Goodwill (Business) Information
The term goodwill was originally used in accounting to reflect the fact that an ongoing business had some "prudent value" beyond its assets, such as the reputation the firm enjoyed with its clients. Likewise, a buyer may agree to "overpay" because he sees potential synergy with his own business. The accounting sense of goodwill followed as a possible explanation of why a firm sells for more than the value of its current assets.
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Modern meaning
Goodwill in financial statements arises when a company is purchased for more than the fair value of the identifiable assets of the company. The difference between the purchase price and the sum of the fair value of the net assets is by definition the value of the "goodwill" of the purchased company. The acquiring company must recognize goodwill as an asset in its financial statements and present it as a separate line item on the balance sheet, according to the current purchase accounting method. In this sense, goodwill serves as the balancing sum that allows one firm to provide accounting information regarding its purchase of another firm for a price substantially different from its book value. Goodwill can be negative, arising where the net assets at the date of acquisition, fairly valued, exceed the cost of acquisition.[1] Negative goodwill is recognized as an extraordinary gain to the extent that it exceeds allocations to certain assets[2].
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, 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.
There is a distinction between two types of goodwill depending upon the type of business enterprise: institutional goodwill and professional practice goodwill. Furthermore, goodwill in a professional practice entity may be attributed to the practice itself and to the professional practitioner.[3]
It should also be noted that while goodwill is technically an intangible asset, goodwill and intangible assets are usually listed as separate items on a company's balance sheet.[4][5]
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. U.S. Generally Accepted Accounting Principles (FAS 141) no longer allows pooling-of-interests method.
Amortization and adjustments to carrying value
Goodwill is no longer amortized under U.S. GAAP (FAS 142)[6]. 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.[7]
Instead of deducting the value of goodwill annually over a period of maximal 40 years, companies are now required to value fair value of the reporting units, using present value of future cash flow, and compare it to their carrying value (booked 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.[8]
When the business is in trouble, with the threat of insolvency, investors will deduct the goodwill from any calculation of residual equity because it will likely have no resale value.
See also
- Intangible asset
- Business valuation
- Consolidation (business)
- Control premium
- Divestment
- Enterprise value
- Mergers and acquisitions
- Subsidiary
References
- ^ ACCOUNTING TERMS — ACCOUNTING DICTIONARY — ACCOUNTING GLOSSARY
- ^ http://www.nysscpa.org/cpajournal/2001/1000/features/f101801.htm
- ^ ValuAdder - Business Goodwill
- ^ Intangible Assets Definition at Wikinvest
- ^ Goodwill Definition at Wikinvest
- ^ Summary of Statement No. 142
- ^ A Primer on Calculating Goodwill Impairment: Valuation Issues Raised by Financial Accounting Statement 142
- ^ Focus on Goodwill, Intangible Assets
Categories: Generally Accepted Accounting Principles | Mergers and acquisitions
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