During an acquisition, a company’s goodwill represents its intangible assets, which cannot be physically measured or calculated. When one firm buys another, they can measure and calculate the tangible assets such as the premises, equipment and stock, but other elements will influence how much to pay to acquire the company.
Intangible assets include the likes of brand value, customer loyalty and any employee’s exceptional or unique abilities. These are represented in the overall cost of the acquisition as goodwill.
Brand value as goodwill
Let’s take a hypothetical example such as Mercedes-Benz buying out Porsche. Porsche can sell its tangible assets like their manufacturing plants for a calculable sum, but it also boasts a globally strong brand associated with high-end sports cars which Mercedes must account for when negotiating the sale price.
Customer loyalty as goodwill
Building up a loyal customer base is another asset that would fall under the goodwill definition. If McDonalds wanted to buy Burger King, it would have to factor into the price that Burger King has a loyal customer base that likes their burgers more than rival burger companies. While you wouldn’t be able to put an exact number on it, it is an intangible asset that Burger King can use to increase its sale value.
Staff talent as goodwill
Another example of an intangible asset that adds value to a company despite not being able to be measured exactly is that of the talent in the workforce. A charismatic sales team, for example, might be the reason a company is doing really well at sales. If another firm wants to buy that company, it is not just the sales numbers that should be factored into the price, but the talented employees who are individually responsible for driving those sales.
Treating goodwill in financial statements
As it involves intangible assets, recording goodwill on financial statements such as balance sheets requires listing them as “noncurrent assets”. This represents an asset that counts as a long-term investment whose full value cannot be realised within the current financial year.
During an acquisition, all tangible assets will be calculated and an amount declared. The goodwill is added on top of what all the tangible assets are worth. The difference is accounted for under goodwill on the financial statement. A company aiming to buy out another will do this in the hope that it will make back the amount spent on goodwill in the purchase price.
The extra amount paid under goodwill remains the same even if the goodwill increases, but it will not if it decreases. If the goodwill decreases after the acquisition, then the company undergoes goodwill impairment.
Goodwill impairment accounting
Every company that buys other companies must analyse the current value of each its acquisitions every financial year. This analysis is called “impairment testing” – the process determines if the acquisitions are still worth the value entered on the balance sheet. If the goodwill value remains the same or increases, there are no issues to resolve.
However, if the goodwill has declined according to the latest goodwill impairment accounting, then the amount of decline must be entered on the balance sheet. If the decline is significant, then the company will report an impairment expense. This expense then reduces net income for the year by the same amount.
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