Accounting for Goodwill

What is goodwill? Depending on whom you ask you may find many different answers to this question. If you were to ask an accountant what goodwill is he or she would exclaim that goodwill is the amount an entity pays in acquiring a business that is in excess of the acquisition’s fair market value of its net assets (Goodwill = Purchase Price of an Entity - The Entity’s Fair Market Value of Net Assets of the business). What this basically means is that goodwill represents a value of an entity above what the current fair market value of the acquired firm’s net assets. Some examples of goodwill would be: future profitability of the acquired firm, client lists, brand name etc… Goodwill is considered an intangible asset and once the value of goodwill is established this amount is listed as an asset on the acquiring firm’s balance sheet.

In the past, firms had to account for goodwill by abiding by the Accounting Principles Board (APB) Opinion 17 issued in 1970. In this opinion, when a firm was purchasing another entity, the purchasing firm could account for any goodwill involved in the transaction as an asset on their balance sheet and amortize the asset over a maximum of 40 years. If the purchasing firm did not want to amortize the value of the goodwill involved in the purchase of another organization it could also use the Pooling-of-Interest accounting method. The Pooling-of-Interests accounting method combines the book value of each firm’s assets and liabilities to create the new entities’ combined balance sheet. In this transaction, it is hard, if not impossible, to figure out which entity is the purchasing entity and which entity is being purchased. The Pooling-of-Interests method basically negated the need to account for goodwill at all. However, the Pooling-of- Interests method was superseded and is no longer an option of merging firms as of the issuance of FAS 141 by the Financial Accounting Standard Board (FASB). The Accounting Principles Board (APB) opinion 17 was also superseded when the Financial Accounting Standards Board (FASB) issued SFAS 142, Goodwill and Other Intangible Assets, in June 2001. In this statement the FASB laid out the new rules when accounting for goodwill. In this statement, amortization of all goodwill stopped regardless of when it was originated. According to this statement goodwill amounts are still to be treated as intangible assets (and listed on the purchasing firms balance sheet), but instead of amortizing this asset over a maximum of 40 years, each firm that records goodwill on their balance sheet must annually test the value of goodwill for impairment. To test goodwill for impairment an organization has to take the book value of the goodwill on their balance sheet (the carrying value), and compare it against the current fair value of this goodwill (using the present value of future cash flows). If the fair value of the goodwill in question were to decrease to a value lower than the book value (carrying value), then the firm must impair (or write off) the difference in the value of the current goodwill asset. An example of this would be if XYZ firm purchased ABC firm, and the transaction involved $100,000 worth of goodwill, this goodwill would have to be tested at least annually to make sure it does not decrease in fair value. If it were to decrease in fair value the amount that the $100,000 was reduced by would need to be impaired (written off). For the purposes of our example let’s say the fair value of the goodwill in question were to decrease by $10,000 and the fair value of this goodwill would now be $90,000 the $10,000 would be impaired (written off). That is, the $10,000 would be reduced from XYZ assets (goodwill) on its balance sheet, and this $10,000 would show up as a loss (expense) on XYZ income statement. SFAS 142 also states that if in the following accounting periods test of goodwill for impairment, the $90,000 in goodwill now on XYZ balance sheet were to increase in value the firm is not allowed to increase the goodwill asset; XYZ is only able to impair the value of the goodwill asset if it were to decrease in value.

The effect of SFAS 142 does have a mixed impact on different organizations. Because goodwill was amortized and expensed on the income statement (prior to SFAS 142) this amortized amount would be part of the expenses deducted from the purchasing firm’s revenue to come up with the entity’s net income. By getting rid of this amortization the purchasing firm in theory may not have to report a loss against its revenue (on the entity’s income statement) if the fair value of the goodwill in question does not decrease in value. Thus SFAS 142 would be advantageous to a firm that does not have to impair any value of their current goodwill assets, and because the amortization expense of this goodwill is no longer netted against current revenues, net income would in essence be higher as a result. SFAS 142 could also lower the purchasing firm’s net income on an irregular basis. Now that the purchasing firm is no longer allowed to amortize goodwill over a maximum of 40 years and it has to test the goodwill asset for impairment; any reduction in net income that would occur from the loss of fair market value of the goodwill in question is going to be more volatile and varying in amounts. This volatility means that a loss could be booked for the goodwill one year and not be booked the next year, and each time the loss is booked it could be by a different amount.

Accounting for goodwill does spark some controversy in the accounting field. Because it is an intangible asset, goodwill is very hard to value, identify, and measure. Also when the acquiring entity does its yearly evaluation of the goodwill in question the fair market value is difficult to measure because it is an intangible asset. The accounting for goodwill is still a controversial topic that will more than likely have to be modified again in the future.