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Goodwill represents the difference between the price paid by one firm to purchase another corporation in excess of the book value of the acquired company. Assume, for instance, that firm A agrees to buy firm B at a price of $10 million. However, the total shareholder equity of firm B equals only $7 million. The $3 million difference must be accounted for, as otherwise the balance sheet of the acquirer will show a mismatch between debit and credit entries. This $3 million will be entered into firm A's balance sheet as goodwill.
Once goodwill has been recorded in the firm's balance sheet, it can be amortized. In other words, its value can be reduced until the goodwill in the balance sheet completely disappears. The amortization, or the amount by which goodwill is decreased in the balance sheet, is recorded as an expense. The idea is that the acquiring firm has incurred an expense by paying more for the firm than the value of its assets, and this expense, equal to the goodwill, can be reflected in income statements over subsequent years. If the acquisition is strategically successful, the extra income generated from the acquired firm should more than make up for the amortization
While goodwill impairment will reduce the firm's tax bill, the precise impact of goodwill on tax liabilities is a complex issue. In certain cases, tax law requires the acquirer to increase the cost basis, or book value, of other assets acquired when purchasing the target firm. This treatment will reduce the firm's tax bill as well, since a higher value placed on tangible assets will eventually reduce taxable income as those assets depreciate.
In other instances, the firm can directly amortize goodwill to reduce its tax bill. In most cases, only a tax expert can determine the appropriate treatment to be used for amortization of goodwill.
Reason for Goodwill
While some acquisitions may occur at a price below book value, and therefore involve no goodwill, in most cases the acquirer pays above the book value of the acquired firm and incurs a significant amount of goodwill. This is because companies that are worth acquiring are usually worth more than their book value, which equals the value of their assets, minus the sum of their debt. Even firms in distress and on the verge of bankruptcy tend to have patents or a brand name or other intangible assets and usually change hands above book value.