What is Goodwill
Goodwill is an intangible asset associated with the purchase of one company by another. Specifically, goodwill is recorded in a situation in which the purchase price is higher than the sum of the fair value of all identifiable tangible and intangible assets purchased in the acquisition and the liabilities assumed in the process. The value of a company’s brand name, solid customer base, good customer relations, good employee relations, and any patents or proprietary technology represent some examples of goodwill.
Goodwill is considered an intangible (or noncurrent) asset because it is not a physical asset like buildings or equipment. The goodwill account can be found in the assets portion of a company's balance sheet.
BREAKING DOWN Goodwill
In mergers and acquisitions (M&A) speak, a company that purchases another is referred to as the acquiring company. The company that is acquired is the target company. The value of goodwill typically arises in an acquisition when an acquirer purchases a target company. The amount the acquiring company pays for the target company over the target’s book value usually accounts for the value of the target’s goodwill. If the acquiring company pays less than the target’s book value, it gains “negative goodwill,” meaning that it purchased the company at a bargain in a distress sale. For example, if the fair value of Macy's is $12 billion, and a company purchases Macy's for $15 billion, the premium value following the acquisition is $3 billion. This $3 billion will be included on the acquirer's balance sheet as goodwill. Goodwill is also recorded when the purchase price of the target company is higher than the debt that is assumed.
Goodwill is recorded as an intangible asset on the acquiring company's balance sheet under the long-term assets account. Under Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS), companies are required to evaluate the value of goodwill on their financial statements at least once a year, and record any impairments. An impairment of an asset occurs when the market value of the asset drops below historical cost. This can occur as the result of an adverse event such as declining cash flows, increased competitive environment or economic depression, among many others. Companies assess whether an impairment is needed by performing an impairment test on the intangible asset. The two commonly used methods for testing impairments are the income approach and the market approach. Using the income approach, estimated future cash flows are discounted to the present value. With the market approach, the assets and liabilities of similar companies operating in the same industry are analyzed.
If a company's acquired net assets fall below the book value or if the company overstated the amount of goodwill, then it must impair or write down the value of the asset on the balance sheet after it has assessed that the goodwill is impaired. The impairment expense is calculated as the difference between the current market value and the purchase price of the intangible asset. The impairment results in a decrease in the goodwill account on the balance sheet. The expense is also recognized as a loss on the income statement, which directly reduces net income for the year. In turn, earnings per share (EPS) and the company's stock price is also negatively affected.
To minimize the cost and complexity associated with impairment testing, private companies can choose, instead, to amortize goodwill over a 10-year period. Since 2001, however, U.S. companies are no longer required to amortize goodwill.
How to Calculate Goodwill
The process for calculating goodwill is fairly straightforward in principle, but in practice it can be quite complex. To determine goodwill, take the purchase price of a company and subtract the fair market value of identifiable assets and liabilities. The determination of goodwill could be expressed as the following formula:
P - (A+L) = G
In this case, P represents the purchase price of the target company, A and L represents the fair market value of assets and liabilities, respectively, and G represents goodwill. It is because of the latter part of this calculation that the process can be quite difficult; determining the fair market value of all of a company's assets and liabilities can be complicated, particularly in the case of large or well-established companies.
Complexities of Goodwill
Goodwill is difficult to price, but it contributes significantly to a company's value and success. For example, a company like Coca-Cola, which has been around for decades, makes a wildly popular product based on a secret formula and is generally perceived positively by the public, would have a lot of goodwill. A competitor, say a small, regional soda company that has only been in business for five years, has a small customer base, specializes in unusual soda flavors and recently faced a scandal over a contaminated batch of soda, would have far less goodwill, or even negative goodwill.
Negative goodwill occurs when an acquirer purchases a company for less than its fair market value. This usually occurs when the target company cannot or will not negotiate a fair price for its acquisition. Negative goodwill is usually seen in distressed sales, and is recorded as income on the acquirer's balance sheet.
Because the components that make up goodwill have subjective values, there is a substantial risk that a company could overvalue goodwill in an acquisition. This overvaluation would be bad news for shareholders of the acquiring company, since they would likely see their share values drop when the company later has to write down or impair goodwill. In fact, this happened in the AOL-Time Warner merger of 2001.
There is also the risk that a previously successful company could face insolvency. When this happens, investors deduct goodwill from their determinations of residual equity. The reason for this is that, at the point of insolvency, the goodwill the company previously enjoyed has no resale value.
Up to this time, there are competing approaches among accountants as to how to calculate goodwill. One reason for this is that goodwill represents a sort of workaround for accountants. This tends to be necessary because acquisitions typically factor in estimates of future cash flows and other considerations which are not known at the time of the acquisition. While this in and of itself is perhaps not a significant issue, it becomes one when accountants look for ways of comparing reported assets or net incomes between different companies when some of those businesses have not purchased other companies and others have.
For this reason, it's likely that accounting practices with regard to goodwill are going to continue to adapt and develop over time. This is the result of changes in perspective and opinion among members of the Accounting Standards Boards.