Accounting goodwill is often misunderstood
Accounting goodwill is an asset shown on the balance sheet. It has a specific definition under generally accepted accounting principles (GAAP) that most investors and many managers misunderstand. Almost every year my upper-level accounting students ask about accounting goodwill and strive to better understand the concept. As a user of financial statement information, you can benefit from working knowledge of accounting goodwill because it signals information about acquisitions. Let’s explore the concept, including several reasons why you might benefit from analyzing accounting goodwill.
What is goodwill according to GAAP?
The definition of goodwill is the excess cost of an acquired firm over the current fair value of the separately identifiable net assets of the acquired firm.
Several observations based on the definition of goodwill follow:
- You will only see goodwill as an asset on an entity’s balance sheet if that entity has acquired another firm. Entities do not record their own goodwill, only goodwill in acquired firms. If XYZ, Inc. purchases (acquires) Widget, Inc., then XYZ will record an asset named called goodwill on its balance sheet based on the acquisition of Widget. Any such goodwill amount recorded by XYZ has nothing to do with the company’s own goodwill.
- GAAP doesn’t allow entities to record their own goodwill in part because it is so imprecise to measure. Entities can discuss goodwill they have created in their annual reports, but not record it in their balance sheets.
- Referring to the definition of goodwill above, fair value is a formal GAAP term that many managers refer to as market value. When XYZ acquires Widget it will “fair value” all identifiable net assets. That is, it will value acquired assets at their market value, assuming a market exists. Since many assets lack fully functioning markets, fair value is a more technically precise term. For example, suppose Widget has older, well-used manufacturing equipment. There may not be a fully functioning market for that particular used equipment, but there are valuation methods whereby the fair value of the used equipment can be estimated accurately. Fair value might be based on bids to buy the used equipment, recent (but not current transactions) in similar used equipment, etc.
- Net assets are assets less liabilities. When XYZ purchases Widget, it will fair value all identifiable assets and liabilities of Widget.
- Separately identifiable net assets are assets and liabilities that can be separated from the rest of the business and sold, leased, rented, settled, etc. Customer loyalty and good employee morale generally can’t be separated from other assets so they are not separately identifiable. In contrast, a customer list is separately identifiable because it can be rented, sold or leased.
- By definition, goodwill is not separable from the acquired firm’s identifiable net assets. It can only be sold as part of the business as a whole to which it is attached.
- According to GAAP, the term “intangible assets” as shown on a balance sheet refers to intangible assets other than goodwill. One interpretation of this GAAP definition is that goodwill is technically not an intangible asset. Intangible assets are separately identifiable and goodwill, by definition, is an amount paid by an acquiring entity above and beyond the fair value of all separately identifiable net assets which includes all intangible assets. This is confusing because clearly goodwill is an asset according to GAAP and clearly it is intangible, but apparently not an intangible asset. As a result, entities list goodwill and intangible assets separately in their balance sheets, or add them together and describe them as “intangible assets and goodwill” or something similar.
An intuitive description of goodwill
What, intuitively, is accounting goodwill? An acquiring firm would be willing to pay the fair value for all net assets and then be willing to pay an excess (goodwill) for non-identifiable items such as a business’s good customer relations, well-respected business names, good employee morale, employee knowledge of business operations, etc. An example might help clarify:
Suppose you are considering purchasing a hot dog stand. You can purchase all the equipment from hotdogstandinakit.com for $10,000. The kit has everything you need to start your new business. You then happen across a hot dog stand and the owner tells you that: a) he just replaced his old hot dog stand with the equipment available from hotdogstandinakit.com; b) he has an established business with a solid reputation and a well-known location; and c) his employee runs the stand and wants to continue doing so if he sells you his business. He wants to negotiate a selling price in excess of $10,000. Would you consider paying more than the $10,000 selling price for the kit?
Of course you would, because you’d be willing to pay for the good location, customer awareness, an employee that knows how to run the stand and the kit is already set up and working. Any extra amount you pay over $10,000 is recorded as goodwill. Notice that if you just bought the hot dog stand from the owner, not the business, you have only purchased equipment, and there is no goodwill to record.
Why analyze goodwill on a balance sheet?
Knowledgeable analysts and investors (and business journalists) will pay close attention to goodwill amounts on an entity’s balance sheet because it helps them assess whether an entity overpaid for an acquisition or is taking a substantial risk buying another entity. The more paid to acquire another firm, the higher the amount of goodwill recorded. Analysts and investors will be keenly interested in how an acquiring firm intends to create wealth from an acquisition after paying a high price above and beyond identifiable net assets. Historically, some technology firms have been purchased at such high prices that goodwill is well more than half the purchase price. Risky acquisitions often exist. Of course, then knowledgeable analysts and investors will track goodwill through time to see if it is impaired. Impairment of goodwill often signals that the acquisition is not working, and wealth has been destroyed.
