| Goodwill accounting is required when a company pays a premium over the book value of another company. The purchasing company then records goodwill as an intangible asset on the balance sheet at its historical cost. |
For example, on November 14, 2007 when Luxottica Group finalized the purchase of Oakley Sunglasses, the total price paid was approximately $2.1 billion. Luxottica acquired approximately $1.5 billion in assets and assumed $729 million in liabilities for a difference of $784 million.
If Luxottica paid $2.1 billion for $784 million in net assets (total assets – total liabilities), what accounts for the difference? The premium Luxottica paid for Oakley in excess of the appraised value of its net assets, or book value, is called goodwill.
Goodwill Accounting Illustrated
| Transaction: | Amount Paid in Acquisition (thousands): |
| Assets Acquired | $1,512,727 |
| Liabilities Assumed | $728,718 |
| Fair Value of Net Assets | $784,009 |
| Total Purchase Price | $2,110,211 |
| Goodwill | $1,326,202 |
Following the accounting equation:
| Assets – Liabilities = Owner’s Equity (Net Assets) |
Net Assets
| Assets Acquired | – Liabilities Assumed | = Net Assets |
| $1,512,727 | – $728,718 | = $784,009 |
Purchase Price – Net Assets = Goodwill
| Total Purchase | – Net Assets | = Goodwill |
| $2,110,211 | – $784,009 | = $1,326,202 |
In this example, because the total purchase price was $2,110,211, and net assets totaled $784,009, the difference between the purchase price and net assets is applied to goodwill in the amount of $1,326,202.
Goodwill Accounting Attempts to Capture the Intangible Benefits of the Company Acquired
This raises the question: why would a company pay more than the appraised value of a company’s total net assets? Goodwill represents favorable characteristics of a company that are intangible and not easily measured by a mere listing of its assets.
Rather, there is a greater aspect of the business that is represented in, for example, its reputation, a superior product, customer loyalty, superior management, or other favorable characteristics that go beyond the collection of assets listed on the balance sheet.
The Oakley name represents a superior brand and technological innovation in sports sunglasses. Luxottica not only purchased Oakley’s net assets, but it purchased its brand name and superior reputation and technology for which it paid a premium of $1.3 billion. Goodwill accounting attempts to capture this benefit as an intangible asset on the balance sheet.
Goodwill Impairment
Similar to land, goodwill remains on the balance sheet at its historical cost for years, and is not depreciated or amortized, but subject to an annual goodwill impairment test.
Goodwill is impaired if the implied value drops below the carrying value on the balance sheet. Examples of goodwill impairment are loss of key personnel, significant adverse changes in the business climate, and unanticipated competition.
Goodwill Accounting Requires a Test for Goodwill Impairment Annually
| Goodwill is an intangible asset recorded at historical cost on the balance sheet at the time of acquisition.Similar to land, it is not depreciated or amortized, but tested for goodwill impairment annually. |
Since the amount of goodwill depends on the total purchase price of a company in comparison to the appraised value of its listed assets, it is subject to judgment and opinion of a company’s total worth at the time of purchase.
A significant share recorded may simply mean a company paid too much for the acquisition. This can occur during “merger manias” and bubbles, when for example dot coms paid a premium for other companies when stocks were overvalued, and during the most recent banking crisis when banks aggressively acquired other companies, most notably mortgage companies, for faster growth before the housing bust and the writing down of bad assets.
Recent Examples of Goodwill Impairment:
In 2008, goodwill accounting charges picked up as the economy deteriorated from the housing crisis:
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Goodwill is often misunderstood, difficult to define due to its abstract nature, and often considered a paper entry or accounting filler to account for the difference between the purchase price and the company’s net assets. Nonetheless, goodwill does represent real resources utilized during an acquisition, and thus goodwill impairments represent real costs to a company that may have misused resources at the time of acquisition.
Other acquisitions may represent a premium paid for superior products or other competitive advantages not easily measured or defined from a listing of its assets, but rewarded with future growth and earnings.
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