. Prior to the adoption of Financial Accounting Standards Board Accounting Standards Update (ASU) 2017-04, Intangibles – Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment, if a reporting unit had a negative carrying amount, a qualitative assessment first was performed to determine whether it was more likely than not that goodwill was impaired. If it was determined that goodwill was likely impaired, Step 2 was performed to determine the amount of impairment. However, ASU 2017-04 eliminated Step 2 of the impairment test. Instead, goodwill impairment is recognized based on the amount by which the carrying amount of the reporting unit exceeds its fair value. As a result, where the carrying amount of a reporting unit is negative, goodwill will automatically not be impaired, and no test would be performed.
When a reporting unit has a negative value as a result of the inclusion of debt, the entity should take a close look at whether the inclusion of the debt is appropriate. A common consideration is related party debt. Debt payable to a significant shareholder should not be included in a reporting unit. Upon a sale of the company, the related party debt likely would be forgiven or otherwise converted to equity. Even if a buyer would pay the debt, the payment might in-substance be no different than payment for equity.
Other liabilities that might be excluded from a reporting unit when testing goodwill include warrant liabilities, equity instruments that are required to be classified as liabilities under the provisions of ASC 480, and instruments classified as temporary equity following SEC guidelines.
Where it has been concluded that debt should not be included in the carrying amount of a reporting unit, the debt also would not be deducted from the enterprise value when determining the fair value of equity.