- What is goodwill?
- Types of goodwill
- Accounting for goodwill in financial statements
- Key factors in accounting for goodwill
- The importance of goodwill in business
- Challenges associated with goodwill in business
- Distinguishing goodwill from other intangibles
What is goodwill?
Goodwill is a type of intangible asset that captures the excess value of an entity beyond its physical assets and liabilities. This excess value comes from elements like the entity’s brand reputation, loyal customer base, and the collective expertise of its employees. It plays a crucial role in assessing an entity’s total worth and can significantly influence its financial outcomes.
According to the principles outlined in AASB 136, when an entity acquires another business, the goodwill it recognises represents the anticipated future benefits from assets that were acquired during the business combination but are not individually identifiable or recognised separately.
Goodwill is unique because it does not produce cash flows by itself but enhances the cash flows from other assets or asset groups within the entity. It is often associated with several cash generating units within an entity because its benefits are not limited to a single unit and it cannot be attributed to specific units without some degree of arbitrariness.
Therefore, for management and monitoring purposes, goodwill is often considered at a broader level within the entity, including multiple cash generating units that benefit from its value, even though it is not directly assigned to them.
Types of goodwill
In the business world, goodwill reflects the extra value of an entity beyond its tangible assets and liabilities, and it primarily comes in two forms: purchased goodwill and inherent goodwill.
Purchased goodwill emerges during the acquisition of one entity by another. If the buying entity pays a price that exceeds the fair market value of the acquired entity’s net identifiable assets, this surplus is recognised as purchased goodwill.
This type of goodwill captures the value of intangible factors like the acquired entity’s brand reputation, loyal customer relationships, and intellectual property. It’s recorded as an intangible asset on the balance sheet of the acquiring entity and must undergo regular checks for any loss in value, known as impairment testing.
Inherent goodwill is the value an entity naturally accumulates through its own operations over time. This form of goodwill is built through the entity’s own efforts in establishing a strong reputation, a solid customer base, effective brand recognition, and other valuable intangible assets.
Unlike purchased goodwill, inherent goodwill is developed internally and is not the result of a specific business acquisition. It’s a reflection of the entity’s ability to generate future economic benefits thanks to its established position and operational strengths in the market.
Although both types of goodwill signify the intangible value that contributes to an entity’s overall worth, they differ in their origins purchased goodwill arises from external transactions, while inherent goodwill grows from within the entity. Each plays a critical role in understanding the full value of a business and its potential for future success.
Accounting for goodwill in financial statements
Goodwill, classified as an intangible asset, is documented on an entity’s balance sheet as an asset. The accounting process for goodwill includes determining its value, amortising it over its expected useful life, and conducting periodic impairment tests.
Gain from a bargain purchase
According to AASB 3, when one entity acquires another, it is important to accurately determine the value of the deal, which involves recognising goodwill or, in some cases, a gain from a bargain purchase.
To calculate goodwill, the excess is calculated as follows:
a. The sum of:
- The consideration given for the acquisition, typically measured at its fair value on the acquisition date.
- Any ownership interest (like shares) in the acquired entity not already owned by the acquiring entity.
- In cases where the acquisition happens in stages, the fair value of any ownership interest the acquiring entity already had in the acquired entity.
b. The net value of the identifiable assets gained and the liabilities.
In cases where both parties exchange only equity interests (like stocks or shares), and it is easier to determine the fair value of the equity interests held by the acquired entity, that value can be used instead of the fair value of the equity interests given up as part of the deal. This helps ensure a more accurate calculation of goodwill.
When no payment is involved in the business combination (i.e., it’s an all equity deal), the acquisition date fair value of the acquiring entity’s interest in the acquired entity is used instead of the consideration value mentioned in point (a) above.
Fair value measurements rely on market based inputs like stock prices or comparable market data to estimate the value of an asset or liability. These inputs are then employed to compute the fair value of the reporting unit and its assets, a critical step in impairment testing and various other accounting assessments.
Amortisation of goodwill
Once the value of goodwill is established, it is generally amortised over its anticipated useful life, representing the duration over which it is expected to provide economic benefits to the entity. This amortisation is recognised as an expense on the income statement and concurrently reduces the recorded value of goodwill on the balance sheet.
Key Factors in Accounting for Goodwill
Goodwill allocation and disposal
According to AASB 136, when an entity has allocated goodwill to a specific cash generating unit and decides to dispose of a part of that unit, the goodwill associated with the disposed operation must be included in the calculation of gain or loss on disposal.
The value of this goodwill should be determined based on the relative values of the disposed operation and the retained portion of the cash generating unit, unless a better method exists to reflect the goodwill’s value.
If an entity undergoes a reorganisation that changes the composition of cash generating units to which goodwill has been allocated, the goodwill must be reallocated to the affected units. This reallocation typically follows a relative value approach, unless a more suitable method is available to assess the goodwill’s value.
Testing for impairment
Impairment occurs when the market value of an asset falls below its historical cost. Various factors, such as increased competition, shifts in market dynamics, changing consumer habits, or technological advancements, can contribute to this decline. For example, consider the case of newspaper mastheads, which have diminished in value with the rise of social media.
To assess whether an impairment is necessary, entities typically conduct impairment tests, especially on intangible assets. Two common methods for testing impairments are the market comparison approach and the income approach.
Market Comparison Approach: This method involves analysing the assets of similar entities within the same industry to gauge whether an impairment is warranted.
Income Approach: Here, future estimated cash flows are discounted to their present value to determine if the asset’s value should be adjusted downward.
When an entity’s acquired net assets drop below their historical value, it means that the entity has overstated the amount of Goodwill on its balance sheet. To rectify this, a write down is performed to lower the asset’s value and reflect the impairment accurately.
The impairment expense is calculated as the difference between the current market value and the asset’s purchase price. Consequently, the impairment leads to a reduction in the Goodwill account on the balance sheet. The expense is then recognised as a loss on the income statement, which in turn decreases the net income for the year.
This decline in net income can impact financial metrics like EPS (Earnings Per Share) and may also affect the entity’s stock price negatively.
The importance of goodwill in business
Goodwill holds significant importance within a business as it embodies the intangible assets an entity has cultivated over time, encompassing aspects like its reputation, customer base, and brand recognition. It plays a pivotal role in both attracting and retaining customers, influencing their buying choices, and fostering loyalty.
Goodwill can exert a profound influence on an entity’s financial performance, affecting its capacity to generate revenue and profits.
Additionally, it carries substantial weight in business acquisitions, where it can substantially impact purchase prices and deal terms.
Challenges associated with goodwill in business
Although goodwill is a valuable asset for businesses, it also presents certain challenges, including:
Difficulty in Valuation: Valuing goodwill is a complex task due to its intangible nature, making it challenging to ascertain its precise value.
Subjectivity in Assessment: Determining the value of goodwill can be subjective, as it relies on factors like brand reputation and customer loyalty, which are often hard to quantify objectively.
Impact of Market Dynamics: Goodwill is susceptible to changes in market conditions, including economic fluctuations, shifts in consumer preferences, and the emergence of new competitors, which can affect its value.
Risk of Impairment: Goodwill is subject to impairment testing, meaning a business may need to reduce its recorded value if impairment is detected, resulting in a loss for the business.
Regulatory Compliance: Entities must adhere to accounting standards and regulations related to goodwill, which can be intricate and demand substantial resources for proper management and compliance.
Thus, while goodwill serves as a valuable asset for businesses, it necessitates diligent oversight and monitoring to ensure its ongoing value and relevance in the long term.
Distinguishing goodwill from other intangibles
Goodwill and other intangible assets are distinct concepts. Goodwill represents a premium paid above the fair value in a transaction and cannot be bought or sold independently. On the contrary, other intangible assets, such as licences, can be acquired or sold separately from a business.
Furthermore, Goodwill is often considered to have an indefinite life, while other intangible assets are typically recognised to have a finite useful life. This distinction underlines the fundamental differences between these two types of assets in the realm of accounting and finance.
This article is general information only and does not provide advice to address your personal circumstances. To make an informed decision you should contact an appropriately qualified professional.