When someone says “goodwill,” you probably associate that word with your local charity-run thrift store. However, in the accounting world, goodwill means something else entirely. Goodwill is an asset resulting from the purchase of a company. Goodwill must be maintained, and learning the rules is a smart place to begin.
When a company is purchased by another company, the difference between the purchase price and the book value of the purchased company is called goodwill. Goodwill is considered an intangible asset, meaning that is has no physical attributes. Being an asset, goodwill is recorded on the balance sheet of a company’s financial statements.
Prior to 2001, companies amortized the goodwill intangible asset by recording an expense on the income statement each year. Goodwill was taken at straight-line amortization over a period of up to 40 years. For example, if Company A purchased Company B for $450,000 (i.e., purchase price) and the book value of Company B was only $400,000, the goodwill intangible asset would be $50,000. The $50,000 asset would be amortized for the same amount each year for up to 40 years. If you assume that Company A decided to amortize the goodwill amount over 40 years, then the amortization expense listed on the income statement is $1,250 annually (i.e., $50,000 divided by 40 years).
In June 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) 142, titled “Goodwill and Other Intangible Assets.” Under this statement, amortizing goodwill ceased entirely. Now, instead of amortizing, goodwill must be tested annually for impairment. Basically, the company must determine whether the value of this intangible asset has decreased based on market factors. If goodwill has decreased, the company must write down the amount of goodwill on the balance sheet. This decrease in the asset value of goodwill is done by entering a goodwill expense on the income statement.
To test goodwill for impairment, the company must assess the fair value of the reporting unit. When Company A purchases Company B, Company B becomes a reporting unit to Company A. So, Company A must determine the fair value of Company B. This must be done yearly. If the fair value of Company B is less than its book value, then Company A may need to decrease its goodwill asset. Company A must now do a calculation to determine what portion of the overall fair value of Company B should be allocated to the goodwill asset. If the portion of fair value that applies to goodwill is less than the goodwill asset amount, Company A must decrease its asset to match the fair value allocated amount.