Goodwill mainly generates when one company purchases another company at a price which is higher than that of the sum of the fair value of net identifiable assets of the company at the time of acquisition and it is calculated by subtracting the fair value of net identifiable assets of the company from the total purchase price.
What is Goodwill?
Goodwill is an “Asset” but it is “Intangible” and cannot be seen. it generally arises from an acquisition of two companies. It is the amount that acquiring companies pay to the target company in excess of the book value of assets. If a company pay less than the book value of assets of the target company, then it is a ‘Negative goodwill’
Simply goodwill, as the name suggests, is a good name that company or organization has in serving its products or services over a period of time. Because of its services, the value of the firm exceeds its assets and an intangible good name is formed in the society towards the company or brand or product or service which is called as goodwill in accounting terminology.
Under the accounting standards of US GAAP and IFRS, it is identified as an intangible asset with an indefinite life. It is not amortized as the other intangible assets, however, it is periodically (yearly) checked for impairment.
Goodwill Example – Google’s Acquisition of Apigee
source: Google SEC Filings
We note from the above Goodwill example, Google acquired Apigee Corp for $571 million in cash.
Here is the breakup of the acquisition amount
- $127 million was attributed to Intangible Assets
- $41 million was cash acquired.
- $27 million was the net assets acquired
- Remaining $376 million was attributed to Goodwill.
How to Calculate Goodwill in an M&A?
We will learn to calculate Goodwill step by step with the help of an example. Let us assume that there is a company A that acquired company B for a total consideration of $480 million.
Let us now look at the steps to calculate goodwill in such an acquisition.
Step 1 – Find the Book Value of Assets
You can find the book value of assets from the balance sheet of the company. Below are the financials of Company B.
Step 2 – Find the Fair Value of Assets
The fair value of assets can be determined with the help of an accounting firm as they are well equipped to value the assets of the firm. Below is the snapshot of the fair value of Assets of Company B.
Step 3 – Calculate Fair Value Adjustments
Fair Value Adjustment is the difference between Fair Value of Assets of Company B and Book Value of Assets of Company B
- Fair Market Value Adjustments = (100 – 80) + (180 – 100) – (40 – 40) – (40-20) = 20 + 80 – 0 – 20 = 80
Step 4 – Calculate Excess Purchase Price
Excess Purchase Price is the net of actual price consideration and the book value of target company.
- Actual Price Paid – $480 million
- Net Book Value of Company B = $100 + 80 + 60 – 20 – 40 = $180
- Excess Purchase Price = Actual Price Paid – Net Book Value of Company B = $480 – 180 = $300
Step 5 – Calculate Goodwill
It is the difference between excess purchase price and fair value adjustments.
- Excess Purchase Price – Fair Value Adjustments = $300 – $80 = $220 million.
Goodwill Journal Entries
It generally is recorded in the journal books of account only when some consideration in money or money worth is paid for it.
The journal entry for goodwill is generally posted as follows…
Acquired asset Dr XXX
Goodwill Dr XXX
Cash/Bank Cr XXX
Let us take an example to understand the goodwill journal entries. The fair value of net assets acquired of ABC & Co in an acquisition is $10 million and amount paid is $12 million then the journal entry is as follows.
Assets (Fixed assets/current assets) Dr $10 million
Goodwill (12Mn-10Mn) Dr $2 million
To Bank/cash/Shares Cr 12 million
What happens to the Internally Generated Goodwill?
It is not recognized as an asset because it is not an identifiable asset controlled by an enterprise that can be measured reliably at cost. The subsequent expenditure on intangible assets like brands, publishing titles, and items of similar nature are recognized as an expense to avoid any internally generated goodwill.
How about Amortization?
As per international accounting standards, it is no longer amortized or depreciated. Instead, it should be tested for impairment every year as explained below. However, as per Indian accounting standards, goodwill acquired on amalgamation or merger is to be amortized over its useful life. Since it is difficult to estimate the useful life with reasonable certainty, it is suggested to be amortized over a period not exceeding five years unless a somewhat longer period is justified.
When a business is expected to wind up or insolvent, investors generally deduct the goodwill from any calculation because it will likely have no resale value.
Impairment of goodwill
Each year goodwill needs to be tested for impairment. Impairment occurs when the market value of assets decline below the book value. Then it needs to be reduced by the amount the market value falls below book value.
For example, ABC Co purchased a company for $12 million where $5 million is goodwill. After running the business for so many years with losses and you feel the market value of assets acquired through the acquisition of ABC company is very less and it is now $9 million only. In this case, the market value of assets acquired dropped by $3 million and it needs to be reduced by the same amount.
In this case, the entry for impairing goodwill is as follows,
Loss on impairment A/c Dr 3 million
Goodwill A/c Cr 3 million
(Goodwill impaired for the drop in the market value of assets acquired by acquisition of ABC Co)
If in subsequent years the fair value decreased further, then it is recognized to the extent of only $5 million and if fair value decreases further, then decrease in fair value is apportioned among all the assets.
Reversal of impairment:
When the reversal of impairment happens due to increase in the fair value of assets, then reversal is allocated to carrying the amount of assets first to assets other than goodwill on pro-rata basis and then allocated later to goodwill.
For example, In the above example, ABC Co acquired assets for $12 million where $5 million is goodwill and when the market value of assets dropped to $6 million then $6 million (12-6) has to be impaired. Then it is impaired for entire $5 million and other assets acquired are proportionately by $1 million.
In this case, 2 years later the market value of assets acquired increased by $4 million, Then the value of $4 million to be first apportioned to assets up to $12 million and if a balance still left then that has to be allocated to Goodwill.
This has been a guide to what is Goodwill? Here we discuss how to calculate Goodwill in M&A. Also, we discuss Goodwill Accounting including journal entries, amortization, impairment, and its reversal. You can learn more about Accounting from the following articles –