Goodwill is an intangible asset that arises if an entity acquires another entity for a price higher than the fair value of total net identifiable assets (total identifiable assets – total liabilities) of acquired entity.
When an organizations (also called parent) buys another organization (also called subsidiary), it records all of the assets and liabilities of purchased organization at fair value after identifying each and everyone of them.
During this process, parent entity may identify and record such assets that were not previously recorded by subsidiary entity in this balance sheet as they were internally generated assets. Internally generated assets are not recognized as its difficult to value them. But now that entity and its assets are changing hands at fair value, therefore valuation of all the intangible assets, previously recognized or not, is possible. Adding up the values of all the identifiable assets will give total value of assets identified at the time of acquisition.
Goodwill is measured as the extra cost paid above the fair value of the identifiable net assets acquired.
Its logical that at the time of acquisition, parent entity must pay the price equal to the net assets acquired in the subsidiary i.e. total assets identified less total liabilities. If parent entity js paying the price exceeding the net identifiable asset then it makes sense only if the amount paid over and above the net assets is for those assets that were not identifiable or separable from entity. For example trust people pose in the organization is something that cannot be separated from organization and is an asset of the organization. This trust asset can only be sold if the whole organization is sold. All of such assets that cannot be separated from entity but hold future economic benefit are collectively called goodwill.
1 Accounting for Goodwill
Goodwill may be internally generated or inherited in a business combination transaction. Lets have a look at the accounting treatment under bother cases.
1.1 Internally generated goodwill
While discussing intangible assets, we learnt that some of the internally generated intangible assets may never be recognized. Reason is simple, its too difficult to measure cost incurred on creating such assets. In absence of reliable measurement, it cannot be recognized in the statement of financial position.
Adding more to the “impossibility” of measuring the internally created goodwill is that its measurement may involve subjectivity. Also there is just no mechanism to separate the cost incurred in operating a business and cost incurred on goodwill. For example what portion of cost of selling one unit to a happy customer should be attributed towards satisfaction of customer and sale of unit itself? This might involve too much of estimation for any good.
1.2 Purchased goodwill
As discussed earlier, as a result of business combination i.e. an entity buying another entity for a price in excess of fair value of identifiable net assets will give rise to goodwill asset.
However, care must be taken while calculating goodwill and it should be confirmed that:
- No asset or liability is left unrecorded or unidentified that should have been recorded and identified.
- No asset is underestimated or a liability overestimated as it will cause net assets value to decrease thus giving a false impression of goodwill.
- All assets and liabilities are measured at most recent fair values
- The liabilities recorded on present value basis are correctly and appropriately “unwound” i.e. increased with applicable interest rates
- Although current assets are not that much significant in value in total assets, still wrong valuation of receivables or inventory may lead to wrong goodwill calculation.
Example: Calculating goodwill
Pasu company recently acquired Shispare Inc for 1,500,000. Last financial statement of Shispare before acquisition is following:
|Non current assets|
|Non current liabilities|
|Total equity and liabilities||1225000|
Shispare carried asset on historical cost basis. Fair value of building was significantly different from fair value and is found to be 500,000. Values of other assets found to be appropriate.
Shispare is the owner of two famous brands named Gulmit and Ghulkin. As these are internally generated, they are not recorded in the above balance sheet of Shispare. It is found that fair value of Gulmit and Ghulin is 100,000 and 200,000 respectively.
Calculate amount of goodwill to be recognized by Pasu company
|Total identiable assets acquired:|
|Less: Liabilities taken up|
|Total identifiable net assets||(1,071,000)|
2 Subsequent increase in goodwill
After the recognition of goodwill acquired under purchase deal, the new entity may work even better than original entity and may induce if goodwill needs revaluation increase. This increase however is not permitted. As subsequent increase is just an increase in internal goodwill and not the purchased goodwill. Therefore, no increments are made to the value of purchased goodwill subsequent to recognition.
3 Amortization and Impairment of Goodwill
Goodwill is considered to be an intangible asset with indefinite life therefore not amortized. However, entities are required to conduct impairment review of goodwill on regular basis without waiting for indicators of impairment.
Technically speaking, the rate at which asset is amortized is required to be in line with the rate at which benefits are rendered by the same intangible asset. Speaking of goodwill, it is really hard to value the benefits goodwill generates over a period of time. And due to this amortisation charge cannot be linked to the economic benefits rendered in particular accounting period.
Therefore, amortization is considered more appropriate as it charges reduction in goodwill in the period expected to have been affected.
4 Negative Goodwill – Bargain Purchase
In rare situations it may occur that purchase price paid to acquire another entity is lesser than the the fair value of net identifiable assets. In other words giving rise to negative goodwill.
In this situation purchaser has bought the entity for a price even lesser than the net fair value of its assets. This is effectively a gain on acquisition or discount on purchase as buyer has paid lesser than what it should have.
Such gain is recorded immediately in the profit and loss account of the buyer just like any other gain or income in the period of acquisition.
The reasons include:
- Seller was unaware of its actual worth and thus entered a bad deal
- Entity is under severe financial crunch with the probability that its liabilities might bloat in future.
- Formalities required to conclude the purchase will cost higher thus seller has to accept a lower price.
- Forced liquidation or compulsory acquisition by government or other body
- Place is haunted or has a bad repute