When companies acquire other companies but pay in excess of the fair market value of the assets and liabilities acquired, the excess of the purchase price over the fair value of the assets and liabilities is accounted for (or “allocated to”) a purely conceptual asset called goodwill.
Goodwill is the amount by which the purchase price for a company exceeds its fair market value (FMV), representing the intangible value unaccounted for in other assets stemming from the acquired (like the company’s business name, customer relations, employee morale, etc.). It is important to remember that goodwill is created (Exhibit 6.9) only after all identifiable physical and intangible assets (patents, licenses) have been assigned fair market value.
Big-Time Acquires Johnny’s InteriorsThe fair market value of a local New York furniture company, Johnny’s Interiors, is determined to be $5 million in 2007. A national furniture company, Big-Time Furniture, believes that under its proven management and expertise, Johnny’s Interiors would be worth much more than the fair market value (FMV) implies and thus decides to acquire Johnny’s Interiors for $8 million, $3 million above the fair market value. The $3 million Big-Time paid above the FMV is recorded as goodwill on its balance sheet. |
Basic Principles Revisited: Goodwill and ConservatismGoodwill can only be written down, not up: If Big-Time Furniture determines that the asset (Johnny’s Interiors) is worth more than the original purchase price, it cannot increase the amount of goodwill on its balance sheet, inline with the conservatism principle. |
Before December 15, 2001, goodwill on the balance sheet was amortized on the income statement.
After December 15, 2001, under a FASB ruling (SFAS 142), goodwill is no longer amortized on the income statement. Instead, the acquired assets that had generated goodwill need to be periodically (annually) tested for impairment (loss of value).
If an asset is determined to be impaired, the goodwill is adjusted down to better reflect current market value (goodwill write-down). Write-downs are expensed through the income statement (noncash expense as there is no real impact on cash).
FAS 142 established a two-step process to determine goodwill impairment:
Impairment test. Comparison must take place between the fair value and the book value of the segment including goodwill. If the fair value is less than the book value, impairment of goodwill has occurred and its amount must be measured (step 2).
Measurement of goodwill impairment. Goodwill impairment equals the difference between the book value of goodwill and its implied fair market value. Goodwill’s fair market cannot be directly measured, and must instead be implied. It amounts to a residual value after allocating fair value to all other assets of the segment.
Goodwill impairments and subsequent write-downs imply that companies over-paid for assets. Two notable cases of goodwill impairments shocked many investors (and confirmed the suspicions of others) when AOL Time Warner recorded a substantial goodwill impairment following the merger of the two companies, while Vodafone announced a similar impairment following its acquisition of Mannesmann in 2000.
In the Real World: AOL’s $100 Billion Goodwill Impairment
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In the Real World: Vodafone—Following AOL’s Lead?
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