One of the concepts that can give non-accounting (and even some accounting) business folk a fit is the distinction between goodwill and intangible assets in a company’s financial statements. Perhaps the confusion is to be expected. After all, “goodwill” denotes the value of certain non-monetary, non-physical resources of the business – and that sounds like exactly what an intangible asset is. However, there are many factors that separate goodwill from other intangible assets, and the two terms represent separate line items on a balance sheet.
Intangible assets are those that are non-physical, but identifiable. Think of a company’s proprietary technology (computer software, etc.), copyrights, patents, licensing agreements and website domain names. These aren’t things that one can touch, exactly, but it is possible to estimate their value to the enterprise. Intangible assets can be bought and sold independently of the business itself.
Goodwill, on the other hand, is more of a miscellaneous category for intangible assets that are harder to parse out individually or measured directly. Customer loyalty, brand equity, name/brand recognition and company reputation – all of the things that make a company worth more than its book value, or quantifiable assets – count as goodwill.
A company’s record of innovation and research and development, and the experience of its management team, are often included, too. Goodwill cannot exist independently of the business, nor can it be sold, purchased or transferred separately. As a result, goodwill has a useful life which is indefinite, unlike most of the other intangible assets.
Goodwill only shows up on a balance sheet when two companies complete a merger or acquisition. When a company buys another firm, anything it pays above and beyond the net value of the target's identifiable assets becomes goodwill on the balance sheet.
Say a soft drink company was sold for $120 million; it had assets worth $100 million and liabilities of $20 million.The sum of $40 million that was paid over and above $80 million (the value of the assets minus the liabilities) is the worth of goodwill and is recorded in the books as such.
Look at this example of an assets section of a balance sheet. Goodwill is a separate line item from intangible assets.
There’s also a key distinction in how the two asset classes are amended once they’re on the books. Because assets tend to lose some of their value over time, companies sometimes have to make periodic write-downs. Intangible assets are amortized, which means a fixed amount is marked down every year, resulting in a simultaneous charge against earnings. The amortization amount is adjusted if the asset's value is impaired at some point after its acquisition or development.
The Financial Accounting Standards Board (FASB) recently came up with a new alternative rule for accounting of goodwill. For a long time, it could be amortized over a period of 40 years. A 2001 ruling decreed that goodwill could not be amortized, but must be evaluated annually to determine impairment loss; this annual valuation process was expensive as well as time-consuming.
Now, as per the alternative FASB rule for private companies (2014) (expanded in 2017 for public companies), goodwill can be amortized on a straight-line basis over a period not to exceed 10 years. The need to test for impairment has decreased; instead, an impairment charge is recorded when some event occurs that signals that the fair value may be have gone below the carrying amount. These rules apply to businesses conforming to generally accepted accounting principles (GAAP) using a full accrual accounting method. If conditions indicate that the carrying value may not be recoverable, then tests for impairment are performed.
If there is no impairment, goodwill can remain on a company's balance sheet indefinitely.
Small businesses using cash-basis accounting or modified cash-basis accounting can use the statutory rates set by the Internal Revenue Service (IRS). The IRS allows for a 15-year write-off period for the intangibles that have been purchased. There is a lot of overlap as well as contrast between the IRS and GAAP reporting.
The Bottom Line
While “goodwill” and “intangible assets” are sometimes used interchangeably, there are significant differences between the two in the accounting world. Goodwill is a premium paid over the fair value of assets during the purchase of a company. Hence, it is tagged to a company or business and cannot be sold or purchased independently, whereas other intangible assets like licenses, patents, etc. can be sold and purchased independently. Goodwill is perceived to have an indefinite life (as long as the company operates), while other intangible assets have a definite useful life.