Goodwill (accounting)

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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.

Contents
[hide]

• 1 Modern meaning
 • 2 History and purchase vs. pooling-of-interests
• 3 Amortization and adjustments to carrying value
• 4 See also

• 5 References

[edit] 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 a gain to the extent that it exceeds allocations to certain assets. Under current
accounting standards, it is no longer recognized as an extraordinary item. 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.[2]

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.[3][4]

[edit] 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.
[edit] Amortization and adjustments to carrying value
Goodwill is no longer amortized under U.S. GAAP (FAS 142)[5]. 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.[6]

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.[7]

When the business is threatened with insolvency, investors will deduct the goodwill from any
calculation of residual equity because it will likely have no resale value.