Accounting is a system of valuations and estimates. Numerous valuation methodologies are used to estimate the value of assets, liabilities, expenses and cash flows over time. When a company buys another company, goodwill generally arises. Goodwill is the value of intangible assets in the acquiring company. In 2002, it became a requirement to assess the value of goodwill every year. If the value of goodwill falls, a noncash charge for the impairment of goodwill should be recorded.
The balance sheet is made up of assets, liabilities and stockholders' equity. The balance sheet equation is assets equals liabilities plus stockholders' equity. Likewise, the difference between assets and liabilities is considered stockholders' equity, or book value. This number represents the value of assets held by the firm over and above its liabilities. Goodwill is defined as the amount paid for a firm that is over and above book value.
For example, say a firm worth $10 million purchases another firm, with a book value of $5 million, for $15 million. The amount paid over book value is $10 million -- this is considered goodwill. Even if the acquiring company simply paid too much for the firm, the extra amount is still considered goodwill, which illustrates how much the concept of goodwill is left open to interpretation as estimates and valuations are provided by accountants.
When the value of goodwill goes down, it is generally due to decreased brand value, negative market information about he company or the need to adjust for overpaying for the company. Before 2002, goodwill was amortized on the balance sheet -- like a patent, or copyright. Now, if the value declines, an impairment charge is recorded and results in a decrease to net income and earnings.
It is important to note that a write-off to goodwill does not hurt cash flows. It, like other write-offs, is a noncash transaction that decreases net income for the time period, but has no effect on cash flows. In this way, it can't hurt the business from a liquidity perspective, but a decrease in equity may trigger covenants attached to bank loans.
