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Goodwill (accounting)

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Goodwill (accounting)

Goodwill in accounting is an intangible asset that arises when one company acquires another, but pays more than the fair market value of the net assets (total assets - total liabilities). The goodwill amounts to the excess of the "purchase consideration" (the money paid to purchase the asset or business) over the total value of the assets and liabilities. It is classified as an intangible asset on the balance sheet, since it can neither be seen nor touched. However, according to International Financial Reporting Standards (IFRS), goodwill is never amortized. Instead, management is responsible to value goodwill every year and to determine if an impairment is required. If the fair market value goes below historical cost (what goodwill was purchased for), an impairment must be recorded to bring it down to its fair market value. However, an increase in the fair market value would not be accounted for in the financial statements.

Contents

  • Calculating goodwill 1
  • Modern meaning 2
  • US practice 3
    • History and purchase vs. pooling-of-interests 3.1
    • Amortization and adjustments to carrying value 3.2
  • See also 4
  • References 5

Calculating goodwill

In order to calculate goodwill, the fair market value of identifiable assets and liabilities of the company acquired is deducted from the purchase price. For instance, if company A acquired 100% of company B, but paid more than the net market value of company B, a goodwill occurs. In order to calculate goodwill, it is necessary to have a list of all of company B's assets and liabilities at fair market value.

                        Fair market value
  Accounts Receivable $10
  Inventory                 $5
  Accounts payable      $6
  Total Net assets     = 10 + 5 - 6 
                             = $9

In order to acquire company B, company A paid $20. Hence, goodwill would be $11 ($20 - $9). The journal entry in the books of company A to record the acquisition of company B would be:

  DR Goodwill             $11
  DR Accounts Receivable  $10
  DR Inventory            $5
       CR Accounts Payable      $6
       CR Cash                  $20

Modern meaning

Goodwill is a special type of intangible asset that represents that portion of the entire business value that cannot be attributed to other income producing business assets, tangible or intangible. [1]

For example, a privately held software company may have net assets (consisting primarily of miscellaneous equipment and/or property, and assuming no debt) valued at $1 million, but the company's overall value (including brand, customers, and intellectual capital) is valued at $10 million. Anybody buying that company would book $10 million in total assets acquired, comprising $1 million physical assets and $9 million in other intangible assets. And any consideration paid in excess of $10 million shall be considered as goodwill. In a private company, goodwill has no predetermined value prior to the acquisition; its magnitude depends on the two other variables by definition. A publicly traded company, by contrast, is subject to a constant process of market valuation, so goodwill will always be apparent.

While a business can invest to increase its reputation, by advertising or assuring that its products are of high quality, such expenses cannot be capitalized and added to goodwill, which is technically an intangible asset. Goodwill and intangible assets are usually listed as separate items on a company's balance sheet.[2][3]

US practice

History and purchase vs. pooling-of-interests

Previously, companies could structure many acquisition transactions to determine the choice between two accounting methods to record a business combination: purchase accounting or pooling-of-interests accounting. Pooling-of-interests method combined the book value of assets and liabilities of the two companies to create the new balance sheet of the combined companies. It therefore did not distinguish between who is buying whom. It also did not record the price the acquiring company had to pay for the acquisition. Since 2001 U.S. Generally Accepted Accounting Principles (FAS 141) no longer allows the pooling-of-interests method.

Amortization and adjustments to carrying value

Goodwill is no longer amortized under U.S. GAAP (FAS 142).[4] FAS 142 was issued in June 2001. Companies objected to the removal of the option to use pooling-of-interests, so amortization was removed by Financial Accounting Standards Board as a concession. As of 2005-01-01, it is also forbidden under International Financial Reporting Standards. Goodwill can now only be impaired under these GAAP standards.[5]

Instead of deducting the value of goodwill annually over a period of maximal 40 years, companies are now required to determine the fair value of the reporting units, using present value of future cash flow, and compare it to their carrying value (book value of assets plus goodwill minus liabilities.) If the fair value is less than carrying value (impaired), the goodwill value needs to be reduced so the carrying value is equal to the fair value. The impairment loss is reported as a separate line item on the income statement, and new adjusted value of goodwill is reported in the balance sheet.[6]

When the business is threatened with insolvency, investors will often deduct the goodwill from any calculation of residual equity because it will likely have no resale value.

See also

References

  1. ^ Creation and Valuation of Business Goodwill
  2. ^ Intangible Assets Definition at Wikinvest
  3. ^ Goodwill Definition at Wikinvest
  4. ^ Summary of Statement No. 142
  5. ^ A Primer on Calculating Goodwill Impairment: Valuation Issues Raised by Financial Accounting Statement 142
  6. ^ Focus on Goodwill, Intangible Assets
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