Goodwill

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.

Exhibit 6.9. Goodwill Represents the Excess of the Purchase Price for a Company Over its Fair Market Value
Source: Used with permission. Microsoft 2005 Annual Report.

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Big-Time Acquires Johnny’s Interiors

The 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 Conservatism

Goodwill 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.


Goodwill Then (Amortizable Until December 2001) ...

Before December 15, 2001, goodwill on the balance sheet was amortized on the income statement.

. . . and Now (Annual Impairment Tests)

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:

  1. 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).

  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 Impairment: Big-Time Furniture

Step.
1: Impairment Test

  • A year after acquiring Johnny’s Interiors for $8m (including $3m of goodwill), Big-Time Furniture has determined that the fair market value (FMV) of Johnny’s Interiors is now $6m.

  • Since FMV of $6m is less than the book (acquisition) value of $8m, Big-Time must measure the amount of goodwill impairment that has occurred.

Step.
2: Measurement of GW Impairment

  • Big-Time allocates fair value to all assets (excluding goodwill) of Johnny’s Interiors and determines it to be $5m.

  • Since FMV of all assets (including goodwill) was estimated to be $6m (Step 1), and the FMV of all assets (excluding goodwill) was determined to be $5m, the residual $1m value is the new FMV of goodwill.

  • Goodwill has been impaired by $2m (from its original value of $3m at the time of the acquisition to its current FMV of $1m).


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

  • In January 2001, AOL merged with Time Warner in a $147 billion transaction.

  • As part of the transaction, the company recorded goodwill (the difference between the purchase price and the fair market value of Time Warner’s assets) of over $100 billion.

  • At the end of 2001, the company performed a two-step goodwill impairment test, inline with the procedure outlined on the previous page, and determined that the value of goodwill had decreased.

  • As a result of this goodwill impairment test, AOL recorded an initial goodwill impairment of $54.2 billion during the first quarter of 2002.

  • The company performed another goodwill impairment test during 2002 and determined that the value of goodwill had declined again.

  • As a result, AOL announced an additional goodwill impairment charge of $45.5 billion during the fourth quarter of the 2002.

  • Most of this $100 billion write-down announced during 2002 stemmed from the Time Warner transaction.


In the Real World: Vodafone—Following AOL’s Lead?

  • In February 2000, Vodafone, now the world’s largest mobile phone operator, acquired Mannesmann in a £101 billion transaction.

  • As part of the transaction, the company recorded goodwill of over £83 billion.

  • Vodafone performed a goodwill impairment test at the end of 2005 and determined that the value of goodwill had declined.

  • As a result, the company announced that it would take a goodwill impairment charge of £23 to £28 billion on February 27, 2006.

  • In its announcement, Vodafone acknowledged that most of the goodwill impairment charge stems from the Mannesmann transaction.


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