Goodwill arises when one company acquires another, but pays more than the fair market value of the net assets (total assets - total liabilities). It is classified as an intangible asset on the balance sheet. However, according to International Financial Reporting Standards (IFRS), goodwill is never amortized. Instead, management is responsible to value goodwill every year end 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.
In order to calculate goodwill, the purchase price is deducted from the fair market value of identifiable assets and liabilities of the company acquired. 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 ($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
To account for acquisition of Company B
For example, a software company may have net assets (consisting primarily of miscellaneous equipment, 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 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.
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). 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 (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 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.
- Intangible asset
- Business valuation
- Consolidation (business)
- Control premium
- Enterprise value
- Mergers and acquisitions