Goodwill

When a company acquires another, the acquisition price is allocated to all identifiable assets (both tangible and intangible) and liabilities based on their fair value. If the acquisition price exceeds the fair value of these identifiable assets and liabilities, the surplus is recognized as goodwill on the balance sheet.

The acquirer may be willing to pay more to purchase a company than the fair value of
the target company’s identifiable assets net of liabilities for the following reasons:

• Factors not reflected in the acquiree’s financial statements, such as its reputation, established distribution system, and trained employees.
• The target company’s research and development efforts may have created value even if they haven’t resulted in a separately identifiable asset.
• The acquisition might bring strategic advantages or synergies, like cost-saving opportunities.

The recognition of goodwill in financial statements is a topic of debate. Proponents argue that goodwill represents the present value of future excess returns expected from the acquisition, similar to the valuation of other assets based on future cash flows. Opponents, however, contend that acquisition prices are frequently based on overly optimistic expectations, leading to future write-downs of goodwill.

Distinguishing Accounting and Economic Goodwill

Economic goodwill pertains to intangible aspects that enhance a business’ value beyond the total of its tangible assets and liabilities. These factors encompass brand recognition, customer loyalty, employee morale, management expertise, and relationships with suppliers. Economic goodwill reflects a business’s capacity to generate profits in the future beyond the expected returns on its tangible and intangible assets. Unlike accounting goodwill, economic goodwill doesn’t appear on the balance sheet. It’s typically assessed based on the company’s market value, representing the price an investor is willing to pay above its book value.

Accounting goodwill, on the other hand, is related to accounting standards and is reported only when an acquisition is involved. Both IFRS and US GAAP require capitalizing accounting goodwill that arises from acquisitions. It is, however, not amortized. Instead, it is tested for impairment on an annual basis. Impairment losses are charged against income in the current reporting period and result in the reduction of current earnings and total assets. Accounting goodwill must be disclosed in the financial statements with detailed notes explaining changes in the goodwill balance, methodology, and assumptions used for impairment testing.

The following steps are used to recognize goodwill, as required by the accounting standards:

Step 1: Determine the total cost to purchase the target company (the acquiree).

Step 2: Measure the target’s identifiable net assets at fair value. The liabilities and contingent liabilities of the acquired company are assessed at their fair value. The net identifiable assets acquired are determined by calculating the difference between the fair value of the identifiable assets and the fair value of the liabilities and contingent liabilities

Step 3: The goodwill is the excess of (I) the cost to purchase the target company over (II) the net identifiable assets acquired. Occasionally, a bargain purchase occurs, and any gain from the bargain purchase is recognized in the profit and loss statement.

Sometimes, a transaction may involve acquiring net identifiable assets whose value exceeds the purchase cost. This type of transaction is referred to as a “bargain purchase.” The gain resulting from a bargain purchase is recorded in the profit and loss statement in the period it occurs.

Disclosures Regarding Goodwill

Companies must also provide disclosures that allow users to assess the characteristics and financial impact of business combinations. These disclosures include, among others, the fair value of the total acquisition cost on the acquisition date, the amounts recognized for each significant class of assets and liabilities at the acquisition date, and a qualitative explanation of the elements contributing to the recognized goodwill.

Challenges and Adjustments in Goodwill Valuation

Despite existing accounting standards, analysts should note that fair value estimates are heavily reliant on management’s discretion. Valuing intangible assets, like computer software, can be challenging during acquisition analysis. This discretion in valuation impacts both present and future financial statements, as identifiable intangible assets with fixed lives undergo amortization. However, goodwill and identifiable intangible assets with indefinite lives are not subject to amortization but are subject to annual impairment tests.

The recognition and impairment of goodwill can greatly influence the comparability of financial statements across companies. As a result, analysts frequently modify companies’ financial statements by eliminating the effects of goodwill. These adjustments typically involve:

• Excluding goodwill from balance sheet data: This involves removing goodwill from total assets, equity, and other relevant balance sheet items before calculating financial ratios. This approach helps in analyzing a company’s financial position and performance based on its tangible assets and equity.
• Excluding goodwill impairment losses from income data: This involves adding back the goodwill impairment losses to the net income before analyzing operating trends. This approach helps in examining a company’s operating performance without the distortion caused by the non-cash expense of goodwill impairment.

Question

Which of the following is least likely correct regarding accounting goodwill?

1. Amortized.
2. Capitalized.
3. Tested annually for impairment.

Solution

The correct answer is A.

Accounting goodwill is not amortized. Instead, it is tested at least annually for impairment under both GAAP and IFRS. This means that the carrying value of goodwill is compared to its recoverable amount, and an impairment loss is recognized if the carrying amount exceeds the recoverable amount.