Goodwill (accounting)
Goodwill in
accounting is an intangible asset that arises when a buyer acquires
an existing business. Goodwill represents assets that are not separately
identifiable. Goodwill does not include identifiable assets that are capable of
being separated or divided from the entity and sold, transferred, licensed,
rented, or exchanged, either individually or together with a related contract,
identifiable asset, or liability regardless of whether the entity intends to do
so. Goodwill also does not include contractual or other legal rights regardless
of whether those are transferable or separable from the entity or other rights
and obligations. Examples of identifiable assets that are not goodwill include
a company’s brand name, customer relationships, artistic intangible assets, and
any patents or proprietary technology. The goodwill amounts to the excess of
the "purchase consideration" (the money paid to purchase the asset or
business) over the total value of the assets and liabilities. It is classified
as an intangible asset on the balance sheet, since it can neither be seen nor
touched. Under US GAAP and IFRS, goodwill is never amortized. Instead,
management is responsible for valuing goodwill every year and to determine if
an impairmentis 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. Private companies in
the United States, however, may elect to amortize goodwill over a period
of ten years or less under an accounting alternative from the Private
Company Council of the FASB.
Calculating
goodwill[edit]
In
order to calculate goodwill, the fair market value of identifiable assets and
liabilities of the company acquired is deducted from the purchase price. For
instance, if company A acquired 100% of company B, but paid more than the net
market value 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
Modern
meaning[edit]
Goodwill
is a special type of intangible asset that represents that portion of the
entire business value that cannot be attributed to other income producing
business assets, tangible or intangible. [1]
For
example, a privately held software company may have net assets (consisting
primarily of miscellaneous equipment and/or property, and assuming no debt)
valued at $1 million, but the company's overall value (including 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 other intangible assets. And any
consideration paid in excess of $10 million shall be considered as 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.[2][3]
US
practice[edit]
History
and purchase vs. pooling-of-interests[edit]
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).[4] 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.[5]
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 carrying value is equal to the fair 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.[6]
Controversy
When
the business is threatened with insolvency, investors will deduct the
goodwill from any calculation of residual equity because it has no resale value.
The
accounting treatment for goodwill remains controversial, within both the
accounting and financial industries, because it is, fundamentally, a workaround
employed by accountants to compensate for the fact that businesses, when
purchased, are valued based on estimates of future cash flows and prices
negotiated by the buyer and seller, and not on the fair value of assets and
liabilities to be transferred by the seller. This creates a mismatch between
the reported assets and net incomes of companies that have grown without
purchasing other companies, and those that have.
While
companies will follow the rules proscribed by the Accounting Standards Boards,
there is not a fundamentally correct way to deal with this mismatch under the
current financial reporting framework. Therefore, the accounting for goodwill
will be rules based, and those rules have changed, and can be expected to
continue to change, periodically along with the changes in the members of the
Accounting Standards Boards. Ironically, the current rules governing the
accounting treatment of goodwill are highly subjective and can result in very
high costs, but have limited value to investors.
References
1.
Accounting Standards Update for FAS 142, Goodwill and Other Intangible Assets.
Testing Goodwill for Impairment. Financial Accounting Standards Board, №
2011-08, 2011, p. 34.
2. B.
Epstein and E. Jermakowicz, “IFRS 2008. Intarpratetion and Application of
International Financial Reporting Standards,” John Wiley and Sons, Inc., 2008,
p. 1117. ISBN 978-0470-13516-7.
3. B.
Epstein and E. Jermakowicz, “IFRS 2010. Intarpratetion and Application of
International Financial Reporting Standards,” John Wiley and Sons, Inc., 2010,
p. 1342. ISBN 978-0470-45323-0.
4. FAS
141 (R), Business combinations. Financial Accounting Standards Board, 2007, p.
201.
5. FAS
142, Goodwill and Other Intangible Assets. Financial Accounting Standards
Board, 2001, p. 110.
6. FAS
157. Fair Value Measurement. Financial Accounting Standards Board, 2007, p. 158.
7. IAS
36, Impairment of Assets. International Accounting Standards Board, 2001, p.
147.
8. IFRS
13, Fair Value Measurement.. International Accounting Standards Board, 2011, p.
46.
9. IFRS
3 (R), Business Combinations. International Accounting Standards Board, 2008,
p. 50.
10. J. Sedláček, A. Konečný and Z. Křížová.
Methods for Valuation of a Target Company at the M&A Market. In
MATHEMATICAL METHODS for INFORMATION SCIENCE and ECONOMICS. 1. ed. Montreux:
WSEAS Press, 2012. p. 255-260, 6 p. ISBN 978-1-61804- 148-7.
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