Goodwill is defined as an intangible asset that is created as the result of an acquisition of one company by another, at a premium price over its fair market value.
The willingness of a buyer to pay a premium for a given business
may be due to value built up over time from things such as the company’s widely-recognized brand name, good customer relations, a deep and diverse customer list, well-trained and loyal employees, unique patents, proprietary technology or processes, and many other other intangible assets which may not be fully-recognized and/or recorded as assets on the company’s books.
To calculate goodwill, subtract the fair market value of the tangible and intangible assets, as well as the liabilities recorded on the company’s balance sheet, from the actual purchase price.
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Amortization of Goodwill
Prior to 2001, U.S. Accounting rules required that goodwill be amortized (or deducted as an expense) over a period of up to 40 years. Because amortizing goodwill reduces the profit for accounting purposes, most companies preferred not to amortize goodwill quickly and elected to stretch the amortization over the full 40-year period. Doing so helped neutralize the periodic earnings effect, and allowed companies to report supplementary cash earnings that could then be added to net income. This is exactly why, in 2001, the Financial Accounting Standards Board (FASB) issued Statement 142 which prohibits this activity.
The elimination of amortization of goodwill does come with some stipulations, however. Now companies have to run costly impairment tests, which must be performed in the first half of the company’s fiscal year. If an impairment is discovered, the company would need to reduce the goodwill carrying value and record an impairment loss.
For large public companies, the benefit of not amortizing goodwill far outweighs the costs, as higher profits make financial statements look better. However, for small and medium-sized private companies, the cost of the impairment tests is more significant.
As a response to this issue, in 2014, FASB began allowing private companies to elect to amortize goodwill on a straight-line basis over a 10-year period, giving them the option to forgo costly impairment testing. It is worth noting that if a “triggering event” happens (when the company’s fair value is less than its carrying amount), private companies who have elected to amortize goodwill will still be required to pay for an impairment test.
How Does Amortization of Goodwill Affect Financial Statements?
It is important to keep in mind that a private company’s financial statements will vary greatly based on whether they are amortizing goodwill or, instead, paying for impairment tests. Private companies that choose to amortize goodwill potentially carry a large amortization expense. As such, investors and companies looking to acquire a private business should standardize ratios and valuation methods across comparable businesses to exclude any non-cash amortization.