Goodwill is the excess of purchase consideration over the total value of assets and liabilities.
It is referred to as an intangible asset, i.e. can neither be seen or touched.
Goodwill arises when one company acquires another, but pays more than the fair market
value of the net assets.
It is classified as an intangible asset on the balance sheet.
However, according to International Financial Reporting Standards, 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, 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.
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, 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.
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.
For example, a privately held software company may have net assets valued at $1 million,
but the company's overall value 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 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.
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 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 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.
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 If the fair value
is less than carrying value, the goodwill value needs to be reduced so the fair value
is equal to carrying 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.
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 Intangible asset
Business valuation Consolidation
Control premium Divestment
Enterprise value Mergers and acquisitions
Subsidiary References