What Is Goodwill?
Sometimes a company’s most valuable assets are impossible to touch or see. These assets are called intangible assets and include a company's brand, a loyal customer base, or a corporation's stellar management team.
If a company wants to acquire another company, it will not only purchase the company's fixed assets like property, plant, and equipment, but also the intangible assets. For example, imagine if Pepsi wanted to acquire Coca-Cola. Coca-Cola's value extends beyond the value of the manufacturing plants, equipment, and the bottling companies it might own. The brand of Coke has value.
As a result, the acquirer has to account for these more elusive qualities. The amount the buyer pays beyond the book value of these identifiable assets is recorded as a separate asset called “goodwill.”
How Goodwill Works
Since goodwill is an intangible asset, it's recorded on the balance sheet as a noncurrent asset meaning it's a long-term asset similar to fixed assets like property, plant, and equipment. There are guidelines stipulated by the Financial Accounting Standards Board in determining the value of goodwill for a company.
Let’s say a clothing retailer, the fictitious Teal Orchid has identifiable assets of $750,000 that include the current value of its real estate, inventory, cash, and accounts receivables. A larger company, Samantha & Steve Fashions, purchases the clothier and agrees to pay $850,000. Why? Perhaps it's because of Teal Orchid’s strong reputation and brand recognition in the area that it operates. The acquiring company hopes it can use the brand name of Teal Orchid to boost profits in the long term and ultimately earn enough to make up for the extra $100,000 it paid above the value of the company's fixed assets.
The $100,000 beyond the value of its other assets is accounted for under goodwill on the balance sheet. If the value of goodwill remains the same or increases, the amount entered there remains unchanged.
The amount can change, however, if this goodwill declines. If that’s the case, the company undergoes what’s known as “goodwill impairment.” Perhaps, a year after the acquisition, the Teal Orchid division is only worth $800,000 in total (versus the original $850,000). Not only does the amount of the asset take a hit, but so do Samantha & Steve’s earnings. That’s because it must now record that $50,000 impairment as an expense on its income statement.
While such write-downs don’t always attract much attention from the investment community, they can say a lot about whether the merger’s success or lack thereof. If the parent company has to keep revising its goodwill amount, it’s often a sign that it overpaid for another business and isn’t seeing the expected returns.
The Bottom Line
By definition, companies with a large amount of goodwill attract higher purchase prices. If the goodwill amount gets written down after the acquisition, it could be an indication that the buyout isn't working out as planned. In short, goodwill impairment is a message to the markets that the value of the acquired assets has fallen below what the company initially paid.
Goodwill is calculated a little differently from intangible assets as a whole.