Goodwill

how is goodwill amortized

Goodwill is a type of intangible business asset. It is defined as the difference between the fair market value of a company's assets (less its liabilities) and the market price or asking price for the overall company. In other words, goodwill is the amount in excess of the company's book value that a purchaser would be willing to pay to acquire it. A combination of advertising, research, management talent, and timing may give a particular company a dominant market position for which another company is willing to pay a high price. This ability to command a premium price for a business is the result of goodwill. If a sale is realized, the new owner of the company lists the difference between book value and the price paid as goodwill in financial statements.

The sale of a business may involve a number of intangible assets. Some of these may be specifically identifiable intangibles — such as trademarks, patents, copyrights, licensing agreements — that can be assigned a value. The remaining intangibles — which may include the business's reputation, brand names, customer lists, unique market position, knowledge of new technology, good location, and special skills or operating methods — are usually lumped into the category of goodwill. Although these factors that contribute to goodwill do not necessarily have an assignable value, they nonetheless add to the overall value of the business by convincing the purchaser that the company will be able to generate abnormally high future earnings.

Although goodwill undoubtedly has value, it is still an intangible asset and as such is not recorded on a company's books. In fact, many companies use a value of one dollar for goodwill in their everyday accounting procedures. Many companies could be sold for a premium price based on the good reputation they have established. But such goodwill is never recorded on the books until an actual acquisition occurs. The acquisition price determines the amount of goodwill that is recorded following the purchase of a company. For example, if a small business with assets of $40,000 is purchased for $50,000, then the purchaser records $10,000 of goodwill.

In general, determining the sales price of a business begins with an assessment of its equity, which includes tangible assets such as real estate, equipment, inventory, and supplies. Then an additional amount is added on for intangible assets (sometimes called a "blue sky" amount), which may include things like patent rights, a trade name, a non-compete clause, and goodwill. Experts note that in small business sales, the combined total of "blue sky" additions should rarely be more than a year's net income, because few purchasers are willing to work longer than that for free. For public companies, the amount of goodwill is often dependent on the vagaries of the stock market. Since the share price determines the purchase price, the value attributed to goodwill may fluctuate wildly during the course of an acquisition.

Standard accounting procedures state that, following an acquisition, the purchaser should amortize goodwill over a period of 15 years using the straight-line method. In other words, one-fifteenth of the original amount attributed to goodwill is deducted each year. Since this writeoff period is longer than that required for most tangible assets, it is usually a good idea to allocate as much of the purchase price as possible to business equipment. The shorter depreciation period would enable the purchaser to accelerate deductions and thus achieve earlier tax savings.

On occasion, the goodwill booked after the sale of a business may be written down or reduced. Such occasions usually occur because of some larger shift within the market in which the business is active, a shift that causes a reevaluation of the business. An example of such is the mobile phone market. During the 2000s the market grew quickly, as many new companies entered the market, and many mergers and acquisitions occurred. In late 2005 and early 2006 T-Mobile and Vodafone announced large write-downs of the goodwill on their books in order to more accurately reflect the competitive marketplace in which they operate.

Over the years, there has been some dissatisfaction expressed with the way that goodwill is handled for accounting purposes. First, since goodwill is sometimes a huge component of a company's acquisition price (particularly in the case of large public companies), the amortization of goodwill can have a significant negative effect on the purchaser's net income. Second, the treatment of goodwill under U.S. law differs from many other countries, which sometimes puts American companies at a disadvantage in international mergers and acquisitions.

see also Business Appraisers

BIBLIOGRAPHY

Anthony, Robert N. and Leslie K. Pearlman. Essentials of Accounting. Prentice Hall, 1999.

Best, Jo. "T-Mobile Goodwill Gut by 1.5 Billion Euros." Mobile and Wireless. Silicon.com Available from http://networks.silicon.com/mobile/0,39024665,39156963,00.htm 3 March 2006.

Bragg, Steven M. Accounting Best Practices. John Wiley, 1999.

Weatherholt, Nancy D. and David W. Cornell. "Accounting for Goodwill Revisited." Ohio CPA Journal. October-December 1998.

                           

                                Hillstrom, Northern Lights

                                                            updated by Magee, ECDI

International Encyclopedia of the Social Sciences

Goodwill

Goodwill

Goodwill is the value placed on the expectation that the clients or customers of an established company will continue to patronize it out of habit or confidence in the conduct of its business. In practice it is simply the amount by which the price of a going concern exceeds the sum of fair values of all of its other net assets. In other words, it is the amount of money that may be paid to the owners of a business over and above the costs of merely buying the assets that the company uses.

The origin of the term lies in developments in accounting that accompanied the rise of the capital market in the second half of the nineteenth century. The easing of the establishment of joint stock companies during this period facilitated the purchase of many retail businesses, whose previous owners were paid for referring their previous customers to the business under new management or ownership. Goodwill came to be used to pay the existing owners of a company ’ s equity a price for their stock inflated above the value of any actual underlying assets by the more active capital markets of the late nineteenth century. The American political economist Thorstein Veblen regarded goodwill as reflecting competitive advantages, which a company may have and which may not be incorporated in the cost of assets. In the course of mergers and acquisitions, the value of a company ’ s stock comes to reflect its increasingly monopolistic market position. However, John Hobson and Alfred Marshall expressed a more common view in the first decades of the twentieth century that goodwill was used to exaggerate a company ’ s business prospects leading to the overcapitalization of that company. In this way financiers and company promoters profited at the expense of the investing public. Despite the relevance of these views, there was little discussion of them amid the inflated capital markets of the late twentieth century and early twenty-first century.

Goodwill purchased in the course of buying a company has wider implications because the cost of it is treated as a business expense. In the United States and Canada this expense is amortized against company earnings over a period of up to forty years. Because, after a company has been purchased, these amortization payments are purely bookkeeping transactions, it has been argued that the recording of these payments in the income and expenditure statement of a company makes that statement less clearly a reflection of actual business income and expenditure. In the United Kingdom an accounting standard in force since 1984 recommends that goodwill should “ normally ” be written off immediately after acquisition against the owners ’ equity or reserves. However, such immediate write-off can lead to extreme shifts in the “ leverage ” or gearing of a company (the ratio of its debt to equity). It is not unknown for such a write-off to result in negative owners ’ equity. Even before that arises, the sudden fall in the value of owners ’ equity may cause difficulty where a company has loan agreements that stipulate a maximum permissible leverage ratio. Such shifts in the value of owners ’ equity also affect the vulnerability of a company to takeover or even to reporting, as the London Stock Exchange obliges its companies to do, where the payment for a company represents 15 percent or more of the acquiring company ’ s equity.

Because business expenses reduce the tax liability of companies, the accounting treatment of goodwill — that is, whether and how it is amortized — may have significant tax implications for a company. Among service companies with limited scope for capital investments that may be set against tax over a period of years, goodwill may be an important factor in the tax planning of a company.

The significance of goodwill in corporate finance has been inflated by the proliferation of mergers and takeovers in active capital markets. The emergence of such markets in Europe and other parts of the world extends the geographical area where goodwill has fiscal and accounting importance.

SEE ALSO Bull and Bear Markets; Capital; Equity Markets; Financial Markets; Stock Exchanges; Veblen, Thorstein

BIBLIOGRAPHY

Daniell, Alfred. 1894 – 1899. Goodwill. In Dictionary of Political Economy. ed. Robert Harry Inglis Palgrave. London: Macmillan.

Financial Accounting Standards Board. 2001. Goodwill and Other Intangible Assets. Statement no. 142. Norwalk, CT.

Hughes, H. P. 1982. Goodwill in Accounting: A History of the Issues and Problems. Atlanta: College of Business Administration, Georgia State University.

Veblen, Thorstein. 1904. The Theory of Business Enterprise. New York: Scribner.

The Oxford Pocket Dictionary of Current English

Source: www.encyclopedia.com

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