By Odhiambo Ocholla
Determining a reasonable goodwill figure for a company’s balance sheet is no easy task.
There is no universal rule on how to figure out goodwill, which adds value to the company. Goodwill is essentially the amount of the asking price for a company over and above its tangible net worth.
Goodwill is an intangible asset on the balance sheet that is used to value a strong brand name, good customer relations, good employee relations, patents, and proprietary technology.
Goodwill arrives on the balance sheet when a firm acquires another for more than the book value of assets acquired.
When a company pays more than the book value for a company, the difference between the price paid and the book value of the assets is classified as goodwill.
Financial Accounting Standards Board defines how to treat goodwill.
The rules require that companies are to assess goodwill for impairment at least annually.
If goodwill is deemed to be impaired, its carrying amount is reduced and an impairment loss is recognised on the income statement.
This means that the amount spent for an acquisition is no longer worth what was paid.
The goodwill is tested at least annually to determine if the recorded value of the goodwill is greater than the fair value.
If the fair value is less than the carrying value, the goodwill is said to be "impaired" and must be charged off.
This reduces the value of the goodwill on the balance sheet to the fair market value.
This is a just like a mark-to-market charge for financial assets only it is for goodwill.
If the goodwill impairment charge is sufficiently large, it can cause the company to report a significant earnings loss.
As every company will point out, goodwill impairment does not involve a loss of cash.
Due to the current economic slowdown and bear market, every company will need to pay greater attention to its annual goodwill impairment test.
How is goodwill accounted for?
In the accounting sense, Goodwill can be thought of as a "premium" for buying a business.
When a company buys another company, they can use one of two accounting methods: pooling of interest or purchase.
When the pooling of interest method is used, the balance sheets of the two businesses are combined and no goodwill is created.
When the purchase method is used, the acquiring company will put the premium they paid for the other company on their balance sheet under the "Goodwill" category.
Accounting rules require the goodwill be amortised over the course of 40 years.
Goodwill is shown under intangible fixed assets of the new group’s balance sheet at an amount equal to the difference between the acquisition price and the share of the new subsidiary’s equity adjusted for unrealised capital gains net of unrealised capital losses on assets and liabilities.
Assets, liabilities and equity of the new subsidiary are transferred to the group’s balance sheet at their estimated value rather than their book value.
In this case, the intangible assets acquired are recorded on the group’s balance sheet even if they did not originally appear on the acquired company’s balance sheet.
Goodwill is assessed each year to verify whether its value is at least equal to its net book value as shown on the group’s balance sheet. If the market value of goodwill is below its book value, goodwill is written down to its fair market value and a corresponding impairment loss is recorded in the income statement.
What this means to investors
While these write-downs do not involve a change in cash, they cause loss of reported earnings, reduction of equity and assets.
Goodwill write-downs raise several questions for investors. In addition, impairment charges reduce a company’s equity levels that might trigger technical loan defaults. Granted, goodwill impairment losses are a non-cash item.
Recognising the impairment of goodwill related to a past acquisition is tantamount to admitting that the price paid was too high. In most instances, goodwill is considered only when a company is being sold.
Even though a strategic location, an impeccable reputation, or a superior product may create goodwill, it is usually not recorded by a company on its financial statements.
The writer work with Sterling Investment [email protected]