Goodwill

Goodwill 

Goodwill in accounting is an intangible asset that arises when a buyer acquires an existing business, but pays more than the fair market value of the net assets (total assets - total liabilities).

An intangible asset that arises as a result of the acquisition of one company by another for a premium value. The value of a company’s brand name, solid customer base, good customer relations, good employee relations and any patents or proprietary technology represent goodwill. Goodwill is considered an intangible 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.

Negative goodwill arises when an acquirer pays less for an acquiree than the fair value of its assets and liabilities. This situation usually only arises as part of a distressed sale of a business.

Breaking Down

The value of goodwill typically arises in an acquisition when one company is purchased by another 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.

Goodwill is difficult to price, but it does make a company more valuable. For example, a company like Coca-Cola (who has been around for decades, makes a wildly popular product based on a secret formula and is generally positively perceived by the public), would have a lot of goodwill. A competitor (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.

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 goodwill. In fact, this happened in the AOL-Time Warner merger of 2001.

Goodwill vs Other Intangible Assets

Companies looking to grow and expand in their business strive not only to acquire tangible assets like land, buildings and factories, but also intangible assets like trademarks, copyrights, patents, formulas, franchises, goodwill, etc. And most major companies that you've heard of--companies with any kind of shelf life--rely heavily on both kinds of assets.

Intangible assets are non-physical assets; differently put, they don’t have a physical substance. These intangible assets can be either developed internally by a company or acquired from others. Intangible assets can sometimes outweigh tangible assets in terms of value, and they are a defining factor for the long-term success of a business. Despite their importance, however, intangible assets are sometimes difficult to recognize, define and measure.

Intangible assets can be further categorized into identifiable and unidentifiable intangibles. Intangibles such as patents, copyrights, licenses, secret formulas, franchise, trademarks, etc fall under the category of identifiable intangibles, while goodwill is the most common unidentifiable intangible. Intangible assets can further categorized as indefinite or definite, depending on the specifics. For example, a patent has a definite life or time frame, whereas such timelines don’t exist for a brand name company's reputation.

There are many factors that separate goodwill from the other intangible assets.

The value of a company may not always be correctly quantified by the assets. A business over a period of time develops customer loyalty, brand name and reputation--all of which make it worth more than its book value. This “X” factor that makes the business worth more than its quantifiable assets is “goodwill”. 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 (=assets - liabilities or $100 - $20) is the worth of goodwill and is recorded in the books as such.

Goodwill, as a typical unidentifiable intangible asset, cannot exist independently of the business, nor can it be sold, purchased or transferred separately without carrying out the same transactions for the business as a whole. In quantifiable terms, goodwill is usually represented by the excess of cost paid during an acquisition which is over and above the fair value of assets. Goodwill can be positive as well as negative and is a part of any acquisition. The life span of goodwill is not definite; it has a useful life which is indefinite unlike most of the other intangible assets.

Other intangible assets, however, can be quantified and have a separate identity of their own which is independent of the business as a whole. They can be bought and sold, rented or exchanged or acquired through legal or contractual rights. The common ones in this category are patents, copyrights, trademarks, etc. The intangible assets have different life spans according to the rules and regulations. For instance, the United States Patent and Trademark Office grants the owner of an invention, patent rights for a period of 20 years. A company can buy a patent by paying a specified amount for a specific period (a case where intangible asset is bought).

The Financial Accounting Standard Board (FASB) has come up with a new alternative rule for accounting of goodwill for private companies. The rules by FASB for public companies and non-profit organizations are to be addressed in a future project. The last amendment was made in 2001 and before that in the 1970s. During that time, goodwill was amortized against earnings over a period not to exceed 40 years. In 2001, there was a change in rules according to which goodwill could not be amortized; but rather was evaluated annually to determine impairment loss. The annual valuation process was expensive as well as time-consuming.

As per the alternative FASB rule for private companies (2014), goodwill can be amortized on a straight-line basis over a period not to exceed ten years. The need to test for impairment has decreased under this rule but not eliminated; test for impairment is conducted when some event occurs that signals that the fair value may be have gone below the carrying amount. The new alternative rule is likely to result in cost savings for private companies. These rules apply to businesses conforming to Generally Accepted Accounting Principles (GAAP) using a full accrual accounting method. Intangible assets having a finite useful life need to be amortized over the estimated useful life. If conditions indicate that the carrying value may not be recoverable, then tests for impairment are performed.

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. Be sure to understand them and then proceed correctly. Read more about reporting requirements of small businesses here.

Goodwill, patents, copyrights, licenses, franchises, etc. all fall under the category of intangible assets. These assets do not possess any physical substance but are of great importance to any business over the long term. Goodwill is a premium paid over the fair value of assets during the purchase process 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 and are amortized over those years.