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Goodwill

Goodwill is a type of intangible asset that is not readily identifiable. Identifiable intangible assets are assets that can be alienated from the firm (for example, they can be sold). Most of these identifiable intangible assets arise from contractual or legal rights. For example, a patent is an intangible asset that arises from a legal right granted by the government to exclude others from using your invention. This right can be sold, transferred, licensed, rented or exchanged.

Goodwill is an intangible asset that arises from things like customer loyalty and report. We know that having a good report with clients or a unique position in a market has value. However, what that value is is difficult to measure: one firm can’t sell its good report to another firm to raise money. The question is, if the value of goodwill can’t be separated from the value of a business as a whole, how do we measure the value of goodwill? Accountants have figured that goodwill can be measured when one firm is sold to another firm for a premium. That is, goodwill is equal to the amount that the price paid for a business exceeds the value of its tangible and identifiable intangible assets; we assume that if a firm is willing to pay more for a company than its individual parts are worth, that premium reflects something else of value, and that value is goodwill.

Recognizing Goodwill

It is important to note that GAAP only allows a company to recognize the value of goodwill when the company is purchased by another company and, as such, a reasonable price can be placed on the value of the goodwill. In equation form, goodwill can be represented as:



Where,



Bargain Purchases

In some instances the price for a business may be less than the fair value of the business’s assets, resulting in what might be seen as “negative goodwill.” These transactions rarely occur, since it would be beneficial for the owner(s) of the business to sell the business’s assets rather than the business as a whole. However, if this situation does occur, the proper accounting treatment is to subtract the value of the “negative goodwill” proportionally from the value of the assets acquired that is recognized on the financial statements. If the value of these assets is reduced to zero, and an amount of “negative goodwill” still remains, GAAP allows the company to recognize a gain on the purchase of these assets.

Valuation of Goodwill after Acquisition

After the acquisition of a new business, the value of that business’s goodwill will appear as an asset on the balance sheet. While there is significant debate about the proper accounting treatment of this goodwill, GAAP requires companies to keep goodwill as an asset on their balance sheet indefinitely, and does not allow for goodwill to be amortized.

Impairment of Goodwill

When goodwill is found to have been impaired, its value is reduced on the balance sheet. There is a two-step process for determining if goodwill is impaired.

Step 1: The first step is to compare the fair value of the business unit with the carrying amount of its assets on the balance sheet including goodwill. If the fair value of the business unit is more than its carrying amount, there is no impairment. If, however, the fair value of the business unit is less than its carrying amount, an impairment of goodwill needs to be recorded.

Step 2: The second step is to measure the impairment of goodwill. This is done by taking the fair value of the business unit as a whole and subtracting the fair value of the unit’s net assets. (This is a different measurement than in step one, but intuitively it makes sense). 

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