Goodwill: basics, understand, interpret and book

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Introduction

All about Goodwill! This post is part of our accounting education series. Finance and accounting, just like taxes, are all around us. To add, it surrounds us like the air we breathe. Finance, accounting, and taxes touch our lives. Like death, we cannot escape them. Ignoring these topics in your life is like ignoring that a cup of tea is hot. At one point, it will burn and burn it will. This is especially true for entrepreneurs and investors. No matter what business you engage in, a sound knowledge of at least the basic principles of finance, accounting and taxes is simply a must. Why let other people do the understanding for you?

What is Goodwill

Goodwill is a position in our Consolidated Balance Sheets (BS) that stem from an acquisition of another company (the target), at a price higher than the target’s net identifiable assets. Now, there are multiple reasons for buying something for more than its net worth. Those can be that the target company has a great customer base, secret formulas, specialized know-how, very important technologies or patents or expected synergies expected to increase income potential of the buying company. We do generally assume that there are no bad reasons for overpaying for a company. An if so, consequences are usually harsh, as Goodwill needs to be impaired. Inventors generally don’t like impairments!

Capitalization

A Goodwill is usually capitalized instead of being an expense. A capitalize transaction shows in the BS. An expense shows in the Income Statement (IS). Capitalization happens if future economic benefits are expected, if not, well, the investment will be more like an expense.

Intangible asset

Goodwill is deemed to be an intangible asset. It is a company attribute that cannot be inspected manually. Generally, Goodwill is recorded during the Consolidation Process of the parent company (the one who acquired). Goodwill stays in the Consolidated BS unless it turns out to be less or of no value at all. At which point, it is to be revalued. This is called impairment. A subsequent increase in Goodwill more than it originally was valued for is not allowed in most GAAP (Generally Accepted Accounting Principles).

Impairment

A yearly assessment of a possible impairment is usually required. Note that we speak of assessment. This means that a formal analysis needs to be performed and documented. The assessment answers the question: have there been indications leading us to believe that our Goodwill is of less value. As an example: the reason for a premium payment (Goodwill) during an acquisition of a target was one large customer. That same customer subsequently terminated business contract, and it is uncertain if that customer can be won back. Now if this is not an indication, huh? Most of the time, it is more of an art looking for those indications.

Negative Goodwill

This happens if an acquiring company gets to buy the target at a bargain. Less money was paid for the existing net assets of the target. Negative Goodwill mostly is usually recorded as an income right away.

To sum up

In conclusion, Goodwill does not undergo a regular amortization or depreciation as we know it with Property, Plant & Equipment. In addition, Goodwill is usually capped at the value it was computed during the acquisition and can only lose value through impairment.

Let’s get advanced

We will now go into a scenario that shows how Goodwill is computed and recorded. As we are covering the “basic understanding” of Goodwill, we will not go into the more advanced topics such as the difference between Merger & Consolidation in Accounting, subsequent development of PPA (Purchase Price Allocation) computation, consolidation process, minority Interest, partial acquisitions or subsequent impairment entries. This shall be subject to more advanced topics.

How to compute Goodwill

We assume a full acquisition, meaning that after all the negotiations, the target will belong to 100% to the acquiring company. Target will become the subsidiary of the acquiring company, now being the mother company of target. In a perfect world, Goodwill is the excess of cash paid and the net assets of the target. Net assets are Assets fewer Liabilities or simply Equity. All amount are in USD ($).

Basic Goodwill Formula
Basic Goodwill Formula

PPA

Yet, no one just sells or buys without negotiating. And negotiate you shall! We follow up on our table above and assume that after intense negotiations, both parties agree that some of the assets of the target are not quite fairly valued. Here is where a PPA (Purchase Price Allocation) has to be performed first in order to determine Goodwill.

A PPA is when a company is revalued to reflect the fair market value of its assets and liabilities. The purchase price the then allocated first to the revalued amounts. Hence, this will ensure proper determination of Goodwill.

PPA and Goodwill.
PPA and Goodwill.

A note: equity = net assets;

In our scenario, we can see that Goodwill is computed to be $200 (6,000 – 5,800) after the PPA.

Next steps

We now bought our target, performed a PPA and computed for our Goodwill. Consequently, how will this appear on the books of the acquiring company and the target?

Target books

Assuming that the target still exists as a separate legal entity, the action they can do is correct their books based on new knowledge acquired during the PPE process, if in fact, these are relevant for the individual Financial Statement (FS) of the target. For example, the Accounts Receivables experienced an impairment of $200. Should this be corrected in target books? Also, the target will need to provide the new parent company with their FS and additional information to allow the parent company to prepare consolidated FS.

That´s the least worse thing that can happen to target. More likely, long and complex harmonization projects are started within all major processes, from accounting to sales to production. This is to create synergies for the parent and/or target. There must have been some reason for the Goodwill, after all, right?

Books of the parent

Initially, the individual books of the mother company will show the investment in subsidiary for $6,000.  Thus, the parent booked the acquisition as follows:

Dr. Investment in Subsidiary $6,000
Cr. Cash / whatever consideration was given $6,000
To record subsidiary acquisition for $6,000.

Let’s assume the books to look like below right after the acquisition of the target company:

Parent FS before consolidation & goodwill.
Parent FS before consolidation & goodwill.

Note that no Goodwill can be seen yet.

Consolidated FS

To truly show the economic extent of the parent, a parent company is usually “required” to show consolidated FS. It is in the process of consolidating the books of parent and subsidiary that the Goodwill reappears. Consolidated FS show parent and subsidiaries to be one company or better yet, one economic unit. That is the very essence of it. Below, we show a simplified consolidation process worksheet.

100% consolidation with Goodwill
100% consolidation with Goodwill

Note 1.

The investment in the subsidiary is the amount parent paid for and shows in the parents individual FS. In the consolidated FS, the Investment does not exist, as one cannot invest in oneself.

Note 2.

Goodwill is recorded in the consolidated column.

Note 3.

Equity shows that of the parent company. Note that net assets (equity) did not change after the consolidation.

Finally, all the other assets and liabilities of parent and subsidiary are summed together.

Journal Entries (correcting and elimination)

Lastly, here the entries made to perform the consolidation (Dr. stands for Debit and Cr. for Credit).

  1. The above numbers of the subsidiary already show the numbers according to the revaluation performed during PPE. In true life, however, we would usually get the pre-PPE numbers. So, we book the PPE revaluation.

Dr. Inventory $500
Cr. Accounts Receivables $200
Cr. Subsidiary equity $300
To book PPE.

  1. Now, to eliminate investment and subsidiary equity.

Dr. Equity of Subsidiary $5,800
Dr. Goodwill $200
Cr. Investment in Subsidiary $6,000
To book equity elimination of subsidiary.

  1. At last, record subsidiary assets (after PPE and Goodwill).

Dr. Cash $500
Dr. Accounts Receivables $1,800
Dr. Inventory 5,500
Cr. Liabilities 2,000
Cr. Equity of Subsidiary 5,800
To record net assets of the subsidiary.

Note, the account “Equity of Subsidiary” was debited in journal entry number 2 for $5,800 and credited in journal entry no. 3 for $5,800. The account is now at null and; thus, has been eliminated.

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