GOODWILL

Goodwill is an intangible asset that is associated with the purchase of one company by another.
Specifically, goodwill is the portion of the purchase price that is higher than the sum of the net
fair value of all of the 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 proprietary technology represent some reasons why goodwill
exists.

• Goodwill is an intangible asset that accounts for the excess purchase price of another
company.
• Items included in goodwill are proprietary or intellectual property and brand recognition,
which are not easily quantifiable.
• Goodwill is calculated by taking the purchase price of a company and subtracting the
difference between the fair market value of the assets and liabilities.
• Companies are required to review the value of goodwill on their financial statements at
least once a year and record any impairments. Goodwill is different from most other
intangible assets, having an indefinite life, while most other intangible assets have a finite
useful life.

The process for calculating goodwill is fairly straightforward in principle but can be quite complex
in practice. To determine goodwill in a simplistic formula, take the purchase price of a company
and subtract the net fair market value of identifiable assets and liabilities.

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 net
assets at fair 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 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.
Goodwill is considered an intangible (or non-current) asset because it is not a physical asset like
buildings or equipment.

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 that are not known at the time of the acquisition. While this is perhaps not a
significant issue, it becomes one when accountants look for ways of comparing reported assets
or net income between different companies; some that have previously acquired other firms and
some that have not.
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 do a write-down on 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 are also negatively affected.

The Financial Accounting Standards Board (FASB), which sets standards for GAAP rules, is
considering a change to how goodwill impairment is calculated.2 Because of the subjectivity of
goodwill impairment and the cost of testing impairment, FASB is considering reverting to an older
method called "goodwill amortization" in which the value of goodwill is slowly reduced annually
over a number of years.

Goodwill is not the same as other intangible assets. Goodwill is a premium paid over fair value
during a transaction and cannot be bought or sold independently. Meanwhile, other intangible
assets include the likes of licenses and can be bought or sold independently. Goodwill has an
indefinite life, while other intangibles have a definite useful life.

Goodwill is difficult to price, and negative goodwill can occur 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 income statement.

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.

Example of Goodwill
If the fair value of Company ABC's assets minus liabilities is $12 billion, and a company purchases
Company ABC 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.

As a real-life example, consider the T-Mobile and Sprint merger announced in early 2018. The
deal was valued at $35.85 billion as of March 31, 2018, per an S-4 filing. The fair value of the
assets was $78.34 billion and the fair value of the liabilities was $45.56 billion. The difference
between the assets and liabilities is $32.78 billion. Thus, goodwill for the deal would be
recognized as $3.07 billion ($35.85 - $32.78), the amount over the difference between the fair
value of the assets and liabilities.

PROBLEM:
The BIR wants to tax the sale of goodwill a sale of an ordinary asset subject to the imposition of
ordinary income tax under Section 27 of the 1997 Tax Code.

SOLUTION:
Seek intervention from the court. In CTA EB Case 1257, the Court of Tax Appeals (CTA) en banc
ruled in the negative. In this case, the CTA canceled the assessment issued by the Bureau of
Internal Revenue against a taxpayer for alleged deficiency income tax due arising from the sale
of a goodwill, pursuant to Section 27(A) of the 1997 Tax Code. The tax court ruled that a goodwill
is not an ordinary asset but a capital asset since (1) it is not included in stock in trade which would
properly be included in the inventory at the close of the taxable year, (2) nor it is held primarily
for sale to customers in the ordinary course of his trade or business, (3) nor it is a property used
in the trade or business, of a character which is subject to the allowance for depreciation
provided in subsection (f) of Section 34 of the National Internal Revenue Code, and (4) nor it is
real property used in the trade or business.

Citing the old case of WM H. Anderson vs. Juan Posadas Jr., GR 44100, September 22, 1938, the
tax court ruled that if the goodwill, that is, the good reputation of the business is acquired in the
course of its management and operation, it does form part of the capital with which it was
established. It is an intangible moral profit, susceptible of valuation in money, acquired by the
business by reason of the confidence reposed in it by the public, due to the efficiency and honesty
shown by the manager and personnel thereof in conducting the same on account of the courtesy
accorded its customers, which moral profit, once it is valuated and used, becomes a part of the
assets.

The gain or the loss is ordinary when the property sold or exchanged is not a capital asset.
Goodwill is not an ordinary asset, as it is not among the exceptions under the definition of capital
assets in Section 39(A)1 of the 1997 Tax Code. Hence, the sale of a goodwill is a sale of a capital
asset subject to capital gains tax.